It is no surprise that independence is required of a CPA performing Yellow Book audits, but what does surprise many CPAs is how directly the GAO addresses one bad habit that CPA’s continue to engage in.
And that bad habit is creating the financial statements and then turning around and auditing them.
I hate the GAO!
I was teaching government auditing standards for a group of CPA’s in public practice in Oklahoma a few years ago. During the break, one of the auditors approached me and complained, “ I hate the GAO! They make me lie all the time.”
And I laughed. I knew exactly what he was talking about, but no one had ever phrased their disdain for the GAO’s independence standards that way before.
No one had ever – flat out – admitted that they lied about complying with the standards in order to continue doing what they wanted or felt like they needed to do. And he wasn’t ashamed of his choice at all! He said it loudly and proudly for everyone in the hotel lobby to hear.
This CPA audited small governments and nonprofits, and the clients expected him to both create and audit the financial statements. There is no way that these small entities could create their own financial statements, because they didn’t have the expertise, and they didn’t want to pay for what they thought was one service (clean, audited financial statements) twice. So, he had been satisfying his clients’ expectations for decades and the GAO wasn’t going to get in the way of him making a living.
But, what he didn’t realize is that he was playing with fire. He really wasn’t a good judge of his own work and grantors and the public were relying on those financials to make decisions. If he missed something (and auditors often do!) and he got sued, he would lose his license and his business.
The GAO has always been squishy regarding this issue
The GAO, in order to slow auditors down and make them think before damaging their credibility and independence, requires auditors to document their thought process when it comes to deciding whether they can both create and audit the financial statements.
Strangely, the GAO has never put its foot down to unequivocally prohibit an auditor from both creating and auditing the financial statements. I have never understood the GAO’s position on this, as I think it would be better for everyone involved if they would just say, “NO!” once and for all.
Instead, they require the auditor to document their answer to a series of pointed questions that the GAO hopes will change the auditor’s mind about allowing the auditee’s cheapness and incapacity to compromise the auditor’s integrity, objectivity and independence:
Question 1: Is your independence threatened?
Obviously creating the subject matter that you are auditing is a management participation threat to your independence.
Question 2: Is this threat significant?
In 2018, the GAO answered this question for auditors:
3.88 Auditors should conclude that preparing financial statements in their entirety from client-provided trail balance or underlying accounting records creates significant threats to auditors’ independence, and should document the threat and safeguards applied to eliminate and reduce threats to an acceptable level in accordance with paragraph 3.33 or decline to provide the services.
That paragraph essentially takes away the judgment from the auditor, and makes it obvious that safeguards need to be applied to protect the auditor’s independence.
Question 3: Since the threat is significant, what safeguards will you put in place?
Here are some options.
3.50 Examples of safeguards include:
a. consulting an independent third party, such as a professional organization, a professional regulatory body, or another auditor to discuss engagement issues or assess issues that are highly technical or that require significant judgment;
b. involving another audit organization to perform or re-perform part of the engagement;
c. having an auditor who was not a member of the engagement team review the work performed; and
d. removing an auditor from an engagement team when that auditor’s financial or other interests or relationships pose a threat to independence.
Question #4: Still feel like proceeding? OK, but only if the auditee will be able to tell if you made a mistake in your work. Can they tell?
In other words, does the client have SKE? SKE stands for skills, knowledge, and experience. Here’s a relevant quote from the Yellow Book.
3.73 Before auditors agree to provide nonaudit services to an audited entity that the audited entity’s management requested and that could create a threat to independence, either by themselves or in aggregate with other nonaudit services provided, with respect to any GAGAS engagement they conduct, auditors should determine that the audited entity has designated an individual who possesses suitable skill, knowledge, or experience and that the individual understands the services to be provided sufficiently to oversee them.
3.79 A critical component of determining whether a threat to independence exists is consideration of management’s ability to effectively oversee the nonaudit service to be provided. Although the responsible individual in management is required to have sufficient expertise to oversee the nonaudit services, management is not required to possess the expertise to perform or re-perform the services. However, indicators of management’s ability to effectively oversee the nonaudit service include management’s ability to determine the reasonableness of the results of the nonaudit services provided and to recognize a material error, omission, or misstatement in the results of the nonaudit services provided.
This is where the CPA in Oklahoma had to lay it on thick, because he knew that the entities he was working with did not have SKE.
Question #5: Did you come to an agreement with the client that they are responsible for the subject matter?
Again, I’m sure that this CPA had a convenient checklist that he filled out that stated that the client accepted responsibility for the subject matter. Another dangerous little lie. I mean, how can an infant take responsibility for paying your mortgage?
So what is the big deal?
If you’re wondering what the big deal is about both creating and auditing the financial statements, please watch All the Queens Horses, a movie about how a small town accounting clerk stole millions while the auditors collected significant audit and consulting fees.
Bottom line? Independence is required of a CPA performing Yellow Book audits and the GAO makes auditors document their thought process regarding independence in the hopes that CPA’s will decide not to both create and audit the financial statements.
Want to know more about auditor independence? Check out the Yellow Book Standards for Financial Auditors Bundle.
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