Auditing

Army Lawyer, Jan-Feb, 2003

GAO Revises Auditor Independence Standard

With accounting scandals dominating headlines, the General Accounting Office (GAO) has revised the independence standard set forth in its publication, Government Auditing Standards, also known as the Yellow Book. (1) The January 2002 revision is part of a complete and ongoing overhaul of the Yellow Book. (2) The change, although not prompted by the most recent scandals, certainly will address them. As the Comptroller General noted in releasing guidance concerning the standard, "recent private sector accounting and reporting scandals have served to re-enforce the critical importance of having tough but fair auditor independence standards to protect the public and [e]nsure the credibility of the auditing profession." (3)

The independence standard is one of several legally binding professional requirements at the core of the accounting profession. These requirements range from those dealing with auditors' professional qualifications to the quality of audit efforts and characteristics of audit reports. (4) The Yellow Book specifies the standards applicable to audits of government organizations and functions; (5) its formulation of the independence standard provides that "in all matters relating to the audit work, the audit organization and the individual auditor, whether government or public, should be free both in fact and appearance from personal, external, and organizational impairments to independence." (6)

Amendment 3 covers a range of auditor independence issues, including the three general classes of independence "impairments"--personal, external, and organizational. Generally, the standard requires that auditors decline engagements when impairments would affect the auditor's capability to perform work and report results impartially, and exhorts auditors to avoid situations that "could lead reasonable third parties with knowledge of the relevant facts and circumstances to conclude that the auditor is not able to maintain independence." (7) In those situations in which the government auditor cannot decline because of legislative or other requirements, the auditor must report those impairments. The standard also requires audit organizations to establish policies to identify, avoid, and where necessary, mitigate impairments. (8)

The most significant change in Amendment 3 relates to non-audit services. Auditors perform a variety of services, including audit and non-audit services. Non-audit services need not comply with the Yellow Book, and are often referred to as management advisory services. Non-audit services include gathering or explaining information and providing technical advice. Often, these services also involve gathering questions for a hearing, preparing reports from unverified or verified data, developing audit methods and plans, and providing advice concerning information systems and controls. Non-audit services differ from audit services in that they either directly support an entity's operations, such as processing payroll or developing internal controls, or do not involve the verification or evaluation of management-provided data. The concern addressed by Amendment 3 is that non-audit engagements might impair an audit organization's independence if it becomes necessary to audit data or systems created, designed, or administered pursuant to a non-audit engagement in which the organization participated. (9)

To avoid these "impairments" to independence, Amendment 3 provides a principle-based threshold test, supplemented with a few safeguards. (10) The new standard is based on two overarching principles: (1) auditors should not perform management functions or make management decisions; and (2) auditors should not audit their own work or provide non-audit services in situations where the amounts or services involved are significant or material to the subject matter of the audit. (11) If an auditor or audit organization cannot be certain that a proposed engagement passes that test, the auditor or organization may not accept the engagement. If the engagement passes this principles test, certain supplemental safeguards, designed to ensure that there is no conflict or misunderstanding arising out of the non-audit engagement, must also be observed. (12)

The new standard expressly prohibits auditors from providing certain bookkeeping or record-keeping services, and limits payroll processing and certain other services, all of which are presently permitted under auditing standards of the American Institute of Certified Public Accountants (AICPA). (13) At the same time, the standard permits auditors to provide routine advice and answer technical questions without violating the two overarching principles or having to meet the supplemental safeguards. The standard also provides examples of how certain services would be treated under the new rules. (14)

Following the issuance of Amendment 3, a host of questions arose concerning its timing and implementation. The GAO considered these questions to be so substantial that it extended Amendment 3's effective date from 1 October 2002 to 1 January 2003. Similarly, the GAO grandfathered any non-audit services that were initiated, agreed to, or performed by 30 June 2002, provided that the non-audit services were completed by 30 June 2003.