Office of the Chief Accountant:
Letter to Florida Institute of Certified Public Accountants
March 4, 2002
Patrick F. Gannon, Chairman
Florida Institute of Certified Public Accountants
2699 South Bayshore Drive, Suite 400
Miami, Florida 33133
Dear Mr. Gannon:
We welcome the interest of the Florida Institute of Certified Public Accountants to understand and convey to its members the Securities and Exhange Commission rules on auditor independence as they relate to bookkeeping services. As you are aware, the prohibition against bookkeeping services has long been part of the Commission's interpretive guidance related to auditor independence as provided in Rule 2-01 of Regulation S-X ("Rule 2-01"). This interpretive guidance may be found in Section 600 of the Codification of Financial Reporting Policies ("Codification"). The recent auditor independence rulemaking initiative has generated a heightened awareness of certain issues, including the provision of bookkeeping services.
The responses to the questions presented in this letter are interpretations of the Staff and do not necessarily reflect the views of the Commission. These interpretations are offered in an effort to provide guidance and answer the specific questions posited. As a matter of convenience and reference, the questions have been reproduced below in italics followed by the Staff's interpretive response.
1. If an auditor performs the mechanical function of converting a client's trial balance into annual or interim financial statements (i.e., balance sheet, income statement, statement of stockholders' equity, and statement of cash flows), will the auditor's independence from the client be considered to be impaired?
The answer depends on the auditor's degree of participation. Rule 2-01(c)(4)(i)(A)(2) precludes the auditor from preparing a client's financial statements that are filed with the Commission or form the basis of financial statements filed with the Commission. As stated in SEC Release No. 33-7919, "...keeping the books is a management function, the performance of which leads to an inappropriate mutuality of interests between the auditor and the audit client." By performing such services for an audit client, the auditor is placed in the position of auditing its own work. Further, the Codification states that when the auditor exercises judgment in the determination of appropriate principles and methods applicable to recording, classification and presentation of financial data, he or she cannot subsequently evaluate such judgments on an impartial and objective basis. Preparing financial statements that are in accordance with Generally Accepted Accounting Principles is the responsibility of management and the auditor's responsibility is to provide an unbiased and objective examination of this product culminating in the issuance of an opinion on the financial statements taken as a whole.
Notwithstanding this prohibition, as stated in the Frequently Asked Questions document issued by the SEC's Office of the Chief Accountant which was quoted in your letter of December 19, 2001, an auditor is not necessarily precluded from assisting a client with preparing financial statements. While the distinction between rendering professional advice and assuming a managerial role is subtle and may sometimes be unclear, the Commission has provided a framework that may be utilized in making this determination. In the Codification, the Commission stated, "managerial responsibility begins when the accountant becomes or appears to become, so identified with the client's management as to be indistinguishable from it. In assessing whether this degree of unity has been reached, the basic consideration is whether, to a third party, the client appears to be (i) substantially dependent upon the accountant's skill and judgment in its financial operations, or (ii) is reliant only to the extent customary for that type of consultation or advice."
The auditor may consider many factors in evaluating the extent of his or her involvement in the construction of financial statements for an audit client. Determinations of the auditor's involvement in this capacity depend on the facts and circumstances of the particular case. The following are examples of operating characteristics that should be considered by the auditor:
- What is the level of management's financial reporting expertise?
- Has management taken full responsibility for the judgments and results of the financial statement preparation process?
- Has the audit client sustained a level of financial expertise that enables the company to maintain its own books and records and avoid a de facto delegation of financial reporting responsibilities to the auditor?
- Is the level of auditor assistance functionally equivalent to that of a member of the management team?
2. If an auditor drafts or makes suggested modifications to the footnotes included within a client's annual or interim financial statements will the auditor's independence from the client be considered to be impaired?
Footnotes to financial statements are an integral component of the financial statements themselves. The development and drafting process of footnotes requires the rigorous exercise of judgment which must be subjected to the objective and unbiased examination of the auditor. As noted above, responsibility for the choices and judgments inherent in the preparation of financial statements, including the footnotes, cannot be delegated to the auditor. Accordingly, the Staff will evaluate the footnote drafting process in the same manner as the preparation of financial statements.
In the course of recommending modifications to the footnotes or basic financial statements, the auditor may provide the client with resources, research materials, advice and comments on the presentation that is proposed by management. This involvement may also include the provision of editorial suggestions that may improve the transparency and clarity of the information presented. Such advisory services do not necessarily fall within the ambit of proscribed management functions. The Staff believes that this type of advice and assistance is generally in the public interest as it more often than not results in improved financial reporting and constitutes a logical and effective way for registrants to adopt and comply with complex accounting and financial reporting standards.
3. If a registrant is unable to perform the mechanical process of converting its trial balance into financial statements in accordance with GAAP, in a format desirable by the board for presentation to its shareholders, does this situation qualify as an "unusual situation" as referred to in Rule 2-01(c)(4)(i)(A), thereby allowing the auditor to perform this function?
The "unusual situation" is meant to be narrow. In Release No. 33-7919, the Commission stated, "...we are adopting an exception from the bookkeeping restriction for emergency or other unusual situations, provided that the accountant does not act as a manager or make any managerial decisions. We expect that such situations will be rare." For example, as a result of the events of September 11, 2001, the Commission issued Release No. 33-8004. Release No. 33-8004 acknowledges that registrants and auditors affected by those events may invoke the "emergency and unusual situation" exception in paragraph (c)(4)(i)(B)(1) of the bookkeeping provisions under Rule 2-01.
Based on the Staff's understanding of the situations that would compel auditor involvement in financial statement preparation, invoking the emergency and unusual situation exception is not appropriate for the situation presented. If a client's accounting department is under-staffed or ill-prepared to perform routine accounting functions, that condition does not rise to the level of an "emergency or unusual situation." The incapacity you have described could be mitigated or avoided with the application of appropriate planning, resources and preventive measures.
Because these positions are based on the facts that have been provided in various phone calls and in your letter dated December 19, 2001, it should be noted that any deviation from the facts or conditions presented may require a different conclusion. Further, this letter expresses the views of the Office of the Chief Accountant on the auditor independence issues presented, and do not purport to express any legal conclusions on the matters discussed herein.
Should you have questions, please call either Bert Mehrer or me at 202-942-4400.
Very truly yours,
Samuel L. Burke
Associate Chief Accountant