Addressing Independence Issues Not Covered by the Code

by MICPA | Jun 03, 2014   ()

This column highlights issues and questions submitted to the MICPA Professional Ethics Task Force. Responses may not consider all of the unique circumstances that are part of an ethical inquiry. 

Scenario: James is a CPA who serves on the board of a neighborhood association that hires a management company for administrative tasks and services. The management company (and not the neighborhood association) hires and directly compensates a separate CPA firm (not associated in any way with James) to perform a compilation of the financial statements of the neighborhood association. In fact, the management company routinely engages the same CPA firm to perform similar compilations for a number of neighborhood associations and condominium associations. Typically, the CPA firm addresses its compilation report letter to the board of directors of the neighborhood association or other third-party organization, and the report letter does not state that the CPA firm lacks independence.

Q. In this case, since the client of the CPA firm may appear to be the management company, rather than the neighborhood association, should James be concerned about whether there is a lack of independence?

A. The board of directors of a neighborhood association, condominium association, corporation, or other organization, has a fiduciary duty to ensure that the governance of the organization is ethical and proper. In partial fulfillment of these fiduciary duties, it is not uncommon for the board of directors to require that a CPA firm perform a compilation of the financial statements of the organization. That CPA firm, in turn, is usually selected by the board of directors, hired by the board of directors, paid by the board of directors, and is accountable to the board of directors.

If the board of directors chooses to delegate certain responsibilities for selecting, hiring and compensating the outside CPA firm for this task, the independence of that CPA firm is not necessarily impaired. For larger organizations, an audit committee of the board of directors is often charged with some of these responsibilities. It is also not uncommon for the board of directors, or the audit committee, to elicit assistance from management in the fulfillment of some of these responsibilities. For example, members of management may be asked to assist with obtaining background information and other pertinent data in regard to the process of selecting, from a number of CPA firms, which firm will be engaged by the organization to perform the compilation. There is no rule within the AICPA Code of Professional Conduct, or other similar authority, prohibiting the delegation of these types of tasks.

But rules are not everything. Here, even if no rules are technically being broken, there is a risk that the CPA firm may appear to lack independence. The neighborhood association is presumably obtaining a compilation of the organization's financial statements for several reasons, including accountability to the neighborhood association members and stakeholders, and also including oversight of management. But it is possible to envision a situation where outsiders might perceive that the management company is effectively "purchasing" compilations from the CPA firm. In other words, the very close relationship between the management company and the CPA firm (as compared to the relatively distant connection between the CPA firm and the organization’s board) can be seen as a threat to the appearance of independence.

Threats to the fact or appearance of a lack of independence are addressed by the Conceptual Framework for AICPA Independence Standards. CPAs, when making decisions on independence matters that are not explicitly addressed by the Code of Professional Conduct, use the Conceptual Framework.

The risk-based approach of the Conceptual Framework entails evaluating the risk that a CPA would not be independent (or would be perceived by a reasonable and informed third party having knowledge of all relevant information as not being independent). That risk must be reduced to an acceptable level, either by removing or reducing the threats themselves, or by ensuring that safeguards are in place to sufficiently mitigate or eliminate the threats.

Here, James has identified a situation that involves a threat to independence. By allowing the management company to select, negotiate with, hire, and compensate the CPA firm, the neighborhood association is assuming the risk that the there may develop an appearance of a lack of independence on the part of the CPA firm. It may appear to some that the CPA firm essentially is "working for" and “beholden to" management, rather than the overseers of management, and that the CPA firm is therefore less likely to be as critical of, or discerning toward, management than might otherwise be the case. The appearance of a lack of independence can damage the credibility of the CPA firm as well as of directors of the neighborhood association, including James.

A number of steps could be taken to provide safeguards in this situation including the following:

  • The board of directors of the neighborhood association, for example, could take a more proactive role in the selection and engagement of the CPA firm.
  • If the management company made available to the board of directors information about several prospective CPA firms, enabling the board of directors to make the final selection, it would appear to all concerned that the CPA firm is effectively working for the board of directors of the neighborhood association rather than for the management company.
  • The compensation of the CPA firm could be approved ahead of time, if not directly negotiated, by the board of directors of the neighborhood association.
  • The engagement letter, in turn, could be executed on behalf of the neighborhood association by a member of its board of directors rather than by the management company.
  • Other direct interaction between the board of directors and the CPA firm would further bolster both the impression and the fact of the board's involvement in the process.
Delegation of tasks by boards of directors is a fact of life. In fact, an important function of management is to implement the policies and directives of the governing board. But the board cannot avoid its fiduciary responsibilities by attempting to delegate them. The attestation function, which supports the fiduciary duty of accountability of a board of directors as well as its oversight of management, is ultimately the responsibility of the board of directors.

By reducing the threats to independence that can occur in a situation like this case involving a neighborhood association, the credibility of both the board of directors and the CPA firm can be enhanced. Both James (the CPA serving as a director), and the outside CPA firm performing attestation services, would benefit from proper implementation of the Conceptual Framework for AICPA Independence Standards.
Source: The Michigan Association of CPAs

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