Independence and Related Topics: Conflict of Interest, Related Parties, Inurement, and Other Issues

Purpose of This Tool. The purpose of this tool is to provide audit committee and governing body members with an overview of issues of independence and related topics. These topics must be considered in connection with audit committee membership, governing body, and relationships with external auditors and other parties.

Independence implies one’s ability to act with integrity and exercise objectivity and professional skepticism. Therefore, independence is critical to promote ethical behavior and reliable financial reporting. With direct contacts to the management team and the auditing firm, the audit committee is quite possibly in the best position to monitor a government’s compliance with independence standards.

Many groups define and require independence from the auditor, the governing body, and management (see Exhibit 1). For example, the AICPA’s independence standards apply to CPAs in all situations requiring independence. In addition, Government Accountability Office (GAO) standards, which are generally more restrictive, apply to engagements involving federal entities and those governments receiving federal funds. The GAO standards have been voluntarily adopted by many state and local governments and other entities both domestically and internationally. Most state and local governments also have prohibitions against self-dealing and conflicts of interest that have specific provisions and implications.

In addition, governing bodies may have adopted their own practices. Many governments include definitions of independence, ethics, and integrity in their policies and procedures. Others require that the board, staff, or both sign annual statements of independence or conflict of interest. It is recommended that senior management define, communicate, and exhibit these qualities to set a high standard throughout the government. Exhibit 1 is a sample conflict of interest policy for a government organization is provided as a part of this tool. Exhibit 2 is a sample disclosure form from an actual city for reporting gifts, benefits, trips or meals that may have been given/provided to a city employee.

AICPA: Auditor Independence

Independence shall be considered impaired by a variety of factors. Generally, CPAs are not independent if they are in a position to influence, make management decisions, provide certain accounting services, or have financial interests in an entity. A CPA is required to document any possible situations that might impair his or her independence on an engagement, inform his or her CPA firm, and inform the potential client if any such situations may exist.

Auditor independence requirements will be determined by state boards of accountancy; the GAO, if law, regulation, agreement, policy, or contract requires the member's report to be filed under GAO regulations; and any organization that issues or enforces standards of independence that would apply to the member's engagement. Such organizations may have independence requirements or rulings that differ from (for example, may be more restrictive than) those of the AICPA.

GAO Yellow Book: Auditor Independence

Government Auditing Standards, commonly referred to as the Yellow Book covers federal entities and those organizations receiving federal funds. Various laws require compliance with the comptroller general’s auditing standards in connection with audits of federal entities and funds. Furthermore, many states, local governments, and other entities, both domestically and internationally, have voluntarily adopted these standards.

Although the standard deals with a range of auditor independence issues, a significant portion of the standard is associated with nonaudit, or consulting, services. Auditors have the capability of performing a range of services for their clients. However, in some circumstances, it is not appropriate for them to perform both audit and certain nonaudit services for the same client. In these circumstances, the auditor, their client, or both will have to make a choice about which of these services they will provide.

The focus of the auditor independence standard is to better serve the public interest and to maintain a high degree of integrity, objectivity, and independence for audits of government entities. The standard includes a principle-based approach to addressing this issue, supplemented with certain safeguards. The independence standard for nonaudit services is based on two overarching principles:

Auditors should not perform management functions or make management decisions.
Auditors should not audit their own work or provide nonaudit services in situations where the amounts or services involved are significant or material to the subject matter of the audit.

For nonaudit services that do not violate these above principles, certain supplemental safeguards have to be met, for example, (1) personnel who perform nonaudit services are precluded from performing any related audit work; (2) the auditor’s work cannot be reduced beyond the level that would be appropriate if the nonaudit work was performed by another unrelated party; and (3) certain documentation and quality assurance requirements must be met.

The standard includes an express prohibition regarding auditors providing certain bookkeeping and recordkeeping services, and limits payroll processing and certain other services, all of which are presently permitted under AICPA auditing standards. At the same time, the standard recognizes that auditors can provide routine advice and answer technical questions without violating these two principles or having to comply with the supplemental safeguards. The standard also provides examples of how certain services are treated under the rules.

Exhibit 1

Summary of Significant Independence and Conflict of Interest Standards and Requirements

AICPA Standards Document: Code of Professional Conduct, Section 100, “Independence, Integrity, and Objectivity”

Sets independence standards that CPAs must adhere to in regards to the type of work performed.
Applies to CPAs in all situations involving an attest client.
Attest: Services requiring independence and assurances from the CPA such as audits, reviews, and agreed-upon procedures.

Government Accountability Office (GAO) Standards Document: Government Auditing Standards (also known as GAGAS or Yellow Book)

Sets independence standards for federal entities and those organizations receiving federal funds. Various laws require compliance with the comptroller general’s auditing standards in connection with audits of federal entities and funds. Furthermore, many states, local governments, and other entities, both domestically and internationally, have voluntarily adopted these standards.
GAO rules are generally more restrictive than those of the AICPA.

State legislation

Most states and local governments include prohibitions against self-dealing or conflict of interest transactions by management and members of the governing body.

Exhibit 2 – Sample Disclosure Form

¹AICPA Plain English Guide to Independence, updated 1/1/2004
www.aicpa.org/Professional+Resources/Professional+Ethics+Code+of+Professional+Conduct/
Professional+Ethics/notice_rev_int101-3.htm
2004_02AICPA-GAO_rules_comparison.pdf