Auditor independence relating to government client affiliates

You must apply, with one exception, the “Independence Rule” and related interpretations of the AICPA Code of Professional Conduct to your state or local government client’s affiliates.
By Flo Ostrum, CPA, and Jennifer Kappler, CPA

IMAGE BY NAQIEWEI/ISTOCK
IMAGE BY NAQIEWEI/ISTOCK

We all know how important it is that auditors maintain their independence. But at times, understanding and applying the rules can be challenging (see the sidebar, "How Pandemic Funding Could Impact Affiliate Determinations" at the end of this article). Take a closer look at the revised ethics interpretation for state and local government client affiliates, and read a few tips on practically applying the guidance.

Why did the AICPA Professional Ethics Executive Committee (PEEC) revise the ethics interpretation addressing state and local government client affiliates in 2019? The last time this interpretation in the AICPA Code of Professional Conduct (the Code) was revised prior to that date was in 1999, shortly after the Governmental Accounting Standards Board (GASB) redefined financial reporting standards for state and local governments with the issuance of GASB Statement No. 34, Basic Financial Statements — and Management's Discussion and Analysis — for State and Local Governments. That standard brought about significant changes to the state and local government (SLG) environment and the required reporting structure.

Since that time, PEEC has issued guidance addressing commercial affiliates. When evaluating the existing interpretation, PEEC wanted to be consistent with commercial affiliates, but some of the concepts didn't translate to the SLG environment. This process led to PEEC's adopting the revised interpretation "State and Local Government Client Affiliates," formerly "Entities Included in State and Local Government Financial Statements," (ET §1.224.020) under the "Independence Rule" (ET §1.200.001) at its May 2019 meeting.

In the fall of 2020, PEEC issued a companion implementation guide to help members apply the revised interpretation. The implementation guide includes decision trees, examples, and tools to assist the auditor in determining which entities are affiliates of their financial statement attest client (FSAC). Due to the impact of the coronavirus pandemic, PEEC chose to delay the effective date. The interpretation is now effective for years beginning after Dec. 15, 2021.

OVERVIEW

If you audit financial statements of state or local governments, you must consider your independence responsibilities when it comes to affiliates of your clients. Simply, you must apply the "Independence Rule" and related interpretations to affiliates of your FSAC. There is one exception to this requirement related to nonattest services, which is highlighted later in this article.

PEEC's revised ethics interpretation:

  • Provides examples of SLG entities in the context of the standard;
  • Changes the language in the standard to refer to "financial statement attest client" rather than "state or local government entity";
  • Defines the terms "investor" and "investment" as they are used in the interpretation;
  • Clarifies the circumstances or relationships that may create threats to independence; and
  • Highlights the importance of materiality, control, and influence as decision points when evaluating potential affiliates.

THE FUNDAMENTALS

In the revised interpretation, the Code defines the following four types of affiliates of SLG FSACs that require auditor independence:

  1. Type I: The entity is included in the financial statements of your FSAC, and you don't refer to another auditor in your audit report.
  2. Type II: The entity is included in the financial statements of your FSAC, and you do refer to another auditor's report. Additionally, that entity is material to your FSAC as a whole, and your client has more than minimal influence over the entity's accounting or financial reporting process.
  3. Type III: The applicable financial reporting framework (such as GAAP) requires your client to include an entity in its financial statements. However, your client has chosen not to include that entity. Even though that entity is excluded, if it is material to your client's financial statements as a whole and your client has more than minimal influence over the entity's accounting or financial reporting process, it is a Type III affiliate.
  4. Type IV: An investment held by an investor (your FSAC or your FSAC's Type I affiliate) where either one of the following conditions exists:
    • The investor controls the affiliated entity unless the investment in the entity is trivial and clearly inconsequential to your FSAC's financial statements; or
    • The investor has significant influence over the affiliated entity, and the investment in the entity is material to your FSAC's financial statements.

The revised interpretation specifies that there is a rebuttable presumption that an FSAC has more than minimal influence over the accounting or financial reporting process of the FSAC's funds and blended component units.

Another important element of the revised interpretation is the nonattest services exception. This exception allows the auditor of the FSAC to provide nonattest services for Type II and Type III affiliates if the results of the nonattest service will not be subject to financial statement attest procedures and any other threats can be eliminated or reduced to an acceptable level by the application of safeguards.

MATERIALITY, CONTROL, AND INFLUENCE

While you should follow the guidance in the interpretation, keep in mind that the thresholds of materiality, control, and influence will mean many entities and investments will not be considered affiliates of the FSAC. There are two affiliate decision trees in the implementation guide that take the auditor through the necessary considerations to conclude whether an entity or investment is considered an affiliate of the FSAC. Each of these decision trees has two inflection points — the first addressing the size, or materiality, of the entity/investment relative to the FSAC and the second addressing the level of influence the FSAC has over the entity/investment. Let's take a closer look at these inflection points.

AFFILIATE DECISION TREES

Entities the FSAC is required to include in its financial statements

The first question is whether the entity is included in the FSAC's financial statements. The applicable financial reporting framework is what creates this requirement. The entity is an affiliate if it is included and the FSAC auditor does not refer to another auditor's report (Type I). An included entity is also an affiliate if reference is made to another auditor's report, the entity is material to the FSAC, and the FSAC has more than minimal influence over the entity's accounting or financial reporting process (Type II). The entity is not an affiliate if both materiality and more than minimal influence are not present.

What if the entity is not included in the FSAC's financial statements? If the entity is not material to the FSAC, the entity is not an affiliate. Suppose the entity is material to the FSAC and the FSAC has more than minimal influence over the entity's accounting or financial reporting process. In that case, the entity is an affiliate (Type III), even though it is not included in the FSAC's financial statements.

For a decision tree for entities, see the chart "Entities That the Applicable Financial Reporting Framework Requires to Be Included in Your FSAC's Financial Statements" (below).

entities-financial-reporting-framework-requires-fsac-statements

Investments held by an investor

Before discussing whether an investment is or is not an affiliate, it's essential to keep in mind what types of investments are not included. Investments do not include temporary investments or equity interests in entities that provide governmental services. Investments do include assets held primarily for the purpose of income or profit and that have present service capacity based solely on their ability to generate cash or be sold to generate cash. This portion of the SLG client affiliates interpretation will primarily affect benefit plans. This application aligns with how employee benefit plans are treated outside the SLG environment.

You must evaluate investments held by an investor (the FSAC and any Type I affiliates) to determine if those investments are also affiliates. You should also be aware of other circumstances or relationships related to investments where you should consider applying the conceptual framework.

There are two pathways one can take to determine whether an investment is considered an affiliate: control and significant influence. With the control pathway, if the investor has control over the investee, unless the investment is trivial and clearly inconsequential, the investee is an affiliate. However, if the investor doesn't have control over the investee, it's not the end of the evaluation. The auditor would next look for the presence of significant influence. If there is significant influence present and the investment is material to the FSAC's financial statements, the investee is an affiliate. A key point to remember is that, when evaluating the investments of a Type I affiliate, materiality is determined at the FSAC level and not the opinion unit.

For a decision tree for investments, see the chart "Investments Held by an Investor" (below).

investments-held

DON'T FORGET ABOUT THE CONCEPTUAL FRAMEWORK

There will be scenarios where entities don't meet any of the definitions of affiliates as outlined in the interpretation. However, the interpretation does highlight that you still might have relationships or circumstances where you should apply the AICPA's "Conceptual Framework for Independence" (ET §1.210.010). Certain relationships might create threats to independence, requiring the application of safeguards to mitigate or reduce the threat to an acceptable level. For example, say your immediate family member is in a key position with a nonaffiliate that includes your client in its financial statements. The nonaffiliate provides accounting staff, shares financial information systems, or establishes internal controls over financial reporting for your client. This situation would need to be evaluated to determine if a significant threat to independence is created. If so, can appropriate safeguards be applied to eliminate the threat or reduce it to an acceptable level? Additional examples could include entities that are not required to be included in the reporting entity and upstream entities.

WHAT SHOULD AUDITORS KEEP AN EYE OUT FOR?

Here are a few key takeaways and important next steps for auditors to follow:

  • Firms will need to perform more evaluation of material entities when referring to another auditor's report. This coincides with the need to evaluate material excluded entities.
  • Firms should revisit existing documentation of all entities within the financial reporting entity that are not in scope of the FSAC. The revised interpretation is a good reason to ensure there is a complete and accurate list and that the understanding of the relationship between the FSAC and each entity is clear.
  • Firms should take an "inventory" of their relationships, including asking the following questions of, or about, potential affiliates:
    • Whom are you doing business with?
    • Which entity is related to which entity?
  • Firm policies will need to be updated for the revised interpretation.

PRACTICAL APPLICATION

As you evaluate relationships and circumstances that could result in the identification of affiliates, you may have questions. The AICPA ethics hotline is one resource that can provide real-time answers. You can contact it at 888-777-7077 (select option 2, then 3). Another resource is a dedicated webcast on this topic sponsored by the AICPA Governmental Audit Quality Center. Many have found the implementation guide, SLG affiliate evaluator: Entities, SLG affiliate evaluator: Investments, and the interactive SLG affiliate matrix to be of great assistance in identifying affiliates and providing documentation to support their assessment. As a final reminder, the effective date for this revised interpretation is for years beginning after Dec. 15, 2021. Don't risk a breach of independence by failing to address your client's affiliates.

Before discussing whether an investment is or is not an affiliate, it's essential to keep in mind what types of investments are not included.

How pandemic funding could impact affiliate determinations

This fictional example illustrates how complex it can be to determine affiliate status and how that status can change over time. For instance, an entity that is not material can become so if it receives a large amount of funding, as this example shows.

University HealthCenter (UC) is a discretely presented component unit of Public University. UC received $12 million in Provider Relief Funds (PRF), all of which are to be reported at June 30, 2021, triggering UC's first single audit. Firm A audits UC, and Firm B audits Public University. Firm B references Firm A's audit report in the auditor's report on Public University's financial statements. While in prior years UC was not material to Public University, UC's receipt of the PRF changed that, and for the year ending June 30, 2021, UC was material to Public University. Public University also provides accounting back-office services to UC; therefore, it has more than minimal influence over UC's accounting or financial reporting process.

In this scenario, UC would be considered a Type II affiliate of Public University. Firm B should apply the "Independence Rule" and related interpretations to UC. In addition, since UC is a Type II affiliate, Firm B does not need to evaluate the investments held by UC for independence purposes and may use the nonattest services exception.

However, if UC was not material to Public University as a whole, then UC would not be an affiliate of Public University as defined in paragraph .03aii of the state and local government client affiliates interpretation. Similarly, if Public University did not have more than minimal influence over UC's accounting or financial reporting process, UC would not be considered an affiliate of Public University.


About the authors

Flo Ostrum, CPA, is a member of the AICPA Professional Ethics Executive Committee (PEEC)State and Local Government Affiliate Task Force and is a partner in Grant Thornton LLP's Audit Quality and Risk Group. Jennifer Kappler, CPA, is a senior manager—Professional Ethics at the Association of International Certified Professional Accountants, representing AICPA & CIMA. To comment on this article or to suggest an idea for another article, contact Courtney Vien at Courtney.Vien@aicpa-cima.com.


AICPA RESOURCES

Article

"Effective Dates Extended for 3 AICPA Ethics Interpretations," JofA, May 6, 2020

Exposure draft

PEEC exposure draft — Compliance audits

Online

Tips for Organizations Subject to Single Audit Requirements

Single Audit Tips for Auditors

Hotline

AICPA Ethics Hotline, 888-777-7077 (select option 2, then 3)


LEARNING RESOURCES

AICPA Code of Professional Conduct

Gain an understanding of professional ethics in the accounting profession, the AICPA Code of Professional Conduct, and how to maintain integrity and objectivity.

CPE SELF-STUDY

Independence

Gain an understanding of the AICPA Code of Professional Conduct and independence rules affecting accounting professionals.

CPE SELF-STUDY

For more information or to make a purchase, go to aicpa.org/cpe-learning or call the Institute at 888-777-7077.

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