Every manager in the country needs to be aware of this possible industry sea change. The scenario depicted below is not real, YET, but could be in the near future.

Imagine this – You are the owner of a management company consisting of 100 association clients and a staff of more than 20 people. You’ve invested 20 years in building your company into one of the finest in your region. You’ve made significant investments in time and money into acquiring good software, developing systems, and training staff.

You’re proud of your efforts to improve the accounting system for your clients. It not only provides them with meaningful financial statements every month, but also provides solid accounting information for the auditors. You want the audits to go smoothly. To help your various boards of directors understand their financial statements, you have listened carefully to their comments and requests, and have decided to present monthly financial statements on the “modified accrual” basis of accounting, which makes it easier for board members to understand. They don’t like accruals but you need to track receivables, so you compromised with a kind of “half accrual.”

It is January 29^th, and you are welcoming back the first of this year’s auditors to begin the audits of your 100 association clients. You had no idea this morning that a recent, relatively obscure ruling by the AICPA (American Institute of Certified Public Accountants) was about to cause you significant damage. Heck, you barely know the AICPA exists; that’s for the CPAs to worry about.

John, the lead partner of the first CPA firm to visit this year, asks for a few minutes to chat before any work begins. You wonder why, and also ask yourself, “Where is John’s audit staff this morning? I don’t see them.” John reminds you that you haven’t paid attention to his several emails regarding AICPA independence rules, and didn’t attend his free seminar on the subject.   You acknowledge that, but remind John that your job is to manage associations, and his job is to know the accounting rules. All you’re worried about is that your accounting system accurately records financial transactions.

John agrees that your accounting system is excellent, but informs you that he can’t start the audits, as you have not presented him with GAAP (Generally Accepted Accounting Principles) basis financial statements, which are now required before he can begin the audits. You tell him “That’s your job. It’s always been your job. You understand those things - I don’t.” John explains that the new independence rules issued by the AICPA prohibit him from “preparing the financial statements.” He explains that your financial statements are considered to be for internal use only and as such, are not required to be prepared in accordance with GAAP. The annual financial statement submitted for audit, however, IS required to be prepared in accordance with GAAP. Under the new rules, John can no longer prepare those financial statements, as to do so would potentially impair his independence, meaning he could no longer perform the audit.

Realizing that your association clients are expecting completed audits within the next few weeks, you tell John that you’ll just have to recommend another CPA firm to perform the audits this year. But John informs you that NO CPA firm can perform the audits, as the new independence rules apply to ALL CPA firms. He suggests there are two ways to resolve the issue so that he can begin the audits:

1. 1)You can bring your internal use financial statements up to GAAP basis. What is required is (a) converting from modified accrual basis to full accrual basis, (b) preparing the balance sheet and income statement in the proper format (like last year’s audit), (c) producing a statement of cash flows in the proper format, (d) preparing all appropriate footnotes (John hands you a 70-page disclosure checklist so you know what the proper disclosures are), and (e) summarizing the reserve disclosures in the appropriate format using information from the reserve study. (This is quite a challenge, as the reserve study report does not contain this information in any easy-to-find format. You would have to manually combine several different exhibits from the reserve study to get the correct information.)
2. 2)John can recommend another CPA firm that is available to come in and prepare compiled financial statements; make the necessary accruals; and prepare the cash flow statement, footnotes, and reserve disclosures. That CPA has estimated his fees will be approximately $500 per association for the compilation services, except for the larger, more complex associations, which will carry a higher price tag.

As this all sinks in, you realize you have neither the staff, time, nor technical ability to handle this matter in-house. You also realize there could be some liability involved if you don’t get it right. So, option number one is not really an option.

You decide to talk to one of your long-time association clients about hiring the CPA to perform the compilation work. After all, you have a very good relationship with the president of the association, and have advised them about problems this tough economy has caused with the association’s budget.

Your board president listens, then gently reminds you that your contract with the association clearly states that your management company is contractually obligated to prepare all financial reports and information and “work with the auditors” on the annual audit. The board president states that the association believes it has paid you for financial services, and it is your responsibility to prepare whatever the auditor requires. The association will NOT pay for a compilation service in addition to an audit service.

OK, you can do this math in your head – 100 associations at $500 each is $50,000. Do you risk losing clients by forcing them to pay for the compilation, or eat the extra cost to make sure you don’t lose your association clients? You wonder for a moment about simply hiring a CPA to do this work in-, then remember that you recently saw an ad for a CPA with a stated salary of $80,000. That option won’t work either.

Now, this ruling has NOT YET taken effect. So the scenario painted above hasn’t happened yet, and isn’t going to happen within the next year. The AICPA’s PEEC (Professional Ethics Executive Committee) sets independence standards for CPAs, and in January 2013 they voted on exactly this issue. The Committee’s decision was to refer it back to the subcommittee study group for further consideration. But, it’s critical to note that the majority of committee members and those commenting on the proposed standard approved of revising the independence rules for CPAs. If this passed, it would drastically restrict the work that could be performed by a CPA performing audit or review services.

The world seems to be getting ever more regulated in an attempt to simply force good behavior. It won’t work. But, we still have to live with the rules as they are handed down from above. This issue of auditor independence has literally been discussed for decades. But in this post-Enron world, the discussion is being considered more seriously than at any time in the past. To my knowledge, this is the first time that this issue has ever come up for a full committee vote.

The AICPA has a well-established vetting process for proposed standards. The revised independence standard was proposed in June 2012, and the public comment period ended November 30, 2012. During that time, the PEEC received 41 comment letters on the proposed standard. While that may seem like a very small number, keep in mind that the majority of these letters did not come from individual CPAs, but rather from the “big four” CPA firms, state accounting societies, and the National Association of State Boards of Accountancy (NASBA). That means that these 41 comment letters represented the majority of CPAs in the country. What is critical to note is that approximately 2/3 of these comment letters supported in full or in part the proposed standard of severely restricting non-attest services that could be performed by a CPA who was also performing an attest engagement (audit or review).

The fact that the Committee did not kill the proposed independence provisions, but simply referred them back for further consideration, means that we will see this issue again. Given the significant majority support it received in its first exposure, there is a distinct probability that we will see this approved, in some form, in the relatively near future. As it was proposed, it allowed for a two-year transition period; that type of transition period will likely survive, so there will still be time to act. But, knowing what COULD come down from AICPA, it is better to act now.

What can a management company do to protect itself? The most important thing is to review your contracts and make sure there is a clear delineation between the services you provide for internal use financial statements as contrasted to preparation of GAAP basis financial statements, which should NOT be the responsibility of the management company.

See next week’s article “Proposed Independence Rules” for both a more detailed explanation of the proposed independence standards and also suggested language for how a management company / association contract can address the issues discussed above.