In this Exposure Draft, the PEEC proposed revisions to “Entities Included in State and Local Government Financial Statements,” the independence interpretation that determines when a member needs to be independent of a state or local governmental (SLG) entity that is related to his or her financial statement attest client. Although the Code includes a “Client Affiliates” interpretation (ET sec. 1.224.010) that is applicable to commercial entities, the PEEC did not believe that the existing interpretation effectively identified relationships requiring independence in the SLG sector because of the fundamental differences between the two sectors. For example:
§ Financial reporting objectives in the commercial sector use FASB definitions of control and significant influence, which are not used in the Governmental Accounting Standards Board’s (GASB’s) reporting standards. Instead, GASB uses a concept of financial accountability to identify when an entity should be included in a state or local government’s financial statements. Although a primary government may not have control or significant influence (as defined by FASB) over an entity, that entity may still be considered an affiliate in the SLG context.
§ In the SLG sector, entities included in a set of financial statements are usually referred to as “funds” or “component units”.
o A fund, which is not a separate legal entity, is a fiscal and accounting entity with a self-balancing set of accounts that are segregated for carrying on specific activities or attaining certain objectives.
o Component units are legally separate entities. Primary governments may not have control or significant influence over component units in the same way that a commercial sector entity has control over its subsidiaries. Component units that are included in a governmental financial reporting entity can operate autonomously from each other, for example, by having separate governing boards, accounting systems, financial reporting systems, operations, and even separate strategic directions. Component units may interact with the primary government in an adversarial fashion that would be quite unusual in a corporate environment. Officials at a component unit may not report up an organizational structure to someone at the primary government as they would in a corporate environment.
Funds and Component Units Required to Be Included in the Financial Reporting Entity of the Financial Statement Attest Client
Referring to Another Auditor’s Report
As in the current interpretation, members must be independent of funds and component units that are included in the financial statement attest client’s financial reporting entity in which the covered member does not refer to another auditor’s report on the fund or component unit. Similarly, under the current rules members do not need to be independent of funds and component units that are included in the financial reporting entity of the financial statement attest client when the member explicitly states reliance on another auditor’s reports. However, the PEEC believes that referring to another auditor’s report will not always reduce threats to an acceptable level when the:
§ fund or component unit is material to the financial reporting entity, and
§ primary government has more than minimal influence over the accounting or financial reporting process of the fund or component unit.
Funds and Component Units Excluded From the Financial Reporting Entity
The current interpretation does not provide any independence guidance related to funds and component units that are excluded from the financial reporting entity but are required to be included under the applicable framework (for example, GAAP, regulatory, or cash basis).
The PEEC proposes incorporating guidance when a material fund or component unit is excluded from the financial statement attest client’s financial reporting entity but is required under the applicable framework to be included in that financial reporting entity. In this situation, PEEC believes members should apply the “Independence Rule” and related interpretations to the material excluded fund or component unit if the primary government has more than minimal influence over its accounting or financial reporting process.
Not Subject to Attest Procedures—Exception
The “Client Affiliates” interpretation (ET sec. 1.224.010) provides an exception that a member may apply to all affiliates (other than those defined as type a and b in the proposal), which permits the member’s firm to provide nonattest services that would impair independence. The condition for applying the exception is that the results of the nonattest services will not be subject to the covered member’s financial statement attest procedures (i.e. nonattest services do not create a self-review threat with respect to the financial statement attest client).
Financial Statement Attest Client Is Required to Be Included in Another Financial Reporting Entity as a Fund or Component Unit and the Primary Government of That Financial Reporting Entity Is Not a Financial Statement Attest Client
Financial Statement Attest Client Is a Material Fund or Component Unit
Under the current interpretation, when the member does not audit the primary government, independence is not required of entities included in the financial reporting entity that the member does not audit. However, covered members and their family members are prohibited from having a key position within the primary government. The PEEC believes there could be circumstances in which a member has a close personal relationship that creates threats that are not at an acceptable level but that these situations are more likely to occur in circumstances described in the proposal. The PEEC proposes members evaluate these matters using the “Conceptual Framework for Independence” interpretation.