by John M. Covaleski

Greenville, S.C. - Accounting firms are slowly preparing for sweeping new auditor independence rules - scheduled to take effect Jan. 1 - that restrict the services they can provide to government clients and many nonprofits.

While some firms are reducing their level of government-sector service offerings, others with already pared-down, focused specialties in this area are gearing for referral work from rival firms who will be forced to limit their services.

What will limit those services is the General Accounting Office’s pending amendments to generally accepted government audit standards, as applied in "yellow book" audits of government entities and audits of non-government clients who receive at least $250,000 in federal funds per year.

The rules say that auditors of these organizations:

• "Should not perform management functions or make management decisions" in addition to the audit services provided to these clients; and,

•  Should not audit their own work or provide non-audit services in which the amounts involved are "significant" or the work is "material to the audit."

The provisions, scheduled to take effect on all audits for periods beginning on or after Jan.1, 2003, are the first frontal assault on rank-and-file accounting firms resulting from the recent spate of audit scandals.

They are essentially a government edition of the Sarbanes-Oxley legislation, which restricts the services that auditors can provide to public company clients.

However, the GAGAS amendments impact far more CPA firms than are affected by Sarbanes-Oxley. Less than 1,000 firms audit public companies, while the number of firms serving government entities numbers in the tens of thousands; there are about 85,000 government entities in the United States, and most of them rely on local or regional CPAs for some services.

The amendments appear to effectively prohibit auditors from providing almost all non-audit services. However, the regulations exempt or "grandfather in" all non-audit services prior to Jan. 25, 2002, the date the GAO unveiled its first draft of the amendments.

Although the rules take effect in a few weeks, not many firms have yet responded. Industry observers speculate that firms by and large are either unaware of the pending change or are waiting until after it takes effect.

Ridgefield, Conn.-based practice management consultant Jay Nisberg said that Comptroller General David Walker, who heads the GAO, recently said that the accounting industry is "in the eye of the storm" regarding the fallout from the GAGAS amendments.

"If that’s true, the changes being made by firms now may be the future; we will see more adjustments," Nisberg said.

Allan Boress, a management consultant based in Eustis, Fla., said that he’s not surprised that firms have been slow to respond. "CPAs are not great planners. They are reactors, and in this matter they will react after the fact," he said.

Firms that have already reacted in a dramatic fashion include Elliot Davis of Greenville, S.C., which has spun off its software consulting business to the partner-in-charge of that business. The accounting firm, ranked 43rd on Accounting Today’s Top 100 list of firms, with $30 million in 2001 revenue, has identified 12 audit and software services clients that would represent conflicts under the GAGAS amendments.

"We could see conflicts coming up down the road with these clients, and we had to decide which kind of engagements made the most sense for our clients and the firm as whole," said Tim Baker, a former Elliott Davis shareholder. He bought out his interest in the software group and is re-launching that as Baker Consulting Inc., with offices in Columbia and Greenville, S.C.

Baker said that he sensed that other practitioners he has discussed the issue with are "taking a wait-and-see attitude" about changing operations in response to the new rules. "I wanted to make our move now so we are not at the end of the line," he added.

Elliott Davis’s decision to sell off Baker’s consulting business, rather than retain it as an affiliate, may be an indication of how other firms may respond. The regulations stipulate that firms should sell off any consulting practices that serve their GAGAS audit clients, and discourage the common industry practice of spinning off consulting groups into separate, but affiliated, organizations.

"In addressing independence matters under the new standards, an audit organization cannot do indirectly what it cannot do directly," the GAO says in a report on its Web site. The report further says that an organization must "totally divest itself" of a consulting unit in order for it to be considered independent while that consulting unit services the organization’s audit clients

Allan Koltin, president of the Practice Development Institute management consultants in Chicago, speculated that the regulations could prompt firms to sell consulting practices that they were already thinking about divesting because of declines in that service area. Elliott Davis’ technology practice had seen its revenue drop by $100,000, to $1.7 million, and its staffing drop to 16 from 18 over the past year.

Also, Elliott Davis’ divestiture is not a complete break from technology.

While Baker acquired the firm’s practice that handled software products by Best Software, Elliott Davis has retained the network and systems consulting operations of its technology operations, and that business’ shareholder-in-charge, Charles Johnson.

Separately, Elliott Davis also sold the technology unit’s business in Microsoft Business Solutions Navision software to a larger Navision dealer, CompuSystems of Georgia Inc., in Duluth, Ga..

On a much smaller scale, in response to the GAGAS changes, Tom C. Davis, president of T.C. Davis Associates, a 20-person CPA firm in Valdosta, Ga., has ceased doing audits in one of its client niches, industrial development authorities, in order to continue performing technology services for that group.

"These new regulations mean business and we had to make a choice," said Davis, who, in addition to his CPA practice, consults with CPA firms on technology matters. Industrial development authorities have accounted for all of his firm’s audit work.

Asked why he is dropping audit work and sticking with consulting, Davis replied, "Because consulting is where the money’s at."

Barbacane and Thornton, a 25-person firm in suburban Philadelphia, plans to stick more tightly to its knitting as a specialist in auditing nonprofits and government entities. "We are a throwback to what accounting firms were 30 years ago - we are audit-only and concentrate on audits for fund accounting clients - so the prohibitions in this area are fine with us," said managing partner Rob Barbacane.

Barbacane expects that his firm’s Philadelphia area reputation as an audit specialist will help it get referrals from other CPA firms that may cease auditing because of the GAGAS change. He noted that his firm has already picked up some new nonprofit clients from Big Four firms that have cut back their services recently.

The nonprofit industry practice of national CPA firm BDO Seidman is also gearing up for referral work resulting from the new regulations. "We’re spreading the word that if you have to let go of work, call us," said Wayne Berson, a partner-in-charge at the Bethesda, Md., practice, which provides audits and other services to nonprofit and government entities.

Berson said that the practice has already been getting audit work referrals from Big Four firms, "because they want to keep their lucrative consulting work." However, he expects that his practice will scale back in providing indirect rate costs services, which assess the costs associated with utilizing federal funds, because the new regulations prohibit offering that service to audit clients.

Berson is among several practitioners who sense that government bodies and nonprofit clients are happy to see the increased standards. "Clients on their own are more concerned about overlapping services, so we must steer clear of any situation that does not look independent," he said. "We have to be squeaky clean."

Barbacane added, "The regulations are pointing us to where the high road is, and we as a profession have to be well above that high road in order get the public back and confident in us."

However, Tom Davis said that the prohibitions will hurt the quality of service that clients receive. He remarked, "What’s most unsettling about this is that it was the big national firms that got us into this mess."

Register or login for access to this item and much more

All Accounting Today content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access