CPA Rules of Professional Conduct

During the past year, the Texas State Board of Public Accountancy has adopted several changes to the Rules of Professional Conduct that apply to all CPAs in Texas. Among those changes include the following:

Section 501.76 Records and Work Papers - The rule requires a licensee to retain work papers for a minimum of five years from the date of any report issued in connection with the attest service, unless otherwise required by another regulatory body. Failure to maintain such documentation or working papers constitutes a violation of the rules and may be considered an admission that the papers do not comply with professional standards. An attest service is generally described as an audit, review, compilation or other assurance engagement required by the board to be performed in accordance with the applicable standards adopted by the American Institute of Certified Public Accountants or another national accountancy organization recognized by the board. This rule change becomes particularly significant for discovery when work papers are not produced, creating a professional standard violation issue.

As discussed in a recent article included in The Journal Accountancy, accountants have historically used quantitative estimates to help them identify potentially material transactions and events. Many accountants base their assessment on the 5% Rule as a starting point, which holds that reasonable investors would not be influenced in their investment decisions by fluctuations in net income of 5% or less. Nor would the investor be swayed by multiple fluctuations of more or less than 5% among many individual income statement line items, as long as the net change was less than 5%. According to the article, this theory has been and remains the fundamental concept behind working materiality estimates today.

Materiality is not a simple calculation, but rather it is a determination of what will vs. what will not affect the decision of a knowledgeable investor given a specific set of circumstances related to the fair presentation of a company’s financial statements and related disclosures. However, because such a qualitative analysis is very complex, most professionals that use financial data, including CPAs, use quantitative estimates and benchmarks to identify potential materiality issues.

According to Staff Accounting Bulletin no. 99, Materiality, issued by the staff of the Securities and Exchange Commission, "This bulletin expresses the views of the staff that exclusive reliance on certain quantitative benchmarks to assess materiality in preparing financial statements and performing audits of the financial statements is inappropriate; misstatements are not material simply because they fall beneath a numerical threshold." Also, the staff stated that, "A matter is "material" if there is a substantial likelihood that a reasonable person would consider it important.

According to Financial Accounting Standards Board Statement of Financial Accounting Concept No. 2, Qualitative Characteristics of Accounting Information, materiality is defined as "the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement."

Rarely, if ever, does one single factor in isolation provide the means for successfully assessing materiality. Regardless of whether the approach is quantitative or qualitative, the assessment of materiality is largely based on professional judgment. The CPA must be confident in defending his or her professional judgment in all areas of practice and especially in concluding on materiality.

The Public Company Accounting Oversight Board (PCAOB) took its first disciplinary action on May 24, 2005 by revoking the registration of a public accounting firm, barring the managing partner of the firm from association with any registered accounting firm and censured two former partners of that firm.

As reported on AccountingWeb.com, the PCAOB found that after the managing partner and two partners attempted to conceal, by omitting requested information from their response to inspection request, that they knew the firm had prepared financial statements for two public company audit clients in violation of federal law requiring auditor independence. Further, the PCAOB found that all three partners created back-dated documents and place them in the firm’s files in order to conceal the firm’s failure to comply with certain auditing standards.

According to Claudius Modesti, director of the PCAOB’s Division of Enforcement and Investigations, "The findings in this case demonstrate that the PCAOB will not tolerate conduct aimed at thwarting the PCAOB’s inspections." Additional information about this disciplinary action can be obtained at http://www.pcaobus.org/News_and_Events/News/2005/05-24.aspx.

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