In the spirit of Independence Day, it’s a good time to review the rules for auditor independence. If you discover potential issues now, there’s still plenty of time to take corrective action before next year’s audit begins.

Definition of independence

Independence is one of the most important requirements for audit firms. It’s why investors and lenders trust CPAs to provide unbiased opinions about the presentation of a company’s financial results. The AICPA and the Securities and Exchange Commission (SEC) have rules regarding auditor independence. Even the U.S. Department of Labor has issued independence guidance for auditors of employee benefit plans.

The AICPA specifically goes to great lengths to explain how audit firms can maintain their independence from the companies they audit. In short, auditors can’t provide any services for an audit client that would normally fall to the company’s management to complete. Auditors also can’t engage in any relationships with their clients that would 1) compromise their objectivity, 2) require them to audit their own work, or 3) result in self-dealing, a conflict of interest or advocacy.

Independence is a matter of professional judgment, but it’s something that accountants take seriously. A firm that violates the independence rules calls into question the accuracy and integrity of its clients’ financial statements.

Prohibited services

Under Rule 2-01 of Regulation S-X, the SEC specifically prohibits auditors from providing the following nonaudit services to a publicly traded audit client or its affiliates:

• Bookkeeping,
• Financial information systems design and implementation,
• Appraisal or valuation services, fairness opinions or contribution-in-kind reports,
• Actuarial services,
• Internal audit outsourcing services,
• Management functions or human resources,
• Broker-dealer, investment advisor or investment banking services, and
• Legal services and expert services unrelated to the audit.

This list isn’t exhaustive. Audit committees should consider whether any service provided by the audit firm may impair the firm’s independence in fact or appearance. SEC independence rules also prohibit audit firms and auditors from engaging in financial relationships with their public audit clients, such as contingent fees, banking, insurance, debtor-creditor arrangements, broker-dealer relationships and futures commission merchant accounts.

In the spotlight

In a recent statement, the SEC’s Acting Chief Accountant Paul Munter noted that current market conditions have caused many companies to engage in complex business arrangements, including restructurings and special purpose acquisition companies. “Such arrangements have the potential to undermine auditor independence. The [general standard of independence, Rule 2-01(b)] is the heart of the Commission’s auditor independence rule, it always applies, and the Commission investigates and enforces against violations of the general standard,” said Munter.

Independence is a critical issue for public and private companies alike. Contact your auditor to discuss any questions you may have regarding auditor independence.

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Recent supply shortages may cause unexpected problems for some businesses that use the last-in, first-out (LIFO) method for their inventory. Here’s an overview of what’s happening so you won’t be blindsided by the effects of so-called “LIFO liquidation.”

Inventory reporting methods

Retailers generally record inventory when it’s received and title transfers to the company. Then, it moves to cost of goods sold when the product ships and title transfers to the customer. You have choices when it comes to reporting inventory costs. Three popular methods are:

1. Specific identification. When a company’s inventory is one of a kind, such as artwork or custom jewelry, it may be appropriate to use the specific-identification method. Here, each item is reported at historic cost and that amount is generally carried on the books until the specific item is sold.

2. First-in, first-out (FIFO). Under this method, the first units entered into inventory are the first ones presumed sold. This method assumes that merchandise is sold in the order it was acquired or produced. Thus, the cost of goods sold is based on older — and often lower — prices.

3. LIFO. Under this method, the last units entered are the first presumed sold. Using LIFO usually causes the low-cost items to remain in inventory. Higher cost of sales generates lower pretax earnings as long as inventory keeps growing.

Downside of LIFO method

LIFO works as a tax deferral strategy, as long as costs and inventory levels are rising. But there’s a potential downside to using LIFO: The tax benefits may unexpectedly reverse if a company that’s using LIFO reduces its ending inventory to a level below the beginning inventory balance. As higher inventory costs are used up, the company will need to start dipping into lower-cost layers of inventory, triggering taxes on “phantom income” that the LIFO method previously has allowed the company to defer. This is commonly known as LIFO liquidation.

Retailers, such as auto dealers, that have less inventory on hand in 2022 may be facing this situation. Higher tax obligations could exacerbate any financial distress they’re currently experiencing.

Fortunately, the House is currently considering legislation — the Supply Chain Disruptions Relief Act — that would provide relief to auto dealers affected by LIFO liquidation. Specifically, the bill would let them wait until the end of 2025 to replace their new vehicle inventory for purposes of determining income for sales in 2020 and 2021. Stay tuned for any progress on this proposed law.

For more information

Accounting for inventory is one of the more complicated parts of U.S. Generally Accepted Accounting Principles. Fortunately, we can help evaluate the optimal reporting method for your business and discuss any concerns you may have regarding LIFO liquidation in today’s volatile marketplace.

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How often does your company generate a full set of financial statements? It’s common for smaller businesses to issue only year-end financials, but interim reporting can be helpful, particularly in times of uncertainty. Given today’s geopolitical risks, mounting inflation and rising costs, it’s wise to perform a midyear check-in to monitor your year-to-date performance. Based on the results, you can then pivot to take advantage of emerging opportunities and minimize unexpected threats.

Appreciate the diagnostic benefits

Monthly, quarterly and midyear financial reports can provide insight into trends and possible weaknesses. Interim reporting can be especially helpful for businesses that have been struggling during the pandemic.

For example, you might compare year-to-date revenue for 2022 against your annual budget. If your business isn’t growing or achieving its goals, find out why. Perhaps you need to provide additional sales incentives, implement a new ad campaign or alter your pricing. It’s also important to track costs during an inflationary market. If your business is starting to lose money, you might need to consider 1) raising prices or 2) cutting discretionary spending. For instance, you might need to temporarily scale back on your hours of operation, reduce travel expenses or implement a hiring freeze.

Don’t forget the balance sheet. Reviewing major categories of assets and liabilities can help detect working capital problems before they spiral out of control. For instance, a buildup of accounts receivable may signal collection problems. A low stock of key inventory items might foreshadow delayed shipments and customer complaints, signaling an urgent need to find alternative suppliers. Or, if your company is drawing heavily on its line of credit, your operations might not be generating sufficient cash flow.

Recognize potential shortcomings

When interim financials seem out of whack, don’t panic. Some anomalies may not be caused by problems in your daily business operations. Instead, they might result from informal accounting practices that are common midyear (but are corrected by you or your CPA before year-end statements are issued).

For example, some controllers might liberally interpret period “cutoffs” or use subjective estimates for certain account balances and expenses. In addition, interim financial statements typically exclude costly year-end expenses, such as profit sharing and shareholder bonuses. Interim financial statements, therefore, tend to paint a rosier picture of a company’s performance than its year-end report potentially may.

Furthermore, many companies perform time-consuming physical inventory counts exclusively at year end. Therefore, the inventory amount shown on the interim balance sheet might be based solely on computer inventory schedules or, in some instances, management’s estimate using historic gross margins. Similarly, accounts receivable may be overstated, because overworked finance managers may lack time or personnel to adequately evaluate whether the interim balance contains any bad debts.

Proceed with caution

Contact us to help with your interim reporting needs. We can fix any shortcomings by performing additional procedures on interim financials prepared in-house — or by preparing audited or reviewed midyear statements that conform to U.S. Generally Accepted Accounting Principles.

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