Official Releases.

Statement on Quality Control Standards Nos. 4 and 5 ... SOP 00-1 ... Audit Interpretations ... Ethics Interpretation Statement on Quality Control Standards No. 4--System of Quality Control for a CPA Firm's Accounting and Auditing Practice

(Amends Statement on Quality Control Standards No. 2, System of Quality Control for a CPA Firm's Accounting and Auditing Practice, AICPA, Professional Standards, vol. 2, QC sec. 20.)

18. Policies and procedures for Engagement Performance encompass all phases of the design and execution of the engagement. To the extent appropriate and as required by applicable professional standards, these policies and procedures should cover planning, performing, supervising, reviewing, documenting, and communicating the results of each engagement. Where applicable, these policies and procedures should also address the concurring partner review requirements applicable to SEC engagements as set forth in membership requirements of the SEC Practice Section of the American Institute of Certified Public Accountants (AICPA).

EFFECTIVE DATE

26. The amendment to paragraph 18 promulgated by this Statement on Quality Control Standards is applicable to a CPA firm's system of quality control for its accounting, auditing, and attestation practice as of January 1, 2000.

This Statement entitled System of Quality Control for a CPA Firm's Accounting and Auditing Practice was adopted unanimously by the fifteen members of the board.

Auditing Standards Board (1999-2000)

Deborah D. Lambert, Chair
James S. Gerson, Vice-Chair
John Barnum
Andrew J. Capelli
Linda K. Cheatham
Robert E Dacey
Richard Dieter
Sally L. Hoffman
J. Michael Inzina
Charles E. Landes
W. Scott McDonald
Keith O. Newton
Robert C. Steiner
George H. Tucker III
O. Ray Whittington

Arleen R. Thomas, Vice-President,
  Professional Standards and Services
Thomas Ray, Director, Audit and Attest Standards

Joint Task Force on Quality Control Standards--Accounting and Auditing (1998-1999)

Barry Barber, Chair
Robert E. Fleming
Lester L. Fordham
Charles E. Landes
Richard L. Miller
Ray Roberts

Susan S. Coffey, Vice-President,
  Self-Regulation and SECPS
David Brumbeloe, Director, SEC Practice Section

The Board gratefully acknowledges the Joint Task Force on Quality Control Standards and the SEC Practice Section Task Force on Concurring Partner Review for their significant contributions.

Note: Statements on Quality Control Standards are issued by the Auditing Standards Board. Firms that are enrolled in an Institute-approved practice-monitoring program are obligated to adhere to quality control standards established by the Institute.

Statement on Quality Control Standards No. 5--The Personnel Management Element of a Firm's System of Quality Control--Competencies Required by a Practitioner-in-Charge of an Attest Engagement

INTRODUCTION

1. Statement on Quality Control Standards (SQCS) No. 2, System of Quality Control for a CPA Firm's Accounting and Auditing Practice (AICPA, Professional Standards, vol. 2, QC sec. 20), provides that a CPA firm shall have a system of quality control for its accounting and auditing practice(1) that should encompass the following elements:

a. Independence, integrity, and objectivity

b. Personnel management

c. Acceptance and continuance of clients and engagements

d. Engagement performance

e. Monitoring

THE PERSONNEL MANAGEMENT ELEMENT OF QUALITY CONTROL

2. Personnel Management encompasses hiring, assigning personnel to engagements, professional development, and advancement activities. Accordingly, policies, and procedures should be established to provide the firm with reasonable assurance that--

a. Those hired possess the appropriate characteristics to enable them to perform competently. Examples of such characteristics may include meeting minimum academic requirements established by the firm, maturity, integrity, and leadership traits.

b. Work is assigned to personnel having the degree of technical training and proficiency required in the circumstances.

c. Personnel participate in general and industry-specific continuing professional education (CPE) and other professional development activities that enable them to fulfill the responsibilities assigned, and satisfy applicable continuing professional education requirements of the AICPA and regulatory agencies.(2)

d. Personnel selected for advancement have the qualifications necessary for fulfillment of the responsibilities they will be called on to assume.

3. This Statement clarifies the requirements of the personnel management element of a firm's system of quality control. In light of the significant responsibilities during the planning and performance of accounting, auditing, and attestation engagements of individuals who are responsible for supervising accounting, auditing, and attestation engagements and signing or authorizing an individual to sign the accountant's report on such engagements, a firm's policies and procedures related to the items noted in paragraph 2 above should be designed to provide a firm with reasonable assurance that such individuals possess the kinds of competencies that are appropriate given the circumstances of individual client engagements. For purposes of this standard, such an individual is referred to as the practitioner-in-charge of the engagement.

COMPETENCIES

4. Competencies are the knowledge, skills, and abilities that enable a practitioner-in-charge to be qualified to perform an accounting, auditing, or attestation engagement. A firm is expected to determine the kinds of competencies that are necessary in the individual circumstances. Competencies are not measured by periods of time because such a quantitative measurement may not accurately reflect the kinds of experiences gained by a practitioner in any given time period. Accordingly, for purposes of this Statement, a measure of overall competency is qualitative rather than quantitative.

Gaining Competencies

5. A firm's policies and procedures would ordinarily require a practitioner-in-charge of an engagement to gain the necessary competencies through recent experience in accounting, auditing, and attestation engagements. In a number of cases, however, a practitioner-in-charge will have obtained the necessary competencies through disciplines other than the practice of public accounting, such as in relevant industry, governmental, and academic positions. If necessary, the experience of the practitioner-in-charge should be supplemented by continuing professional education (CPE) and consultation. The following are examples.

* A practitioner-in-charge of an engagement whose recent experience has consisted primarily in providing tax services may acquire the competencies necessary in the circumstances to perform a compilation or review engagement by obtaining relevant CPE.

* A practitioner-in-charge of an engagement who did not have any experience in auditing the financial statements of a public company and only possessed recent prior experience in auditing the financial statements of nonpublic entities may develop the necessary competencies by obtaining relevant CPE related to the Securities and Exchange Commission (SEC) rules and regulations and consulting with other practitioners who possess relevant knowledge related to SEC rules and regulations.

* A practitioner-in-charge of an engagement who did not have any experience in auditing the financial statements of a public company but possessed prior public accounting practice experience auditing financial statements of nonpublic entities and who also has relevant experience as the controller of a public company may have the necessary competencies in the circumstances.

* A practitioner-in-charge of an engagement whose actual experience consists of performing review and compilation engagements may be able to obtain the necessary competencies to perform an audit by becoming familiar with the industry in which the client operates, obtaining CPE relating to auditing, and/or using consulting sources during the course of performing the audit engagement.

* A person in academia might obtain the necessary competencies to perform accounting, auditing, or attestation engagements by (a) obtaining specialized knowledge through teaching or authorship of research projects or similar papers, and (b) a rigorous self-study program or by engaging a consultant to assist on such engagements.

6. Regardless of the manner in which a particular competency is gained, a firm's quality control policies and procedures should be adequate to provide reasonable assurance that a practitioner-in-charge of an engagement possesses the competencies necessary to fulfill his or her engagement responsibilities.

7. The nature and extent of competencies established by a firm that are expected of the practitioner-in-charge of an engagement should be based on the characteristics of a particular client, industry, and the kind of service being provided. For example, the following should be considered.

* The competencies expected of a practitioner-in-charge of an engagement to compile financial statements would be different than those expected of a practitioner engaged to review or audit financial statements.

* Supervising engagements and signing or authorizing others to sign reports for clients in certain industries or engagements, such as financial services, governmental, or employee benefit plan engagements, would require different competencies than those that would be expected in performing attest services for clients in other industries.

* The practitioner-in-charge of an engagement to audit the financial statements of a public company would be expected to have certain technical proficiency in SEC reporting requirements, while a practitioner-in-charge who is not assigned to the audits of public companies would not need to be proficient in this area. This would include, for example, experience in the industry and appropriate knowledge of SEC and [Independence Standards Board] rules and regulations, including accounting and independence standards.

* The practitioner-in-charge of an attestation engagement to examine management's assertion about the effectiveness of an entity's internal control over financial reporting would be expected to have certain technical proficiency in understanding and evaluating the effectiveness of controls, while a practitioner-in-charge of an attestation engagement to examine investment performance statistics would be expected to have different competencies, including an understanding of the subject matter of the underlying assertion.

Competencies Expected in Performing Accounting, Auditing, and Attestation Engagements

8. In practice, the kinds of competency requirements that a firm should establish for the practitioner-in-charge of an engagement are necessarily broad and varied in both their nature and number. However, the firm's quality control policies and procedures should ordinarily address the following competencies for the practitioner-in-charge of an engagement. Firm policies and procedures should also address other competencies as necessary in the circumstances.

a. Understanding of the Role of a System of Quality Control and the Code of Professional Conduct--Practitioners-in-charge of an engagement should possess an understanding of the role of a firm's system of quality control and the AICPA's Code of Professional Conduct, both of which play critical roles in assuring the integrity of the various kinds of accountant's reports.

b. Understanding of the Service to Be Performed--Practitioners-in-charge of an engagement should possess an understanding of the performance, supervision, and reporting aspects of the engagement, which is normally gained through actual participation in that kind of engagement under appropriate supervision.

c. Technical Proficiency--Practitioners-in-charge of an engagement should possess an understanding of the applicable accounting, auditing, and attest professional standards including those standards directly related to the industry in which a client operates and the kinds of transactions in which a client engages.

d. Familiarity With the Industry--To the extent required by professional standards applicable to the kind of service being performed, practitioners-in-charge of an engagement should possess an understanding of the industry in which a client operates. In performing an audit or review of financial statements, this understanding would include an industry's organization and operating characteristics sufficient to identify areas of high or unusual risk associated with an engagement and to evaluate the reasonableness of industry specific estimates.

e. Professional Judgment--Practitioners-in-charge of an engagement should possess skills that indicate sound professional judgment. In performing an audit or review of financial statements, such skills would typically include the ability to exercise professional skepticism and identify areas requiring special consideration including, for example, the evaluation of the reasonableness of estimates and representations made by management and the determination of the kind of report necessary in the circumstances.

f. Understanding the Organization's Information Technology Systems--Practitioners-in-charge of an audit engagement should have an understanding of how the organization is dependent on or enabled by information technologies and the manner in which information systems are used to record and maintain financial information.

Interrelationship of Competencies and Other Elements of a Firm's System of Quality Control

9. The competencies listed in the preceding are interrelated, and gaining one particular competency may be related to achieving another. For example, familiarity with the client's industry interrelates with a practitioner's ability to make professional judgments relating to the client.

10. In establishing policies and procedures related to the nature of competencies needed by the practitioner-in-charge of an engagement, a firm may need to consider the requirements of policies and procedures established for other elements of quality control. For example, a firm would consider its requirements related to engagement performance in determining the nature of any competency requirements that assess the degree of technical proficiency necessary in a given set of circumstances.

THE RELATIONSHIP OF THE COMPETENCY REQUIREMENT OF THE UNIFORM ACCOUNTANCY ACT TO THE PERSONNEL MANAGEMENT ELEMENT OF QUALITY CONTROL

11. The Uniform Accountancy Act (UAA) is a model legislative statute and related administrative rules that the AICPA and the National Association of State Boards of Accountancy (NASBA) designed to provide a uniform approach to the regulation of the accounting profession. CPAs are not required to follow the provisions of the UAA itself but rather the accountancy laws of the individual licensing jurisdictions in the United States governing the practice of public accounting, which may have adopted the UAA in whole or in part. The UAA provides that "any individual licensee who is responsible for supervising attest or compilation services and signs or authorizes someone to sign the accountant's report on the financial statements on behalf of the firm shall meet the competency requirements set out in the professional standards for such services." A firm's compliance with this Statement is intended to enable a practitioner who performs the services described in the preceding sentence on the firm's behalf to meet this competency requirement; however, this Statement's applicability is broader than what is required by the UAA since the definition of an accounting and auditing practice in quality control standards encompasses a wider range of attest engagements.

EFFECTIVE DATE

12. The provisions of this Statement are applicable to a CPA firm's system of quality control for its accounting and auditing practice as of June 30, 2000. Earlier implementation is encouraged.

This Statement entitled The Personnel Management Element of a Firm's System of Quality Control-Competencies Required by a Practitioner-in-Charge of an Attest Engagement was adopted unanimously by the fifteen members of the board.

Auditing Standards Board (1999-2000)

Deborah D. Lambert, Chair
James S. Gerson, Vice-Chair
John T. Barnum
Andrew J. Capelli
Robert F. Dacey
Richard Dieter
Sally L. Hoffman
Stephen D. Holton
J. Michael Inzina
Charles E. Landes
Keith O. Newton
Alan Rosenthal
R.C. Steiner
George H. Tucker III
Oliver R. Whittington

Arleen R. Thomas, Vice-President
  Professional Standards and Services
Thomas Pay, Director
  Audit and Attest Standards

Joint Task Force on Quality Control Standards--Accounting and Auditing (1998-1999)

Barry Barber, Chair
Robert E. Fleming
Lester L. Fordham
Charles E. Landes
Richard L. Miller
Pay Roberts

Susan S. Coffey, Vice-President
  Self-Regulation and SECPS
David Brumbeloe, Director
  SEC Practice Section
Anthony J. Pugliese, Director
  Assurance Services

The Board gratefully acknowledges the Joint Task Force on Quality Control Standards for their significant contributions.

Note: Statements on Quality Control Standards are issued by the Auditing Standards Board. Firms that are enrolled in an Institute-approved practice-monitoring program are obligated to adhere to quality control standards established by the Institute.

Space considerations prevent publishing here the appendix to SOP 00-1. Since appendices often are important to understanding SOPs, readers are advised to obtain complete copies. To obtain a copy of SOP 001 (product no. 014926JA), contact the AICPA order department at 888-777-7077.

(1) Accounting and auditing practice refers to all accounting, audit, and attestation services for which standards have been established by the AICPA Auditing Standards Board or the AICPA Accounting and Review Services Committee under rule 201 or 202 of the AICPA Code of Professional Conduct (AICPA, Professional Standards, vol. 2, ET sec. 201 and 202). Standards may also be established by other AICPA senior technical committees; engagements that are performed in accordance with those standards are not encompassed in the definition of an accounting, auditing, and attestation practice.

(2) Regulatory agencies that have established continuing education requirements include state boards of accountancy and the U.S. General Accounting Office (GAO).

Statement of Position 00-1--Auditing Health Care Third-Party Revenues and Related Receivables

NOTE

This Statement of Position presents the recommendations of the AICPA Health Care Third-Party Revenue Recognition Task Force with regard to auditing financial statement assertions about third-party revenues and related receivables of health care entities. The Auditing Standards Board has found the recommendations in this Statement of Position to be consistent with existing standards covered by rule 202 of the AICPA Code of Professional Conduct. AICPA members should be prepared to justify departures from the recommendations in this Statement of Position.

TABLE OF CONTENTS

Summary
Introduction and Background
Scope and Applicability
Third-Party Revenues and Related Receivables--Inherent
   Uncertainties
Management's Responsibilities
The Auditor's Responsibilities
Evidential Matter
Potential Departures From GAAP Related to
  Estimates and Uncertainties
     Unreasonable Accounting Estimates
     Inappropriate Accounting Principles
     Inadequate Disclosure
Appendix: Other Considerations Related to
  Government Investigations

SUMMARY

This Statement of Position provides guidance to auditors regarding uncertainties inherent in health care third-party revenue recognition. It discusses auditing matters to consider in testing third-party revenues and related receivables, and provides guidance regarding the sufficiency of evidential matter and reporting on financial statements of health care entities exposed to material uncertainties.

INTRODUCTION AND BACKGROUND

1. Most health care providers participate in payment programs that pay less than full charges for services rendered. For example, some cost-based programs retrospectively determine the final amounts reimbursable for services rendered to their beneficiaries based on allowable costs. With increasing frequency, even non-cost-based programs (such as the Medicare Prospective Payment System) have become subject to retrospective adjustments (for example, billing denials and coding changes). Often, such adjustments are not known for a considerable period of time after the related services were rendered.

2. The lengthy period of time between rendering services and reaching final settlement, compounded further by the complexities and ambiguities of reimbursement regulations, makes it difficult to estimate the net patient service revenue associated with these programs. This situation has been compounded due to the frequency of changes in federal program guidelines.

3. The AICPA Audit and Accounting Guide Health Care Organizations (the Guide) requires that patient revenues be reported net of provisions for contractual and other adjustments (paragraph 10.20). As a result, patient receivables, including amounts due from third-party payors, are also reported net of expected contractual and other adjustments. However, amounts ultimately realizable will not be known until some future date, which may be several years after the period in which the services were rendered.

4. This Statement of Position (SOP) provides guidance to auditors regarding uncertainties inherent in health care third-party revenue recognition. It discusses auditing matters to consider in testing third-party revenue and related receivables, including the effects of settlements (both cost-based and non-cost-based third-party payment programs), and provides guidance regarding the sufficiency of evidential matter and reporting on financial statements of health care entities exposed to material uncertainties.

SCOPE AND APPLICABILITY

5. This SOP applies to audits of health care organizations falling within the scope of the Guide. Its provisions are effective for audits of periods ending on or after June 30, 2000. Early application of the provisions of this SOP is permitted.

THIRD-PARTY REVENUES AND RELATED RECEIVABLES--INHERENT UNCERTAINTIES

6. Health care entities need to estimate amounts that ultimately will be realizable in order for revenues to be fairly stated in accordance with generally accepted accounting principles (GAAP). The basis for such estimates may range from relatively straightforward calculations using information that is readily available to highly complex judgments based on assumptions about future decisions.

7. Entities doing business with governmental payors (for example, Medicare and Medicaid) are subject to risks unique to the government-contracting environment that are hard to anticipate and quantify and that may vary from entity to entity. For example--

* A health care entity's revenues may be subject to adjustment as a result of examination by government agencies or contractors. The audit process and the resolution of significant related matters (including disputes based on differing interpretations of the regulations) often are not finalized until several years after the services were rendered.

* Different fiscal intermediaries (entities that contract with the federal government to assist in the administration of the Medicare program) may interpret governmental regulations differently.

* Differing opinions on a patient's principal medical diagnosis, including the appropriate sequencing of codes used to submit claims for payment, can have a significant effect on the payment amount.(1)

* Otherwise valid claims may be determined to be nonallowable after the fact due to differing opinions on medical necessity.

* Claims for services rendered may be nonallowable if they are later determined to have been based on inappropriate referrals.(2)

* Governmental agencies may make changes in program interpretations, requirements, or "conditions of participation," some of which may have implications for amounts previously estimated.

8. Such factors often result in retrospective adjustments to interim payments. Reasonable estimates of such adjustments are central to the third-party revenue recognition process in health care, in order to avoid recognizing revenue that the provider will not ultimately realize. The delay between rendering services and reaching final settlement, as well as the complexities and ambiguities of billing and reimbursement regulations, makes it difficult to estimate net realizable third-party revenues.

MANAGEMENT'S RESPONSIBILITIES

9. Management is responsible for the fair presentation of its financial statements in conformity with GAAP. Management also is responsible for adopting sound accounting policies and for establishing and maintaining internal control that will, among other things, record, process, summarize, and report transactions (as well as events and conditions) consistent with management's assertions embodied in the financial statements. Despite the inherent uncertainties, management is responsible for estimating the amounts recorded in the financial statements and making the required disclosures in accordance with GAAP, based on management's analysis of existing conditions.

10. Management's assertions regarding proper valuation of its revenues and receivables are embodied in the financial statements. Management is responsible for assuring that revenues are not recognized until their realization is reasonably assured. As a result, management makes a reasonable estimate of amounts that ultimately will be realized, considering--among other things--adjustments associated with regulatory reviews, audits, billing reviews, investigations, or other proceedings. Estimates that are significant to management's assertions about revenue include the provision for third-party payor contractual adjustments and allowances.

11. Management also is responsible for preparing and certifying cost reports submitted to federal and state government agencies in support of claims for payment for services rendered to government program beneficiaries.

THE AUDITOR'S RESPONSIBILITIES

12. The auditor's responsibility is to express an opinion on the financial statements taken as a whole. In reaching this opinion, the auditor considers the evidence in support of recorded amounts. If amounts are not known with certainty, the auditor considers the reasonableness of management's estimates in the present circumstances. The auditor also considers the fairness of the presentation and adequacy of the disclosures made by management.

13. In planning the audit, the auditor considers current industry conditions, as well as specific matters affecting the entity.(3) Among a number of things, the auditor's procedures typically include an analysis of historical results (for example, prior fiscal intermediary audit adjustments and comparisons with industry benchmarks and norms) that enable the auditor to better assess the risk of material misstatements in the current period. When there are heightened risks, the auditor performs more extensive tests covering the current period. Exhibit 5.1 of the Guide includes a number of examples of procedures that auditors may consider.

14. With respect to auditing third-party revenues, in addition to the usual revenue recognition considerations, the auditor considers whether amounts ultimately realizable are or should be presently known or are uncertain because they are dependent on some other future, prospective actions or confirming events. For example, under a typical fee-for-service contract with a commercial payor, if the provider has performed a service for a covered individual, the revenue to which the provider is entitled should be determinable at the time the service is rendered. On the other hand, if the service was provided under a cost-based government contract, the revenue ultimately collectible may not be known until certain future events occur (for example, a cost report has been submitted and finalized after desk review or audit). In this case, management estimates the effect of such potential future adjustments.

15. As stated previously, management is responsible for preparing the estimates contained in the financial statements. The auditor evaluates the adequacy of the evidence supporting those estimates, reviews the facts supporting management's judgments, and evaluates the judgments made based on conditions existing at the time of the audit. The fact that net revenues recorded at the time services are rendered differ materially from amounts that ultimately are realized does not necessarily mean the audit was not properly planned or carried out. Similarly, the fact that future events may differ materially from management's assumptions or estimates does not necessarily mean that management's estimates were not valid or the auditor did not follow generally accepted auditing standards (GAAS) as described in this SOP with respect to auditing estimates.

EVIDENTIAL MATTER

16. The measurement of estimates is inherently uncertain and depends on the outcome of future events. Statement on Auditing Standards (SAS) No. 57, Auditing Accounting Estimates (AICPA, Professional Standards, vol. 1, AU sec. 342), and SAS No. 79, Amendment to SAS No. 58, Reports on Audited Financial Statements (AICPA, Professional Standards, vol. I, AU sec. 508), provide guidance to the auditor when the valuation of revenues is uncertain, pending the outcome of future events. In the current health care environment, conclusive evidence concerning amounts ultimately realizable cannot be expected to exist at the time of the financial statement audit because the uncertainty associated with future program audits, administrative reviews, billing reviews, regulatory investigations, or other actions will not be resolved until sometime in the future.

17. The fact that information related to the effects of future program audits, administrative reviews, regulatory investigations, or other actions does not exist does not lead to a conclusion that the evidential matter supporting management's assertions is not sufficient to support management's estimates. Rather, the auditor's judgment regarding the sufficiency of the evidential matter is based on the evidential matter that is available or can reasonably be expected to be available in the circumstances. If, after considering the existing conditions and available evidence, the auditor concludes that sufficient evidential matter supports management's assertions about the valuation of revenues and receivables, and their presentation and disclosure in the financial statements, an unqualified opinion ordinarily is appropriate.

18. If relevant evidential matter exists that the auditor needs and is unable to obtain, the auditor should consider the need to express a qualified opinion or to disclaim an opinion because of a scope limitation. For example, if an entity has conducted an internal evaluation (for example, of coding or other billing matters) under attorney-client privilege and management and its legal counsel refuse to respond to the auditor's inquiries and the auditor determines the information is necessary, ordinarily the auditor qualifies his or her opinion for a scope limitation.

19. The auditor considers the reasonableness of management's assumptions in light of the entity's historical experience and the auditor's knowledge of general industry conditions, because the accuracy of management's assumptions will not be known until future events occur. For certain matters, the best evidential matter available to the auditor (particularly as it relates to clinical and legal interpretations) may be the representations of management and its legal counsel, as well as information obtained through reviewing correspondence from regulatory agencies.

20. Pursuant to SAS No. 85, Management Representations (AICPA, Professional Standards, vol. 1, AU sec. 333), the auditor should obtain written representations from management concerning the absence of violations or possible violations of laws or regulations whose effects should be considered for disclosure in the financial statements or as a basis for recording a loss contingency. Examples of specific representations include the following:

* Receivables

--Adequate consideration has been given to, and appropriate provision made for, estimated adjustments to revenue, such as for denied claims and changes to diagnosis-related group (DRG) assignments.

--Recorded valuation allowances are necessary, appropriate, and properly supported.

--All peer review organizations, fiscal intermediary, and third-party payor reports and information have been made available.

* Cost reports filed with third parties

--All required Medicare, Medicaid, and similar reports have been properly filed.

--Management is responsible for the accuracy and propriety of all cost reports filed.

--All costs reflected on such reports are appropriate and allowable under applicable reimbursement rules and regulations and are patient-related and properly allocated to applicable payors.

--The reimbursement methodologies and principles employed are in accordance with applicable rules and regulations.

--Adequate consideration has been given to, and appropriate provision made for, audit adjustments by intermediaries, third-party payors, or other regulatory agencies.

--All items required to be disclosed, including disputed costs that are being claimed to establish a basis for a subsequent appeal, have been fully disclosed in the cost report.

--Recorded third-party settlements include differences between filed (and to be filed) cost reports and calculated settlements, which are necessary based on historical experience or new or ambiguous regulations that may be subject to differing interpretations. While management believes the entity is entitled to all amounts claimed on the cost reports, management also believes the amounts of these differences are appropriate.

* Contingencies

--There are no violations or possible violations of laws or regulations, such as those related to the Medicare and Medicaid antifraud and abuse statutes, including but not limited to the Medicare and Medicaid Anti-Kickback Statute, Limitations on Certain Physician Referrals (the Stark law), and the False Claims Act, in any jurisdiction, whose effects should be considered for disclosure in the financial statements or as a basis for recording a loss contingency other than those disclosed or accrued in the financial statements.

--Billings to third-party payors comply in all material respects with applicable coding guidelines (for example, ICD-9-CM and CPT-4) and laws and regulations (including those dealing with Medicare and Medicaid antifraud and abuse), and billings reflect only charges for goods and services that were medically necessary; properly approved by regulatory bodies (for example, the Food and Drug Administration), if required; and properly rendered.

--There have been no communications (oral or written) from regulatory agencies, governmental representatives, employees, or others concerning investigations or allegations of noncompliance with laws and regulations in any jurisdiction (including those related to the Medicare and Medicaid antifraud and abuse statutes), deficiencies in financial reporting practices, or other matters that could have a material adverse effect on the financial statements.

21. Management's refusal to furnish written representations constitutes a limitation on the scope of the audit sufficient to preclude an unqualified opinion and is ordinarily sufficient to cause an auditor to disclaim an opinion or withdraw from the engagement. However, based on the nature of the representations not obtained or the circumstances of the refusal, the auditor may conclude that a qualified opinion is appropriate.

POTENTIAL DEPARTURES FROM GAAP RELATED TO ESTIMATES AND UNCERTAINTIES

22. In addition to examining the evidence in support of management's estimates, the auditor determines that there has not been a departure from GAAP with respect to the reporting of those estimates in the financial statements. Such departures generally fall into one of the following categories:

* Unreasonable accounting estimates

* Inappropriate accounting principles

* Inadequate disclosure

Therefore, in order to render an opinion, the auditor's responsibility is to evaluate the reasonableness of management's estimates based on present circumstances and to determine that estimates are reported in accordance with GAAP and adequately disclosed.

23. As discussed in SAS No. 31, Evidential Matter (AICPA, Professional Standards, vol. 1, AU sec. 326), the auditor's objective is to obtain sufficient competent evidential matter to provide him or her with a reasonable basis for forming an opinion. As discussed previously, exhibit 5.1 of the Guide provides a number of sample procedures that the auditor might consider in auditing an entity's patient revenues and accounts receivable, including those derived from third-party payors. For example, the Guide notes that the auditor might "test the reasonableness of settlement amounts, including specific and unallocated reserves, in light of the payors involved, the nature of the payment mechanism, the risks associated with future audits, and other relevant factors."(4)

Unreasonable Accounting Estimates

24. In evaluating the reasonableness of management's estimates, the auditor considers the basis for management's assumptions regarding the nature of future adjustments and management's calculations as to the effects of such adjustments.(5) The auditor cannot determine with certainty whether such estimates are right or wrong, because the accuracy of management's assumptions cannot be confirmed until future events occur.

25. Though difficult to predict, it is reasonable for the auditor to expect that management has made certain assumptions (either in detail or in the aggregate) in developing its estimates regarding conditions likely to result in adjustments. The auditor gathers evidence regarding the reasonableness of the estimates (for example, consistency with historical experience and basis of management's underlying assumptions). In evaluating reasonableness, the auditor should obtain an understanding of how management developed the estimate. Based on that understanding, the auditor should use one or a combination of the following approaches:

a. Review and test the process used by management to develop the estimate.

b. Develop an independent expectation of the estimate to corroborate the reasonableness of management's estimates.

c. Review subsequent events or transactions occurring prior to completion of fieldwork (AU sec. 342.10).

26. Since no one accounting estimate can be considered accurate with certainty, the auditor recognizes that a difference between an estimated amount best supported by the audit evidence and the estimated amount included in the financial statements may be reasonable, and such difference would not be considered to be a likely misstatement. However, if the auditor believes the estimated amount included in the financial statements is unreasonable, he or she should treat the difference between that estimate and the closest reasonable estimate in the range as a likely misstatement and aggregate it with other likely misstatements. The auditor also should consider whether the difference between estimates best supported by the audit evidence and the estimates included in the financial statements, which are individually reasonable, indicate a possible bias on the part of the entity's management. For example, if each accounting estimate included in the financial statements was individually reasonable, but the effect of the difference between each estimate and the estimate best supported by the audit evidence was to increase income, the auditor should reconsider the reasonableness of the estimates taken as a whole (SAS No. 47, Audit Risk and Materiality in Conducting an Audit [AICPA, Professional Standards, vol. 1, AU sec. 312.36]).

27. The auditor recognizes that approaches and estimates will vary from entity to entity. Some entities with significant prior experience may attempt to quantify the effects of individual potential intermediary or other governmental (for example, the Office of Inspector General and the Department of Justice) or private payor adjustments, basing their estimates on very detailed calculations and assumptions regarding potential future adjustments. Some may prepare cost report(6) analyses to estimate the effect of potential adjustments. Others may base their estimates on an analysis of potential adjustments in the aggregate, in light of the payors involved; the nature of the payment mechanism; the risks associated with future audits; and other relevant factors.

28. Normally, the auditor considers the historical experience of the entity (for example, the aggregate amount of prior cost-report adjustments and previous regulatory settlements) as well as the risk of potential future adjustments. The fact that an entity currently is not subject to a governmental investigation does not mean that a recorded valuation allowance for potential billing adjustments is not warranted. Nor do these emerging industry trends necessarily indicate that an accrual for a specific entity is warranted.

29. In evaluating valuation allowances, the auditor may consider the entity's historical experience and potential future adjustments in the aggregate. For example, assume that over the past few years after final cost report audits were completed, a hospital's adjustments averaged 3 percent to 5 percent of total filed reimbursable costs. Additionally, the hospital is subject to potential billing adjustments, including errors (for example, violations of the three-day window, discharge and transfer issues, and coding errors). Even though specific incidents are not known, it may be reasonable for the hospital to estimate and accrue a valuation allowance for such potential future retrospective adjustments, both cost-based and non-cost-based. Based on this and other information obtained, the auditor may conclude that a valuation allowance for the year under audit of 3 percent to 5 percent of reimbursable costs plus additional amounts for potential non-cost-based program billing errors is reasonable.

30. Amounts that ultimately will be realized by an entity are dependent on a number of factors, many of which may be unknown at the time the estimate is first made. Further, even if two entities had exactly the same clinical and coding experience, amounts that each might realize could vary materially due to factors outside of their control (for example, differing application of payment rules by fiscal intermediaries, legal interpretations of courts, local enforcement initiatives, timeliness of reviews, and quality of documentation). As a result, because estimates are a matter of judgment and their ultimate accuracy depends on the outcome of future events, different entities in seemingly similar circumstances may develop materially different estimates. The auditor may conclude that both estimates are reasonable in light of the differing assumptions.

Inappropriate Accounting Principles

31. The auditor also determines that estimates are presented in the financial statements in accordance with GAAP. If the auditor believes that the accounting principles have not been applied correctly, causing the financial statements to be materially misstated, the auditor expresses a qualified or adverse opinion.

32. Valuation allowances are recorded so that revenues are not recognized until the revenues are realizable. Valuation allowances are not established based on the provisions of Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 5, Accounting for Contingencies.

33. The auditor should be alert for valuation allowances not associated with any particular program, issue, or time period (for example, cost-report year or year the service was rendered). Such a reserve may indicate measurement bias. The auditor also considers the possibility of bias resulting in distorted earnings trends over time (for example, building up specific or unallocated valuation allowances in profitable years and drawing them down in unprofitable years).

Inadequate Disclosure

34. If the auditor concludes that a matter involving a risk or an uncertainty is not adequately disclosed in the financial statements in conformity with GAAP, the auditor should express a qualified or adverse opinion. SOP 94-6, Disclosure of Certain Significant Risks and Uncertainties, provides guidance on the information that reporting entities should disclose regarding risks and uncertainties existing as of the date of the financial statements.

35. In the health care environment, it is almost always at least reasonably possible that estimates regarding third-party payments could change in the near term as a result of one or more future confirming events (for example, regulatory actions reflecting local or national audit or enforcement initiatives). For most entities with significant third-party revenues, the effect of the change could be material to the financial statements. Where material exposure exists, the uncertainty regarding revenue realization is disclosed in the notes to the financial statements. Because representations from legal counsel are often key audit evidence in evaluating the reasonableness of management's estimates of potential future adjustments, the inability of an attorney to form an opinion on matters about which he or she has been consulted may be indicative of an uncertainty that should be specifically disclosed in the financial statements.

36. Differences between original estimates and subsequent revisions might arise due to final settlements, ongoing audits and investigations, or passage of time in relation to the statute of limitations. The Guide (paragraph 5.07) requires that these differences be included in the statement of operations in the period in which the revisions are made and disclosed, if material. Such differences are not treated as prior period adjustments unless they meet the criteria for prior period adjustments as set forth in FASB Statement No. 16, Prior Period Adjustments.

31. Disclosures such as the following may be appropriate:

General Hospital (the Hospital) is a (not-for-profit, for-profit, or governmental hospital or health care system) located in (City, State). The Hospital provides health care services primarily to residents of the region.

Net patient service revenue is reported at estimated net realizable amounts from patients, third-party payors, and others for services rendered and includes estimated retroactive revenue adjustments due to future audits, reviews, and investigations. Retroactive adjustments are considered in the recognition of revenue on an estimated basis in the period the related services are rendered, and such amounts are adjusted in future periods as adjustments become known or as years are no longer subject to such audits, reviews, and investigations.

Revenue from the Medicare and Medicaid programs accounted for approximately 40 percent and 10 percent, respectively, of the Hospital's net patient revenue for the year ended 1999. Laws and regulations governing the Medicare and Medicaid programs are extremely complex and subject to interpretation. As a result, there is at least a reasonable possibility that recorded estimates will change by a material amount in the near term. The 1999 net patient service revenue increased approximately $10,000,000 due to removal of allowances previously estimated that are no longer necessary as a result of final settlements and years that are no longer subject to audits, reviews, and investigations. The 1998 net patient service revenue decreased approximately $8,000,000 due to prior-year retroactive adjustments in excess of amounts previously estimated.

Auditing Standards Board

Deborah D. Lambert, Chair
James S. Gerson, Vice-Chair
John Barnum
Andrew J. Capelli
Linda K. Cheatham
Robert F. Dacey
Richard Dieter
Sally L. Hoffman
J. Michael Inzina
Charles E. Landes
W. Scott McDonald
Keith O. Newton
Robert C. Steiner
George H. Tucker III
O. Ray Whittington

AICPA Health Care Third-Party Revenue Recognition Task Force

William R. Titera, Chair
Martha Garner
Robert A. Wright

AICPA Health Care Committee

Robert A. Wright, Chair
Thomas J. Aaron
Phillip J. Brummel
A. James Budzinski
Rick R. Corcoran
Michael T. Defreece
Robert E. Mazer
Charles V. Robb
Peggy B. Scott
Alan A. Schachter
Gordon J. Vetsch
Jonathan G. Weaver
Audrey L. Went

AICPA Staff

Thomas Ray
Director, Audit and
Technical Manager,

Annette Schumacher Barr
Attest Standards
  Professional Standards & Services

Auditing Interpretations

Interpretations are issued by the Audit Issues Task Force of the Auditing Standards Board to provide timely guidance on the application of pronouncements of that Board. Interpretations are reviewed by the Auditing Standards Board. An interpretation is not as authoritative as a pronouncement of that Board, but members should be aware that they may have to justify a departure from an interpretation if the quality of their work is questioned.

AU SECTION 9334

Interpretation of AU Section 334, Related Parties

7. Management's and Auditor's Responsibilities for Related Party Disclosures Prefaced by Terminology Such As "Management Believes That"

.22 Question--Management discloses in its financial statements that a related party transaction was consummated on terms equivalent to those that prevail in arm's-length transactions, and prefaces the representation with a phrase such as "Management believes that" or "It is the Company's belief that." Does the use of such terminology change management's responsibility to substantiate the representation?

.23 Answer--No. FASB Statement No. 57, Related Party Disclosures, paragraph 3 [AC section R36.103, FASB, Current Text], states that the representations about a related party transaction "shall not imply that the related party transactions were consummated on terms equivalent to those that prevail in arm's-length transactions unless such representations can be substantiated." A preface to a disclosure such as "Management believes that" or "It is the Company's belief that" does not change management's responsibility to substantiate the representation. Section 334, Related Parties, paragraph 12, indicates that if such a representation is included in the financial statements and the auditor believes that the representation is unsubstantiated by management, he should express a qualified or adverse opinion because of a departure from generally accepted accounting principles, depending on materiality.

AU SECTION 9508

Interpretation of AU Section 508, Reports on Audited Financial Statements

13. Reference to Country of Origin in the Auditor's Standard Report

.53 Question--Financial statements prepared in conformity with accounting principles established in the United States and audited in accordance with standards issued by the American Institute of Certified Public Accountants may be disseminated beyond U.S. borders. For example, they may be accessible from many locations throughout the world on electronic networks such as the Internet. The auditor's standard report illustrated in AU section 508.08 [AICPA, Professional Standards] does not include reference to the country of origin of the accounting standards used to prepare the financial statements or of the auditing standards the auditor followed in performing the audit. It may be beneficial for readers of audited financial statements to be able to easily ascertain this information. May a U.S. auditor include such a reference in the auditor's standard report?

.54 Interpretation--Yes. This reference may be made in a manner similar to the following (additional wording is shown in bold/ace italics and deleted wording is struck through):

   Independent Auditor's Report

   [Same first paragraph as the standard report]

   We conducted our audit in accordance with <s>generally accepted</s>
   auditing standards generally accepted in the United States. Those standards
   require that we plan and perform the audit to obtain reasonable assurance
   about whether the financial statements are free of material misstatement.
   An audit includes examining, on a test basis, evidence supporting the
   amounts and disclosures in the financial statements. An audit also includes
   assessing the accounting principles used and significant estimates made by
   management, as well as evaluating the overall financial statement
   presentation. We believe that our audit provides a reasonable basis for our
   opinion

      In our opinion, the financial statements referred to above present
   fairly, in all material respects, the financial position of X Company as of
   [at] December 31, 19XX, and the results of its operations and its cash
   flows for the year then ended in conformity with <s>generally accepted</s>
   accounting principles generally accepted in the United States.

  [Signature]

  [Date]

.55 A U.S. auditor also may be engaged to report on the financial statements of a U.S. entity that have been prepared in conformity with accounting principles generally accepted in another country. In those circumstances, the auditor should refer to the guidance in AU section 534, Reporting on Financial Statements Prepared for Use in Other Countries.

Ethics Interpretation

Ethics interpretations and rulings are promulgated by the executive committee of the professional ethics division to provide guidelines as to the scope and application of the rules but are not intended to limit such scope or application. Publication of an interpretation or ethics ruling in the Journal of Accountancy constitutes notice to members. A member who departs flora interpretations or rulings shall have the burden of justifying such departure in any disciplinary hearing.

(The Professional Ethics Executive Committee has made editorial revisions to an interpretation under rule 101 of the Code of Professional Conduct [AICPA, Professional Standards, ET section 101.11]. "Member or Member's Firm" has been revised. The remainder of the interpretation is unchanged except for a renumbering of footnotes following the added material. [Added text is in boldface italics; deleted text is struck through.])

REVISION OF INTERPRETATION 101-9 UNDER RULE 101: The Meaning of Certain Independence Terminology and the Effect of Family Relationships on Independence

This interpretation defines certain terms used in interpretation 101-1 [ET section 101.02] and, in doing so, also explains how independence may be impaired through certain family relationships.

Member or Member's Firm

A member (as used in rule 101 [ET section 101.01]) and a member or a member's firm (as used in interpretation 101-1 [ET section 101.02]) include--

   1. The member's firm and its proprietors, partners, or shareholders. A
   member's firm is defined as a form of organization permitted by state law
   or regulation whose characteristics conform to resolutions of Council that
   is engaged in the practice of public accounting, including the individual
   owners thereof.

   2. All individuals(7) participating in the engagement, except those who
   perform only routine clerical functions, such as typing and photocopying.

   3. All individuals(8) with a managerial position located in an office
   participating in a significant portion of the engagement.

   4. Any entity (for example, a partnership, corporation, trust, or joint
   venture) whose operating, financial, or accounting policies can be
   controlled (<s>see definite of control for consolidation purposes in
   Financial Accounting Standards Board [FASB] Statement No. 94 [AC section
   C51]</s> as defined by GAAP for consolidation purposes) by one or more of
   the persons described in (1) through (3) or by two or more such persons if
   they choose to act together.

<s>A member or a member's firm does not include an individual</s>(8) <s>solely because he or she was formerly associated with the client in any capacity describes in interpretation 101 1B [ET section 101.02], if such individual</s>(8) <s>has disassociated himself or herself from the client and does not participate in the engagement for the client covering any period of his or her association with the client.</s>

   .5 <s>A member or a member's firm includes</s> All individuals(9) who
   provide services to clients and are associated with the client in any
   capacity described in interpretation 101-1B [ET section 101.02], if the
   individuals(10) are located in an office participating in a significant
   portion of the engagement.

A member or a member's firm does not include an individual(11) solely because he or she was formerly associated with the client in any capacity described in interpretation 101-1B [ET section 101.02], if the individual has dissociated himself or herself from the client and does not participate in the engagement requiring independence for the client covering any period of his or her association with the client. For all other firm clients, such individuals should immediately comply with rule 101 and its interpretations and rulings(12) in the performance of any services requiring independence.

The following actions should be taken by an individual(13) to dissociate from the client prior to becoming a member through employment, ownership, or merger so that the member or member's firm's independence will not be impaired with respect to such client:

   1. Terminate any relationship with the client as described under
   interpretation 101-1B [ET section I01.02].

   2. Dispose of any direct or material indirect financial interest in the
   client.

   3. Collect or repay all loans to or from the client unless specifically
   permitted or grandfathered under interpretation 101-5 [ET section 101.07].

   4. Cease active participation(14) in and withdraw from health or welfare
   plans sponsored by the client, unless the client is legally required to
   allow the member to participate in the plan (for example, COBRA) and the
   member pays 100 percent of the premiums on a current basis.

   5. Cease making contributions to any benefit plans sponsored by the client,
   other than those identified in item 4 above, and terminate any management
   or trustee relationships with any of the benefit plans sponsored by the
   client.

   6. Liquidate or transfer all vested benefits in the client's defined
   benefit plans, defined contribution plans, deferred compensation and other
   similar arrangements, at the earliest possible date. When the right of
   possession does not exist, independence of the member's firm would not be
   considered to be impaired, provided that the member does not participate in
   the engagement.(15) The right of possession is not considered to exist if
   either of the following occur:

   * A penalty(16) significant to the benefits is imposed upon liquidation or
   transfer.

   * The member is unable to complete a timely liquidation or transfer due
   solely to the administrative requirements of the plan (for example, certain
   plans may only permit payments on a quarterly or semiannual basis, or upon
   attaining a certain age.)

[Footnotes formerly numbered 9 through 15 in this interpretation have been renumbered. The remainder of the interpretation is unchanged.]

(1) Historically, the Health Care Financing Administration (HCFA) contracted with Peer Review Organizations (PROs) to validate the appropriateness of admissions and the clinical coding from which reimbursement was determined. Such reviews were typically performed within ninety days of the claim submission date. However, the government has modified its policies with respect to such reviews and now analyzes coding errors through other means, including in conjunction with investigations conducted by the Office of the Inspector General (OIG) of the U. S. Department of Health and Human Services.

(2) Effective January 1, 1995, the Limitation on Certain Physician Referrals law prohibited physicians from referring Medicare and Medicaid patients to health care organizations with which they had a financial relationship for the furnishing of designated health services. Implementing regulations have not yet been adopted as of the date of this publication.

(3) Risk factors, including ones related to legislative and regulatory matters, are discussed annually in the AICPA Audit Risk Alert Health Care Industry Developments.

(4) See paragraphs 25-28.

(5) The lack of such analyses may call into question the reasonableness of recorded amounts.

(6) Medicare cost reimbursement is based on the application of highly complex technical rules, some of which are ambiguous and subject to different interpretations even among Medicare's fiscal intermediaries. It is not uncommon for fiscal intermediaries to reduce claims for reimbursement that were based on management's good faith interpretations of pertinent laws and regulations. Additionally, the Provider Reimbursement Review Board (PRRB) or the courts may be required to resolve controversies regarding the application of certain rules. To avoid recognizing revenues before their realization is reasonably assured, providers estimate the effects of such potential adjustments. This is occasionally done by preparing a cost report based on alternative assumptions to help estimate contractual allowances required by generally accepted accounting principles. The existence of reserves or a reserve cost report does not by itself mean that a cost report was incorrectly or fraudulently filed.

(7) Refers to all employees of the member and all contractors retained by the member, except specialists as discussed in SAS No. 3 [AU section 336], irrespective of their functional classification (for example, audit, tax, or management consulting services).

(8) Ibid.

(9) Ibid.

(10) Ibid.

(11) Ibid.

(12) For example, see Ethics Ruling no. 66, "Member's Retirement or Savings Plan Has Financial Interest in Client" [ET section 191.132 through. 133].

(13) See note 7.

(14) See Ethics Ruling no. 107, "Participation in Health and Welfare Plan of Client" [ET section 191.214 through .215], for instances in which participation was the result of permitted employment by the member's spouse or cohabitant.

(15) Participation in the engagement includes any partner or staff member directly involved with providing services requiring independence to the client, as well as those in a position to influence the engagement(s).

(16) A penalty does not include income taxes that would be owed or market losses that may be incurred as a result of the liquidation or transfer.

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