By Robert Durak, CPA, and Michael Westervelt, CPA, for the Journal of Accountancy
An employee retention credit (ERC) grant is a fully refundable payroll tax credit that eligible businesses and tax-exempt organizations can claim for qualified wages paid to their employees. This credit was designed to help businesses retain their employees during periods of economic hardship during the COVID-19 pandemic. Eligible employers must meet certain criteria, such as experiencing a significant decline in gross receipts or being fully or partially shut down by a government order. The credit is claimed by amending payroll tax returns.
On Dec. 6, the IRS announced that it was sending letters notifying more than 20,000 taxpayers that their ERC claims were being disallowed because either the entities did not exist or did not have paid employees during the period of eligibility for the credit during the pandemic. The letters are one part of an IRS campaign to curb ERC abuse that the Service blames on unscrupulous promoters using misleading marketing campaigns to make money by convincing small businesses to file dubious ERC claims.
In September, the IRS announced a moratorium on processing new refund claims through the end of the year. In October, the IRS outlined steps to help small businesses withdraw ineligible ERC claims. The IRS has also issued multiple warnings, a generic legal advice memorandum (AM 2023-005 (June 30, 2023)), and the "Dirty Dozen" list warning taxpayers against aggressive schemes for claiming COVID-related relief with the ERC program.
Finding noncompliance with ERC eligibility requirements: What should an auditor do?
As practitioners conduct their audit engagements, some are concluding that clients were not eligible for, or eligibility was questionable for, their ERC claims. ERC rules can be complex. The complexity of the rules and the fact that claims for ERCs were submitted quickly may have led to a heightened risk of noncompliance with the requirements.
In some cases, clients may have used a third-party adviser to assist with ERC filings, resulting in claims the auditor may identify as invalid. Clients may believe that they are compliant with the ERC rules and may not believe that they are willfully and negligently breaking the law. This may result in a difference in opinion between the auditor and the third-party advisers.
U.S. GAAP does not address accounting for government grants for private, for-profit entities. FASB ASC 105-10 provides the framework for selecting accounting principles to be used in preparing financial statements when no specific guidance is available for a particular transaction or event.
Under ASC 105-10, an entity may look to other accounting principles that are similar or that provide guidance on similar transactions or events. This allows the entity to analogize to the principles and guidance that best represent the substance of the transaction or event being accounted for.
When an auditor identifies situations where it appears that the rules related to ERCs (such as eligibility requirements) were not complied with, noncompliance may be material to the financial statements. Auditors would need to evaluate possible accounting misstatements and noncompliance with laws and regulations.
In some cases, noncompliance with ERC rules/eligibility requirements may be clear to the auditor. In other cases, the auditor may be uncertain about whether noncompliance exists. Disagreements with management may occur when evaluating whether an entity complied with ERC requirements. These uncertainties should be resolved through application of the recognition threshold of the applicable accounting model, either International Accounting Standard 20, Accounting for Government Grants and Disclosure of Government Assistance, or FASB ASC 958-605, Not-for-Profit Entities — Revenue Recognition.
If noncompliance with ERC program requirements results in misstatements in the financial statements, auditors should follow the requirements in AU-C section 450, Evaluation of Misstatements Identified During the Audit, in AICPAProfessional Standards. Auditors also should be aware of any responsibilities under the AICPA's Code of Professional Conduct.
Noncompliance with ERC rules may result in fines and repayment of amounts received. The IRS can audit entities' eligibility for ERCs in the future and seek return of the related amounts. The American Rescue Plan Act of 2021 (ARPA), P.L. 117-2, extended the statute of limitation for the IRS to audit ERC claims to five years. Ineligibility for ERCs may indicate that a legal liability for the amounts received exists. Additionally, disclosure of the liability and a description of the related circumstances may be warranted.
Audit procedures when noncompliance is identified or suspected
The requirements and guidance in AU-C section 250, Consideration of Laws and Regulations in an Audit of Financial Statements, should be followed when noncompliance with ERC rules may exist. As indicated in paragraph .17 of AU-C section 250, when auditors become aware of noncompliance or suspected noncompliance with ERC requirements, they should obtain further information to evaluate the possible effect on the financial statements. In addition, paragraph .18 of AU-C section 250 indicates that the auditor should discuss the matter with management (at a level above those involved with the suspected noncompliance, if possible) and, when appropriate, those charged with governance (TCWG).
If management or, as appropriate, TCWG, do not provide sufficient information that supports that the entity is in compliance with the relevant regulations and, in the auditor's professional judgment, the effect of the suspected noncompliance may be material to the financial statements, the auditor should consider the need to obtain legal advice.
The guidance in AU-C section 250 paragraphs .19–.20 states that if sufficient information about suspected noncompliance cannot be obtained, the auditor should evaluate the effect of the lack of sufficient appropriate audit evidence on the auditor's opinion. Also, the auditor should evaluate the implications of noncompliance in relation to other aspects of the audit, including the auditor's risk assessment and the reliability of written representations, and take appropriate action.
Reporting noncompliance to TCWG
As indicated in AU-C section 250 paragraphs .21–.23, unless all TCWG are involved in the management of the entity and aware of identified or suspected noncompliance with ERC rules already communicated by the auditor, the auditor should communicate with TCWG matters involving noncompliance with the regulations that come to the auditor's attention during the audit, other than when the matters are clearly inconsequential. If, in the auditor's professional judgment, the noncompliance is believed to be intentional and material, the auditor should communicate the matter to TCWG as soon as practicable.
If the auditor suspects that management or TCWG are involved in noncompliance, the auditor should communicate the matter to the next higher level of authority at the entity, if it exists. When no higher authority exists, or if the auditor believes that the communication may not be acted upon or is unsure about the person to whom to report, the auditor should consider the need to obtain legal advice about options and next steps.
Reporting noncompliance in the auditor's report on the financial statements
AU-C section 250 paragraph .24 specifies that if the auditor concludes that the noncompliance has a material effect on the financial statements, and it has not been adequately reflected in the financial statements, the auditor should, in accordance with AU-C section 705, Modifications to the Opinion in the Independent Auditor's Report, express a qualified or adverse opinion on the financial statements.
If management or TCWG precludes the auditor from obtaining sufficient appropriate audit evidence to evaluate whether noncompliance that may be material to the financial statements has, or is likely to have, occurred, AU-C section 250 paragraph .25 indicates that the auditor should express a qualified opinion or disclaim an opinion on the financial statements based on a limitation on the scope of the audit, in accordance with AU-C section 705. If management or TCWG refuse to accept a modified opinion on the financial statements, the auditor may withdraw from the engagement, when withdrawal is possible under applicable law or regulation, and indicate the reasons for withdrawal in writing to TCWG.
If the auditor is unable to determine whether noncompliance has occurred because of limitations imposed by the circumstances rather than by management or TCWG, the auditor should evaluate the effect on the auditor's opinion, in accordance with AU-C section 705 (AU-C §250 ¶.26).
Concluding thoughts
There is significant complexity related to ERC compliance, including differing interpretations by professionals. For this reason, not all report modifications and differences in opinion will result in noncompliance with laws and regulations. Due care should be taken when considering these matters.
Robert Durak, CPA, CGMA, is director, Audit & Accounting Technical Services, for the Association of International Certified Professional Accountants and head of the AICPA's Center for Plain English Accounting (CPEA). Michael Westervelt, CPA, is principal, National Assurance, Construction, for CliftonLarsonAllen (CLA).