Fake Bank Confirmation Responses: How One Man Defrauded Investors of $6 Million

Can auditors be fooled with fake bank confirmations? You bet.

The Western District of North Carolina U.S. Attorney’s Office issued a press release on June 17, 2013, detailing how James Shepherd, an investment company owner, defrauded over 100 investors of approximately $6 million. How? By misusing funds and tricking his company’s external auditors with fake bank confirmation responses.

fake bank confirmation responses

Hiding Theft with Fake Bank Confirmation Responses

The press release states, “Documents indicate that Shepherd built a $2 million residence in Vass, North Carolina, and used investor money to make mortgage payments on the residence.” The U.S. Attorney’s Office said, “For seven years Shepherd used his investment fund as his personal piggy bank and repeatedly lied to his investors who trusted him with their savings.” The release goes on to say the fraud was concealed as “Shepherd sent to investors certified financial statements…accompanied by an Independent Auditor’s Report.” The fraudulent December 31, 2012, financial statement reflected a $6,041,850 cash balance when in reality the fund had less than $100,000. So, how was Shepherd able to get an independent auditor’s report based on fraudulent numbers?

The auditor sent bank confirmations to a P.O. Box address provided by Shepherd. Additionally, the confirmations were sent to the attention of a “Charles Fisher”–a fictitious bank employee.

And who controlled the P.O. Box? Mr. Shepherd.

According to the U.S. Attorney’s Office, Shepherd would receive the bank confirmations, “forge the name Fisher on a fake bank letter” and “send forged bank statements with fake balances” to the auditor. The responses came in the form of both letters and faxes.

So, how were the forged bank statements created? The press release stated that “Shepherd generated the fraudulent bank statements using a version of Adobe Acrobat that enabled him to type false numbers over true bank statements.”

Given the false bank confirmations, how was Mr. Shepherd ever caught? In March 2013 the auditors “insisted on verifying the cash balance of funds’ bank account electronically through the audit confirmation website www.confirmation.com.” Shepherd then refused to give the accountant authority to utilize the site to verify the cash balance. After that, the auditor notified the National Futures Association that his audit opinion could no longer be relied upon.

Given this cautionary tale, how can auditors combat the threat of false bank contact information?

Designing Confirmations 

A while back, my friend James Ulvog brought to my attention the following clarified auditing section about confirmations.

AU-C Section 505.A7 states:

Determining that requests are properly addressed includes verifying the accuracy of the addresses, including testing the validity of some or all of the addresses on the confirmation requests before they are sent out, regardless of the confirmation method used. When a confirmation request is sent by e-mail, the auditor’s determination that the request is being properly directed to the appropriate confirming party may include performing procedures to test the validity of some or all of the e-mail addresses supplied by management.

Auditors confirm bank accounts using:

  1. Letters
  2. Faxes
  3. Emails

Regardless of how an account is confirmed, auditors need to verify the contact information provided by the auditee–at least for some of the confirmations.

Bottom line

Audit standards require that steps be taken to ensure that confirmations are sent to the appropriate persons.

Using Confirmation.com reduces risk related to faulty confirmations. If you don’t use Confirmation.com, then consider checking street addresses by Googling them, or you might call the confirming party–especially for high-risk accounts.

The procedures used to verify mailing addresses, fax numbers, and email addresses should be documented in the auditor’s work papers.

Postscript

On February 11, 2015, Mr. Shepherd was sentenced to 84 months in prison and three years of supervised release. Shepherd pleaded guilty to one count of securities fraud in June 2013.

Modified Audit Opinions: Determining Which is Appropriate

Options include qualified, disclaimer and adverse

You are performing an audit that has a material misstatement, and the client is unwilling to post the proposed audit adjustment. So, you are wondering, “how do I modify the opinion?”

First, let’s take a look at a summary of opinion options, and then we will review sample opinion language.

modified audit opinions

 

Opinion Modification Options

Opinion TypeCircumstance
QualifiedMaterial misstatement is not pervasive
AdverseMaterial misstatements are pervasive
DisclaimerSufficient audit evidence not available; potential material misstatements are pervasive
QualifiedSufficient audit evidence not available; potential material misstatement is not pervasive

Definitions

Before we explore potential opinions, let’s review relevant definitions included in AU-C 705:

Modified opinion. A qualified opinion, an adverse opinion, or a disclaimer of opinion

Pervasive. A term used in the context of misstatements to describe the effects on the financial statements of misstatements or the possible effects on the financial statements of misstatements, if any, that are undetected due to an inability to obtain sufficient appropriate audit evidence [my italics]. Pervasive effects on the financial statements are those that, in the auditor’s professional judgment:

  • are not confined to specific elements, accounts, or items of the financial statements;
  • if so confined, represent or could represent a substantial proportion of the financial statements; or
  • with regard to disclosures, are fundamental to users’ understanding of the financial statements.

Sample Modified Audit Opinions 

1. Qualified Opinion

Suppose your audit reveals inventories are materially misstated, the client will not record your proposed audit adjustment, and there are no other material misstatements. If this is your situation (a material misstatement exists that is not pervasive), then audit standards allow for the issuance of a qualified opinion.

The sample opinion language provided by AU-C 705 is as follows:

Basis for Qualified Opinion

The Company has stated inventories at cost in the accompanying balance sheets. Accounting principles generally accepted in the United States of America require inventories to be stated at the lower of cost or market. If the Company stated inventories at the lower of cost or market, a write-down of $XXX and $XXX would have been required as of December 31, 20X1 and 20X0, respectively. Accordingly, cost of sales would have been increased by $XXX and $XXX, and net income, income taxes, and stockholders’ equity would have been reduced by $XXX, $XXX, and $XXX, and $XXX, $XXX, and $XXX, as of and for the years ended December 31, 20X1 and 20X0, respectively.

Qualified Opinion

In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion paragraph, the financial statements referred to above present fairly, in all material respects, the financial position of ABC Company …

2. Adverse Opinion

Now let’s suppose that you are auditing a consolidated entity, and your client is not willing to include a material subsidiary and which, if included, would have a pervasive impact on the statements.

The sample opinion language provided by AU-C 705 is as follows:

Basis for Adverse Opinion

As described in Note X, the Company has not consolidated the financial statements of subsidiary XYZ Company that it acquired during 20X1 because it has not yet been able to ascertain the fair values of certain of the subsidiary’s material assets and liabilities at the acquisition date. This investment is therefore accounted for on a cost basis by the Company. Under accounting principles generally accepted in the United States of America, the subsidiary should have been consolidated because it is controlled by the Company. Had XYZ Company been consolidated, many elements in the accompanying consolidated financial statements would have been materially affected. The effects on the consolidated financial statements of the failure to consolidate have not been determined.

Adverse Opinion

In our opinion, because of the significance of the matter discussed in the Basis for Adverse Opinion paragraph, the consolidated financial statements referred to above do not present fairly the financial position of ABC Company and its subsidiaries as of …

3. Disclaimer of Opinion

Finally, let’s suppose you are performing an audit in which insufficient audit information is provided with regard to receivables and inventories (both of which are material) and that the misstatements have a pervasive impact on the financial statements as a whole.

The sample opinion language provided by AU-C 705 is as follows:

Basis for Disclaimer of Opinion

We were not engaged as auditors of the Company until after December 31, 20X1, and, therefore, did not observe the counting of physical inventories at the beginning or end of the year. We were unable to satisfy ourselves by other auditing procedures concerning the inventory held at December 31, 20X1, which is stated in the balance sheet at $XXX. In addition, the introduction of a new computerized accounts receivable system in September 20X1 resulted in numerous misstatements in accounts receivable. As of the date of our audit report, management was still in the process of rectifying the system deficiencies and correcting the misstatements. We were unable to confirm or verify by alternative means accounts receivable included in the balance sheet at a total amount of $XXX at December 31, 20X1. As a result of these matters, we were unable to determine whether any adjustments might have been found necessary in respect of recorded or unrecorded inventories and accounts receivable, and the elements making up the statements of income, changes in stockholders’ equity, and cash flows.

Disclaimer of Opinion

Because of the significance of the matters described in the Basis for Disclaimer of Opinion paragraph, we have not been able to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion. Accordingly, we do not express an opinion on these financial statements.

Resolving Conflict with Clients

If, as described above, you have a client that is unwilling to post a material audit adjustment, consider creating a draft of the opinion and providing it to them. This is not a threat, just a clear way to communicate the effect of not posting the adjustment. 

Before doing anything, allow the client to fully explain their position. There is no profit in upsetting a client with needless talk about a modified opinion, if they are correct (and I am wrong). But after the discussion, if the auditor is still convinced there is a material misstatement, a modified opinion may be necessary.

Research

Deciding on the opinion is often the most important decision you will make in an audit. So, do your research, and, if needed, consult with others to gain assurance about your decisions. 

Using Project Management in Audits: The How and the Why

It's not enough to be effective, we must be efficient

On the first day of your audit, you’re confident you’ll deliver your report on time. You have visions of a happy client and happy firm partners. But, somewhere along the way, things break down. Your best auditor transfers to another job. You learn–as the audit progresses–that your junior staff member lacks sufficient training. Your client is not providing information as requested. And, additionally, your audit team has unearthed a fraud.

How can you lessen or respond to these problems? Project management. In this post, I’ll tell you what it is and how you can start using project management in audits, including software selection and practical implementation steps.

Using Project Management in Audits

 

Using Project Management in Audits

Auditors need to be effective (by complying with professional standards), but we also need to be efficient (if we want to make money). And project management creates efficiency.

Managing resources, identifying impediments to audit processes, responding to scope creep–these are just a few of the issues that we encounter. And these challenges can increase engagement time and decrease profits. Worse yet, that promise regarding timely completion can go unmet. 

Either we will manage our audits, or they will manage us. 

So, what are the keys to using project management in audits?

  • Audit team members
  • Project management software
  • Create a project management plan
  • Be aware
  • Be vigilant

Audit Team Members

The number one ingredient to a successful audit is your team members. Even more important is the person managing the engagement.

Have you noticed that some people–regardless of the obstacles–just get things done? If possible, get and keep people like this on your audit teams. You may be thinking–at this moment–“but our firm has a difficult time hiring and retaining great employees.” Then revisit your hiring and retention practices.

Having great team members is essential, but they need to work together. So, how do we get them to play their roles at the right time? A project management plan defined in project management software.

Project Management Software

There are plenty of useful project management software packages. They include:

Pricing varies. Some are free while others are expensive. So, you’ll need to do your research to determine which solution is best for you. Personally, I use Basecamp at $50 per month. If you want to start with a free application, try Trello or Asana. Another option is Smartsheet (an Excel-spreadsheet-based product) at $25 per month. Larger firms may desire to take a look at XCMWorkflow.

Regardless, get your feet wet. If you’ve never used a project management package, it’s hard to understand the beauty of doing so.

Basecamp

Here’s how I got my own feet wet.

Four years ago I started using Basecamp. And why did I pick this software? Mainly, because of ease of use. I can create cloud-based to-do lists for my audit teams and my clients. Also, Basecamp allows me to hide my audit team’s to-do list from my client. So, my audit team can see the client’s to-do list, but the client can’t see my audit team’s list.

Additionally, I can assign each to-do item to an audit team member or client personnel. And even better, I can assign a due date. When the to-do item is due, the designated person receives a reminder email. (As you can see, I no longer need to send a client assistance checklist to my clients. Those tasks that once resided in a Word doc now live in Basecamp.)

Basecamp provides iPad and iPhone apps so that I can see my projects on those devices. Additionally, I access my projects on my Windows desktop using the Internet. So, Basecamp is accessible from anywhere.

Here’s a video overview of Basecamp:

Once you’ve picked your project management software, you need to create a project management plan.

Create a Project Management Plan

What is a project management plan? It’s deciding what, when, and who. These three factors are dependent upon the deliverables, and in our case, the deliverable is the audit report.

Who

First, let’s start with who will perform the actions.

A partner, an in-charge, and one or two staff members often comprise an audit team. Regardless of the team size, your first decision is “who is going to work on the engagement?” and as we said above, this is the most crucial element in getting your audit done. But notice that an audit involves not only your team members but client personnel. You can’t audit unless they provide information, answer questions, and allow you to inspect documents. You might also work with specialists or attorneys

Add all persons to your project management software, including audit team members, client staff, and others. (In Basecamp, I add persons to the project by sending an invitation email from within the software.) But how do we know who we will work with? That depends on what we plan to do.

What

Second, determine what needs to be done. But how do we do this? The development of our audit plan.

The audit plan is our response to risk assessment which is performed early in the engagement. Once we perform walkthroughs, make inquiries, inspect documents, and make observations, we become aware of risks. And in response, we create an audit plan to address those risks. Now we know what needs to be done. The audit plan feeds the project management plan.

Notice the risk assessment process and audit plan informs the project management plan. Notice also that the project management plan is not the same as the audit plan; they are distinctly different. One addresses risk and the other addresses the how, when, and who of getting things done. For me, my audit plan lives in the audit programs (inside my audit software), and my project management plan lives in Basecamp in the cloud. 

Here’s an example of how the risk assessment process feeds my project management plan. As I perform my risk assessment procedures, I see that one person makes disbursements, records the payment, and reconciles the bank statement. Now I know the client lacks segregation of duties in the payables area and has a fraud risk. I will respond to those risks by performing procedures such testing disbursements. Now I know what I am to do. In my project management plan, I need to marry this audit procedure (the testing of disbursements) to a team member. So, I add the task to my project management plan and assign it to one of my people. I also specify a performance date.

Some audit tasks are performed in every audit, regardless of the audit risks, such as obtaining a signed representation letter.  These tasks can be set up in a project management template which can be used to create your initial project management plan. Then you can add the client-specific tasks as needed.

When

Thirdly, we need to specify a date for each action.

Project management software allows you to specify when an action is to occur. Once I know who is on the audit team and what is to be done, my remaining duty is to specify a date for the action. You may wonder, “how do I know when each action will occur?” You may not know precisely, but you have an idea. So, go ahead and specify a date. If later you need to change that date, you can. There is no sin in amending the plan. 

Now that I have a project management plan, I need to be aware and vigilant to keep the plan on track.

Be Aware

The purpose of project management is to enable you to control your audit. But many times the original scope and particulars of our audits change. And if our project management plan doesn’t change concurrently, we lose control.

using project management in audits

For example, if your audit team discovers a fictitious vendor fraud, then your time budget may need to expand. Let’s say we believe the audit will now take an additional 80 hours, and that we need to bring in a fraud specialist. At this point, if we don’t amend the engagement letter, we’ll eat this additional cost. So, it’s time to ask the client for an additional fee. The fraud was not anticipated in the original contract. Now, you need to amend the contract to cover the additional work. (Construction contractors do this all the time with change orders. But auditors are often hesitant to do so.)

As you perform your audit, be aware of scope creep. If your client asks you to perform additional services, then amend your contract. Otherwise, your profit realization will diminish quickly. This is especially true for bid audits such as governmental engagements.

More times than not, changes will occur during the engagement. And regardless of the cause, we must amend our plan. For me, I’m going back into Basecamp and adding additional steps.

In addition to being aware of potential changes, we need to be vigilant.

Be Vigilant

We know from experience that it is natural for the audit process to fall apart. It’s like most things in our universe. Entropy happens.

When it does, you must fight to restore order. Why is this so hard to do? Because you have so much going on. You aren’t working on one audit. You’re working on two–or three. You have office meetings, client meetings, tax deadlines. You are busy! Therefore, if you don’t have a way to maintain control, you will feel desperate.

But that’s the beauty of project management. With it, you can maintain control.

Think of your project management plans as dashboards that flash green or red lights. And those indicators allow you to see how things are progressing–or not. Moreover, this knowledge allows you to react in real time–and to stay vigilant. As you monitor your audits, you can take corrective actions to keep your projects on track.

Summary of Using Project Management in Audits

Project management is simple in concept. You plan tasks, you assign them, and you specify due dates. Then you need project management software to track the actions, assignments and due dates. Once the system is in place, you can monitor your projects and manage change.

So why do most auditors not use project management? Because many think they can do so in their heads–and I know many who feel this way. Sorry, but I have to disagree. If you’re like me (and I bet you are), you have a million things going on. So without project management, you’ll do your work by the seat of your pants. The result? Missed deadlines. Frustrated clients and disappointed partners. Not what you desire.

So, give it try. You will find yourself delivering audits on time and on budget.

Auditing Blog Series

This post is a part of my auditing series. In it, I take you from the start to the end of the audit process. Click here if you’ve missed my prior posts.

What’s on a CPA’s Computer Desktop?

I'm sharing what's on my computer desktop

I’m always curious about what another golfer has in his or her bag. 60-degree wedge? Belly Putter? Callaway driver? You can tell a lot about a golfer by what he carries.

The same is true with, “what’s on a CPA’s computer desktop?” Our desktops say a great deal about how we think and get things done.

So, in the interest of sharing, here are some things on my desktop. Hopefully, you’ll see some ideas that you can use. 

CPA's Computer Desktop

 

CPA’s Computer Desktop

1. Checkpoint Tools for PPC.

With one click I can see all of the practice aids I’ve subscribed to, things like:

  • Engagement letters
  • Audit programs
  • Risk assessment forms
  • Letters to those charged with governance

I also have access to PPC’s Interactive Disclosure Libraries. I use this to find sample note disclosures.

2. The peer review general audit engagement checklist.

With one click, I can see what the AICPA peer review checklist says about work papers. (There are many more peer review checklists, but this one provides a generic quick look.)

3. The most recent PPC disclosure checklist.

The checklist provides me with quick answers to disclosure questions.

4. TValue Link.

Need a loan amortization? It’s one click away.

5. Scansnap Organizer Link.

I keep a Fujitsu iX500 ScanSnap scanner on the corner of my desk. When paper arrives, I scan it and file it.

6. Link to Excel (in Windows toolbar).

One click to spreadsheets.

7. Link to Word (in Windows toolbar).

One click to documents.

8. Snipping Tool (accessed with Windows Start button)

I use the Windows snipping tool to capture anything on my screen quickly.

9. Link to Adobe Acrobat (in Windows toolbar).

How can one live without Adobe Acrobat? Scan and annotate your documents.

10. Link to Judy’s Tenkey (in Windows toolbar).

One click to my electronic adding machine.

11. Link to Evernote (in Windows toolbar).

One click to my personal digital library.

12. Link to Firefox (in Windows toolbar).

Yes, I’m a Firefox fan (I like it better than Explorer).

13. ShareFile icon (in Windows toolbar).

One click to secure file sharing.

14. Zoom icon (in Windows toolbar).

One click to conferencing software.

Finally, let me recommend Fences (by Stardock) for Windows-based systems. It allows you to group your desktop icons into one area of your screen (e.g., Research). 

That’s what’s on my desktop. What about yours?

Wrapping Up Audits: The How and The Why

Why is it so hard to finish audits? They seem to go on for ever and ever.

Sometimes we think we are almost done with an audit, but then–days later–we realize we were nowhere near the finish line. Very frustrating! For our clients and us. Why does this happen? That’s the question I’ll answer in this post. Wrapping up audits is not always easy, but–in this article–you’ll learn how to finish them efficiently and effectively.

wrapping up audits

Wrapping Up Audits: An Overview

In the final stages of an audit, we are (among other things):

  • Reviewing the file
  • Updating subsequent events
  • Obtaining a management representation letter
  • Summarizing passed journal entries
  • Considering going concern
  • Creating final analytics
  • Creating management letters
  • Communicating control deficiencies

Reviewing the File

If we review our audit work as we perform the engagement, then the review process (at the end) will not be difficult. The thorns and snares come when we allow a junior staff person to work without supervision and without a timely review process. Then, when the manager or partner begins to review the file (at the end of the engagement), it’s a disaster.

The review problem starts at the beginning of the audit, namely in the scheduling of the engagement. Too many times, audit firms send an untrained person out–just to get a warm body on the job. Sure, someone is onsite with the client, but does he know what he’s doing? I said this “warm body” effort could be the result of scheduling, but look even deeper. The root problems could be poor hiring or retention practices or insufficient training. If audit firms are to properly schedule work, they must first hire, retain, and train. Only then will sufficient staff be available.

Once a firm has sufficient personnel, then it needs discipline. Review files daily (or at least weekly)–not at the end of the engagement. Why are timely reviews more efficient and effective? Because the work is still fresh in the staff member’s mind. As he receives review comments, he is better able to respond. Also, timely reviews enable junior staff members to learn as they go, and the reviews provide them with confidence as they work. But in terms of wrap-up, you are much closer to your goal of completing the engagement.

In short, review work and provide feedback as soon as possible, at least weekly.

Updating Subsequent Events

The financial statements should disclose material subsequent events such as legal settlements, the issuance of new debt, the adoption of a new benefit plan, or the sale of stock. And while disclosure is important, subsequent events–such as legal settlements–can have a bearing upon the recognition of amounts in the financial statements.

Here are common subsequent event procedures:

  • Inquire of management about subsequent events
  • Review subsequent receipts and payments
  • Consider attorneys’ responses to request for litigation information
  • Read subsequent minutes
  • Review subsequent interim financial statements
  • Obtain an understanding of management’s methods for accumulating subsequent event information

Perform these procedures so that audit evidence is obtained through the audit report date. Auditors often need to update attorney’s response to coincide with the audit report date. You want the attorney’s letter to be as close as to the audit report date as possible. How close? Usually within two weeks of the audit report date. If there are significant issues, you may want to bring the written response even closer.

Obtaining a Management Representation Letter

Another part of wrapping up in obtaining a written representation letter. The letter should address issues such as:

  • Management’s responsibility for the financial statements
  • Management’s responsibility for internal controls
  • Assurances that all transactions have been recorded
  • Whether known fraud has occurred
  • Whether known non-compliance with laws or regulations
  • The effects of uncorrected misstatements
  • Litigation
  • The assumptions used in computing estimates
  • Related party transactions
  • Subsequent events
  • Supplementary information
  • Responsibility for nonattest services

The date of the representation letter should be the same as the date of the audit report. Also, the representation letter should be for all financial statements and periods referred to in the auditor’s report. If management refuses to provide the management letter, then consider the effect upon the audit report. Such a refusal constitutes a limitation on the scope of the audit and will usually preclude the issuance of an unmodified opinion.

If your audit firm creates the financial statements, then provide them to management in a timely manner. Management needs to review the financial statements prior to signing the representation letter.

Summarizing Passed Journal Entries

Prior to creating the representation letter, the auditor needs to summarize passed journal entries. Why? You need to attach the passed entries to the representation letter. Audit standards require management to provide a written assertion regarding whether the uncorrected misstatements are material. That wording could, for example, read “the effects of uncorrected misstatements are immaterial.”

Once you summarize the uncorrected misstatements, you as the auditor should consider whether they are material. Review your audit materiality and performance materiality documentation and consider if the passed adjustments are acceptable. If the uncorrected misstatements are material, then an unmodified opinion is not appropriate.

Considering Going Concern

Even in the planning stage, auditors need to think about going concern, especially if financial weaknesses are present. But as you approach the end of the audit, the going concern evaluation should crystallize. Now you have your audit evidence, and it’s time to determine if a going concern opinion is in play. Also, consider whether the going concern disclosures are sufficient. If substantial doubt is present, then the entity should include going concern disclosures (whether doubt is alleviated by management’s plans or not).

Substantial Doubt

And what is substantial doubt? The Financial Accounting Standards Board defines it this way:

Substantial doubt about the entity’s ability to continue as a going concern is considered to exist when aggregate conditions and events indicate that it is probable that the entity will be unable to meet obligations when due within one year of the date that the financial statements are issued or are available to be issued.

So for nongovernmental entities, ask “Is it probable that the company will meet its obligations for one year from the opinion date?” If it is likely that the entity will meet its obligations, then substantial doubt does not exist. If it is not probable that the entity will meet its obligations, then substantial doubt exists.

Evaluation Period

And what is the period to be considered when assessing going concern? One year from the audit report date unless the entity is a government. If the entity is a government, then the evaluation period is one year from the financial statement date (though this period can be lengthened in certain circumstances).

Who Makes the Evaluations?

The going concern evaluation is one that management makes as it considers whether disclosures are necessary.

Then the auditor considers going concern from an audit perspective. Based on the audit evidence, the auditor could possibly issue a going concern opinion or qualify the opinion if required going concern disclosures are not included in the financial statements.

Creating Final Analytics

Another part of wrapping up is the creation and review of final analytics.

Auditors create planning analytics as a risk assessment procedure. Why? We are looking for risk. So, what is the purpose of final analytics? We are performing analytical procedures, near the end of the audit, to assist in forming an overall conclusion about whether the financial statements are consistent with our understanding of the entity.

What type of analytics should be used? Audit standards don’t specify the particular analytics. Those standards say that a wide variety of procedures can be used, including reading the financial statements. An auditor can also use analytics similar to those used in the planning stage of the engagement. Regardless of the procedures used, they should be documented. So, if you read the financial statements as an analytical procedure, you should say so in a work paper.

I commonly use the same analytics in the close of the audit that I used in the beginning. I want to know that the questions raised in the beginning have been answered by the end of the engagement.

Creating Management Letters

At the conclusion of an audit, you can provide a written management letter.

wrappping up audits

What should be included in such a letter? It’s up to the auditor, but here are some examples:

  • Communication of control weaknesses that are not significant or material
  • Recommendations concerning the implementation of new accounting standards
  • Efficiency recommendations such as how to process cash receipts
  • Warnings regarding cyber attacks and suggestions for preventing them
  • Suggestions that may expedite next year’s audit
  • Recommendations regarding procurement
  • Suggestion for the creation of a code of conduct
  • Recommendation that an accounting manual be created
  • Suggestion to use excess cash to pay off high-interest rate leases
  • Suggestion to create a more robust IT change management process

Significant internal control deficiencies and material weaknesses must be reported in writing. Other control weaknesses (those not significant or material) can be communicated in writing or orally. If such weaknesses are orally communicated, then they must be documented in some manner such as in a work paper. Alternatively, the control weaknesses can be included in a management letter.

If a management letter is provided, consider providing a draft to the client prior to issuance. Doing so will allow you to avoid the embarrassment of making inaccurate or inappropriate suggestions. Also, the auditor, if desired, can include client responses (e.g., the status of implementation) in the management letter.

Communicating Control Deficiencies

Audit standards require that significant control deficiencies and material weaknesses be reported in writing to management and to those charged with governance. As we saw in the previous section, control weaknesses that are not significant or material are normally communicated in the management letter. Significant deficiencies and material weaknesses are defined as follows:

  1. Significant deficiency. A deficiency, or a combination of deficiencies, in internal control that is less severe than a material weakness yet important enough to merit attention by those charged with governance.
  2. Material weakness. A deficiency, or a combination of deficiencies, in internal control, such that there is a reasonable possibility that a material misstatement of the entity’s financial statements will not be prevented, or detected and corrected, on a timely basis.

Control deficiencies are often noted during the risk assessment procedures, particularly when walkthroughs are performed. They may also be noted as audit journal entries are created, especially when material adjustments are made. It is best to capture control weaknesses as they are noted. Otherwise, you may forget your notice of them. Also, if control weaknesses are material, you may desire to communicate them to management as they are discovered.

As recommended for the management letter, a draft of this internal control report should be provided to management prior to final issuance to avoid potential misunderstandings. Management can better assess the correctness of a control weakness communication once they see it in black and white. If there’s a disagreement between management and the auditor, it’s best to clear the issue prior to final issuance of the internal control weaknesses letter.

Wrapping Up Audits

Now you have an overview of how to wrap up your audits. You may have thought while reading the above, “How does an auditor make all of this happen at the appropriate time?” Sound project management.

While this article covers wrapping up audits from a professional standards perspective, you’ll find additional insights into managing your engagements by reading my Basecamp post. What is Basecamp? It’s a cloud-based project management application. As you can see in the above wrap-up article, there are a lot of moving parts. So, use of sound project management software and procedures can significantly increase your efficiency.

You’ll also find my twin brother’s article How to Identify and Manage Audit Stakeholders helpful.

Continuing Audit Series

This post is a part of my continuing audit series titled The Why and How of Auditing: A Blog Series About Basics. I have covered the planning and substantive parts of audits in earlier posts. To see an overview of the blog series, click here.

Why Higher Risks Should Result in Higher Priced Audits

Risk equals uncertainty. So, shouldn't higher risk audits cost more?

Audit risk increases uncertainty–and price. At least, it should.

audit pricing risk-adjusted

Picture is courtesy of AdobeStock

Factors that Increase Audit Risk

Factors that increase audit risk include:

  • Entity (audit client) that is about to be sold
  • Records not reconciled on a timely basis (including bank accounts, inventory, accounts receivable, and accounts payable)
  • Business with a high debt load and covenant violations
  • Known existence of fraud
  • Inexperienced management in a complicated business
  • Known legal proceedings against the company
  • Unusual estimates (e.g., environmental liabilities)
  • Complex transaction cycles with varied accounting systems (systems differ at each location)
  • Group audit situations with subsidiaries audited by other audit firms (especially if the components are foreign entities)
  • Entities with severe cash flow deficiencies

A Risk Perspective

Pretend, for a moment, that you are a representative of a professional liability insurance carrier, and you’ve been assigned the duty of reviewing an audit firm’s book of business. How would you rate–from an insurance perspective–audits of the following entities?

  1. The City of Perfect has a CPA as its finance director. For the last twenty years, they have received the financial reporting Government Finance Officer’s Certificate of Achievement. They have never had a significant fraud. The city’s net position is strong, and it has no debt.
  2. Shazaam, Incorporated, is a high-tech company funded with venture capital. Operations began two years ago. Shazaam has weak cash flow, but the company has successfully created one new whiz-bang product, making it a highly desirable acquisition target. Potential suitors have already made visits to the company’s headquarters inquiring about a purchase.
  3. Sterling Parts, Incorporated, sells auto parts mainly in the United States, but it also has manufacturing operations in Germany. The company has eight subsidiaries, one of which is the German production component. This entity has been cited for contaminating the Rhine river. The cost of cleanup and damages are not known. The foreign entity uses an accounting system that is entirely different from the other companies. A German accounting firm audits the manufacturing component.

Would you price the insurance for all three engagements the same? Certainly not. The City of Perfect is…well perfect. The second and third audits have risk elements.

So if we–as auditors–examine prospective audit clients purely with an eye on risk, there should be a premium (higher fee) for those with increased risk. Why? There is a higher probability that the audit firm will suffer loss. The inherent risks in examples 2 and 3 increase the chance of faulty financial reporting, which increases the possibility a suit against the audit firm.

From a project management perspective, will all three engagements take the same amount of time? Obviously no. The higher risk engagements will require more resources, effort, and time.

Risks Require More Time

You might think of the additional time element in this way:

Risk = Additional Time = Higher Price

Too often, CPA firms fish for audits without giving appropriate consideration to risk. Then, the flat fee creates pressure to ignore risks, because, after all, the audit firm wants to make a profit. It is critical that auditors incorporate a pricing premium for identified risks.

Unidentified Risks

But what about unknown risks (those that exist before starting the engagement)?

Well, that’s another story. Discovering fraud, for example, may require an expansion of the engagement scope. As with any project, when the scope increases, price increases. But the price increase is dependent upon the size and complexity of the theft. If the fraud is nominal and requires little additional time, then no price increase is necessary. But if the theft is broad and complex, a contract amendment may be needed.

Client Acceptance And Continuance

Does your firm use any type of risk score in your new client acceptance or in your annual continuance decision? If yes, how do you do this?