Auditing Equity: The Why and How Guide

Auditing equity is usually quite easy--until it's not

What are the keys to auditing equity correctly? In this post, we’ll answer this question, showing you how to focus on the important equity accounting issues.

how to audit equity

Auditing Equity — An Overview

In this post, we will cover the following:

  • Primary equity assertions
  • Equity walkthroughs
  • Directional risk for equity
  • Primary risks for equity
  • Common equity control deficiencies
  • Risk of material misstatement for equity
  • Substantive procedures for equity
  • Common equity work papers

Primary Equity Assertions

Before we look at assertions, consider various potential equity accounts such as:

  • Common stock
  • Paid in capital
  • Preferred stock
  • Treasury stock
  • Accumulated other comprehensive income
  • Noncontrolling interests
  • Members’ equity (for an LLC)
  • Net assets (for a nonprofit)
  • Net position (for a government)

Certain types of equity accounts are used for certain types of entities. For example, you’ll find common stock in an incorporated business, net assets in nonprofits, and members’ equity in a limited liability corporation. 

Then, the equity accounts used will depend upon what the entity does. Examples include:

  • Has the company purchased treasury stock?
  • Does a commercial entity have unrealized gains or losses on available-for-sale securities?
  • Does a nonprofit organization have restricted contributions?
  • Does a government have restricted net position?

So, it’s a must–before you determine the relevant assertions–that you understand the accounting for (1) the type of entity and (2) the particular equity-related transactions.

The primary relevant equity assertions (often) are:

  • Existence and occurrence
  • Rights and obligations
  • Classification

When a company reflects equity on its balance sheet, it is asserting that the balance exists and that the equity transactions occurred. For example, if common stock is sold, the balance of the account is based upon the actual sale of stock and the monies received. The balance is not fictitiously or erroneously stated. 

Equity instruments also have certain rights and obligations. For example, common stock provides rights to retained earnings. Also, some classes of stock provide voting privileges. Others do not.

Additionally, the classification of equity balances is important. Determining how to present equity is usually easy, but classification issues arise when an entity has equity instruments such as convertible stock. Classification is also relevant when there is a noncontrolling interest

Keep these assertions in mind as you perform your transaction cycle walkthroughs.

Equity Walkthroughs

Early in your audit, perform a walkthrough of equity to see if there are any control weaknesses. As you perform this risk assessment procedure, what questions should you ask? What should you observe? What documents should you inspect? Here are a few suggestions.

Walkthrough Questions and Actions

As you perform your equity walkthrough ask or perform the following:

  • What types of equity does the entity have?
  • How many shares are authorized? How many shares have been issued?
  • Does the company have any convertible debt?
  • Has the company declared and paid dividends?
  • Are there any state laws restricting distributions?
  • Does the company have accumulated other comprehensive income?
  • Inspect ownership documents such as stock certificates.
  • Read the minutes to determine if any new equity has been issued.
  • Does the company have classes of stock? What are the rights of each?
  • Is the entity attempting to raise additional capital?
  • Has the company sold any additional equity ownership?
  • Is there a noncontrolling interest in the company?
  • Does the company have stock compensation plan?
  • For a nonprofit, are there any restricted donations?
  • For a government, is the net position restricted?
  • For a limited liability corporation, are there differing classes of ownership? 

As you perform your walkthroughs, also consider if there are risks of material misstatement due to fraud or error.

Equity-Related Fraud and Errors

Theft seldom occurs in the sale of stock. If fraud occurs, it’s usually an intentional false equity presentation. Inflating an entity’s equity can make the organization appear healthier than it really is. 

Additionally, mistakes can lead to errors in accounting for equity. Such mistakes may occur if the entity sells complex equity instruments. Understanding the rights and obligations of ownership interests is a key to proper accounting.

Directional Risk for Equity

The directional risk for equity is that it is overstated (companies desire strong equity positions). So, audit for existence. 

Primary Risks for Equity

The primary risks for equity are:

  1. Equity is intentionally overstated
  2. Misclassified equity 

As you think about these risks, consider the control deficiencies that allow equity misstatements.

Common Equity Control Deficiencies

In smaller entities, it is common to have the following control deficiencies:

  • One person performs two or more of the following: 
    • Approves the sale of equity interests,
    • Enters the new equity in the accounting system, 
    • Deposits funds from the sale of the equity instruments
  • Accounting personnel lack knowledge regarding equity transactions

Another key to auditing equity is understanding the risks of material misstatement.

Risk of Material Misstatement for Equity

In auditing equity, the assertions that concern me the most are existence, classification, and rights. So my risk of material misstatement for these assertions is usually moderate to high. 

My response to the higher risk assessments is to perform certain substantive procedures: namely, a review of equity transactions. Why?

A company may desire to overstate its equity. Also, misclassifications occur due to misunderstandings about equity accounting.

Once your risk assessment is complete, you’ll decide what substantive procedures to perform.

Substantive Procedures for Equity

My normal substantive tests for auditing equity include:

  1. Summarizing and reviewing all equity transactions
  2. Reviewing all equity accounts for proper classification
  3. Agreeing all beginning of period balances to the prior period’s ending balances
  4. Reviewing equity disclosures for compliance with the requirements of the reporting framework (e.g., GAAP)

In light of my risk assessment and substantive procedures, what equity work papers do I normally include in my audit files?

Common Equity Work Papers

My equity work papers normally include the following:

  • An understanding of equity-related internal controls 
  • Documentation of any equity internal control deficiencies
  • Risk assessment of equity at the assertion level
  • Equity audit program
  • A copy of (sample) equity instruments 
  • Minutes reflecting the approval of new equity
  • A summary of equity activity (beginning balances plus new equity less equity distributions and ending balance)

In Summary

In summary, today we reviewed the keys to auditing equity. Those keys include risk assessment procedures, determining relevant assertions, performing risk assessments, and developing substantive procedures. The most important issues to address are usually (1) equity accounting (especially when there are more complex types of equity transactions) and (2) the classification of equity.

Look for my next post in The Why and How of Auditing

If you’ve missed my prior posts in this audit series, click here.

Forty Mistakes Auditors Make

Here are 40 technology, planning, and execution deficiencies

Here are forty mistakes auditors make. While the list is (obviously) not comprehensive, you’ll see common technology, planning, and execution mistakes.

forty mistakes auditors make

  1. We aren’t paperless.
  2. We don’t link our trial balances to our work papers.
  3. We haven’t learned to use Adobe Acrobat.
  4. We don’t use optical character recognition (OCR), so we can’t electronically search our documents.
  5. We don’t use project management software such as Basecamp.
  6. We lose team communications (i.e., emails) because we aren’t using Slack.
  7. We use old (slow) computers.
  8. We don’t properly consider and document our independence.
  9. We don’t perform continuance procedures.
  10. We don’t assign appropriate personnel to risky engagements.
  11. We don’t appropriately price the engagement which leads to unattainable time budgets.
  12. We don’t focus our efforts on particular niches (thinking we can audit anything that comes our way).
  13. We keep doing the same thing year after year after year (and then complain we have too much time in the job).
  14. We assume we already know all the risks.
  15. We perform no (real) risk assessment.
  16. We don’t perform walkthroughs because we assume nothing has changed.
  17. We don’t perform walkthroughs because we are afraid of interacting with client personnel.
  18. We don’t consider internal control weaknesses in our risk assessment and audit program development.
  19. We create preliminary analytics in a perfunctory manner, not allowing them to inform us about risks.
  20. We ask perfunctory fraud questions without truly considering fraud risks.
  21. We don’t perform retrospective reviews of estimates.
  22. We don’t link identified risks to our audit plans.
  23. We don’t (really) have an engagement team discussion.
  24. We don’t tailor our audit programs.
  25. We don’t add purpose statements or conclusions on our work papers.
  26. We don’t define our tickmarks.
  27. We receive unnecessary documents from the client and leave them in the audit file.
  28. We leave review notes in the file.
  29. We don’t sign off on work papers, so no one knows who created the document.
  30. We don’t perform post-audit reviews to document the mistakes we made (so they won’t be repeated next year).
  31. We ask clients for certain documents without showing them the prior year example (and they provide the wrong document).
  32. We get on and off the same engagement too many times, losing momentum and wasting time.
  33. We send our audit team into the field even though the client hasn’t provided requested information.
  34. We don’t educate the client regarding the importance of timely information.
  35. We use staff that are not properly trained.
  36. We don’t plan our CPE to address upcoming audits.
  37. We don’t review staff work on a timely basis, so feedback is late (or not provided at all).
  38. We don’t report significant deficiencies or material weaknesses (because of client push-back).
  39. We fail to lock down our files.
  40. We don’t add value to our audits.

Auditing Debt: The Why and How Guide

A key risk is that debt is classified as noncurrent when it should be current

What are the keys to auditing debt correctly?

While auditing debt can be simple, sometimes it gets tricky. You might even get eclipsed by the accounting! The violation of covenants can darken the sky. Also, some companies keep debt off the books by structuring leases to avoid capitalization. So, put on your shades and let’s take a look at how to audit debt.

auditing debt

Auditing Debt — An Overview

In many governments, nonprofits, and small businesses debt is a significant part of total liabilities. Consequently, it is often a significant transaction area. 

In this post, we will cover the following:

  • Primary debt assertions
  • Debt walkthroughs
  • Directional risk for debt
  • Primary risks for debt
  • Common debt control deficiencies
  • Risk of material misstatement for debt
  • Substantive procedures for debt
  • Common debt work papers

Primary Debt Assertions

The primary relevant debt assertions are:

  • Completeness
  • Classification

I believe—in general—completeness and classification are the most important debt assertions. When a company shows debt on its balance sheet, it is asserting that it is complete and classified correctly. By classification, we mean it is properly displayed as either short-term or long-term.

Keep these assertions in mind as you perform your transaction cycle walkthroughs.

Debt Walkthroughs

Early in your audit, perform a walkthrough of debt to see if there are any control weaknesses. As you perform this risk assessment procedure, what questions should you ask? What should you observe? What documents should you inspect? Here are a few suggestions.

Walkthrough Questions and Actions

As you perform your debt walkthrough ask or perform the following:

  • Are there any debt covenants?
  • Does the company have any covenant violations?
  • If the company has violations, is the debt classified appropriately (usually current)?
  • Is the company reconciling the balance sheet to a loan amortization schedule?
  • Inspect amortization schedules.
  • Does the company have any unused lines of credit or other credit available?
  • Inspect loan documents.
  • Has the company refinanced its debt with another institution? Why?
  • Who approves the borrowing of new money?
  • Inspect loan approvals.
  • How are debt service payments made (e.g., by check or wire)?
  • Are there any sinking funds? If yes, who is responsible for making deposits and how is this done?
  • Observe the segregation of duties for persons:
    • Approving new loans,
    • Receipting new loan proceeds, 
    • Recording debt in the general ledger, and 
    • Reconciling the debt on the balance sheet to the loan amortization schedules
  • Is the company required to file any periodic (e.g., quarterly) reports with the lender?
  • Inspect sample quarterly debt reports, if applicable.
  • Does the company have any capital leases?
  • Who is responsible for determining whether a lease should be capitalized?
  • What criteria is the company using to capitalize leases?
  • Has collateral been pledged? If yes, what?
  • What are the terms of the debt agreements?
  • Has all debt of the company been recorded in the general ledger?
  • Have debt issuance costs been netted against debt in the financial statements?
  • Has the company guaranteed the debt of another entity?

If control weaknesses exist, create audit procedures to respond to them. For example, if—during the walkthrough—we see that one person approves loans and deposits loan proceeds, then we will perform fraud-related substantive procedures. 

Debt-Related Fraud

Companies can intentionally omit debt from their balance sheets in order to inflate their equity total. (Since total assets equal liabilities plus equity, then equity goes up if debt is omitted.)

As we saw with Enron many years ago, some entities try to move their debt to other entities. So auditors need to consider that a company may intentionally omit debt from its balance sheet.

Another potential fraudulent presentation is showing short-term debt as long-term. When might this happen? When there is a debt covenant violation. The company may need to present the debt as current when such violations occur. Here’s how to report debt covenant violations.

Additionally, mistakes can lead to errors in debt accounting.

Debt Mistakes

Debt errors may occur when accounting personnel misclassify debt service payments. Also, debt can be mistakenly presented as long-term when it is current.

We also need to consider the directional risk for debt. 

Directional Risk for Debt

The directional risk for debt is that it is understated. So, audit for completeness (and determine that all debt is recorded).

Primary Risks for Debt

The primary risks for debt are:

  1. Debt is intentionally understated (or omitted)
  2. Debt is not classified as current though there is a covenant default that requires such treatment

As you think about these risks, consider the control deficiencies that allow debt misstatements.

Common Debt Control Deficiencies

In smaller entities, it is common to have the following control deficiencies:

  • One person performs two or more of the following: 
    • Approves the borrowing of new funds,
    • Enters the new debt in the accounting system, 
    • Deposits funds from the new debt
  • Funds are borrowed without appropriate approval
  • Debt postings are not agreed to an amortization schedule
  • The accounting personnel don’t understand the accounting standards for debt covenant violations and lease capitalization

Another key to auditing debt is understanding the risks of material misstatement.

Risk of Material Misstatement for Debt

In auditing debt, the assertions that concern me the most are classification and completeness. So my risk of material misstatement for these assertions is usually moderate to high. 

My response to the higher risk assessments is to perform certain substantive procedures: namely, a review of debt covenant compliance and a review of lease accounting. Why?

A company desires to display debt as long-term (even though it is short-term). Doing so makes working capital (current assets minus current liabilities) stronger. If a debt covenant violation causes debt to be current, working capital can tank quickly. So, the temptation is to show debt as long-term even though it is technically current.

Additionally, debt issuance costs are a deduction from debt. Review the classification of these costs which prior to ASU 2015-03 were assets. See this post for more information.

And one more thing. If capital leases are not capitalized (though they should be), the debt does not appear on the balance sheet, making the company look healthier than it is. (FASB has issued a new lease standard that will require the capitalization of all leases of more than one year, but it’s not presently effective. You can see ASU 2016-02, Leases here.)

Once your risk assessment is complete, you’ll decide what substantive procedures to perform.

Substantive Procedures for Debt

My customary tests for auditing debt are as follows:

  1. Summarize and review all debt covenants
  2. Review all leases for correct classification as capital or operating
  3. Confirm all significant debt with the lender
  4. Determine if all debt is classified appropriately (as current or noncurrent)
  5. Agree the end-of-period balances on the balance sheet to the amortization schedule
  6. Review any significant accrued interest at period-end

In light of my risk assessment and substantive procedures, what debt work papers do I normally include in my audit files?

Common Debt Work Papers

My debt work papers normally include the following:

  • An understanding of debt-related internal controls 
  • Documentation of any debt internal control deficiencies
  • Risk assessment of debt at the assertion level
  • Debt audit program
  • A copy of all significant debt agreements (including leases and line-of-credit agreements)
  • Minutes reflecting the approval of new debt
  • A summary of debt activity (beginning balance plus new debt minus principal payments and ending balance)
  • Amortization schedules for each debt

If there’s any question about debt agreements and their presentation, I include additional representation letter language to address the issue.

In Summary

In summary, today we looked at the keys to auditing debt. Those keys include risk assessment procedures, determining relevant assertions, creating risk assessments, and developing substantive procedures. The most important issues to address are usually (1) the classification of debt (especially if debt covenant violations exist) and (2) lease accounting.

Look for my next post in The Why and How of Auditing. Next week we’ll look at how to audit equity.

If you’ve missed my prior posts in this audit series, click here.

Audit Planning Analytics for First-Year Businesses

How to create planning analytics when there is no prior year

How do you create audit planning analytics for first-year businesses? We commonly compare current year numbers to the prior period, but, in this case, there are no prior year numbers. What other options are available?

Audit Planning Analytics for First Year

Courtesy of iStockphoto.com

Planning Analytics for First-Year Businesses

Audit standards don’t require the use of any particular analytics, so let’s think outside the box (of comparing current and prior year numbers). There are at least four alternatives:

  1. Nonfinancial information
  2. Ratios compared to industry averages
  3. Intraperiod totals (e.g., monthly or quarterly)
  4. Budgetary comparisons

How can we use nonfinancial information?

AU-C 315, paragraph .A7 states:

Analytical procedures performed as risk assessment procedures may include both financial and nonfinancial information (for example, the relationship between sales and square footage of selling space or volume of goods sold).

First Option

So one option is to compute expected numbers using nonfinancial information. Then compare the calculated numbers to the general ledger to search for unexpected variances.

Second Option

A second option is to calculate ratios common to the entity’s industry and compare the results to industry benchmarks. While industry analytics can be computed, I’m not sure how useful they are. An infant company often will not generate numbers comparable to more mature entities. But we’ll keep this choice in our quiver, just in case.

Third Option

A more useful option is the third–comparing intraperiod numbers. First, discuss the expected monthly or quarterly revenue trends with the client before you examine the accounting records. The warehouse foreman might say, “We shipped almost nothing the first six months. Then things caught fire. My head was spinning the last half of the year.” Does the general ledger reflect this story? Did revenues and costs of goods sold significantly increase in the latter half of the year?

Fourth Option

The last option we’ve listed is a review of the budgetary comparisons. Some entities, such as governments, lend themselves to this alternative; others, not so–those that don’t adopt budgets.

Summary

So, yes, it is possible to create useful risk assessment analytics–even for the first year of operation.

Remember: planning analytics are for the purpose of detecting risk. If the numbers don’t line up as expected, then you have a risk indicator. It is here that you may need to respond with substantive procedures.

Other Ideas?

What planning analytics do you perform for first-year audit clients?

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Going Concern: How to Understand the Accounting and Auditing Standards

ASU 2014-15 and SAS 132 are shaking up going concern decisions

Are you preparing financial statements and wondering whether you need to include going concern disclosures? Or maybe you’re the auditor, and you’re wondering if a going concern paragraph should be added to the audit opinion. You’ve heard there are new requirements for both management and auditors, but you’re not sure what they are.

This article summarizes (in one place) the new going concern accounting and auditing standards.

going concern

Going Concern Standards

For many years the going concern standards were housed in the audit standards–thus, the need for FASB to issue accounting guidance (ASU 2014-15). It makes sense that FASB created going concern disclosure guidance. After all, disclosures are an accounting issue. 

Accounting Standard

ASU 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern, provides guidance in preparing financial statements. This standard was effective for years ending after December 15, 2016.

GASB Statement 56, Codification of Accounting and Financial Reporting Guidance Contained in the AICPA Statements on Auditing Standards, is the relevant going concern standard for governments. GASB 56 was issued in March 2009. (GASB 56 requires financial statement preparers to evaluate whether there is substantial doubt about a governmental entity’s ability to continue as a going concern for 12 months beyond the date of the financial statements. As you will see below, this timeframe is different from the one called for under ASU 2014-15. This post focuses on ASU 2014-15 and SAS 132.)

Meanwhile, the Auditing Standards Board issued their own going concern standard in February 2017: SAS 132.

Auditing Standard

Auditors will use SAS 132, The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern, to make going concern decisions. This SAS is effective for audits of financial statements for periods ending on or after December 15, 2017. SAS 132 amends SAS 126The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern.

So, let’s take a look at how to apply ASU 2014-15 and SAS 132.

Two Stages of Going Concern Decisions

In the past, the going concern decisions were made by auditors in a single step. Now, it is helpful to think of going concern decisions in two stages:

  1. Management decisions concerning the preparation of financial statements 
  2. Auditor decisions concerning the audit of the financial statements

First, we’ll consider management’s decisions.

Stage 1. Management Decisions

 

ASU 2014-15 provides guidance concerning management’s determination of whether there is substantial doubt regarding the entity’s ability to continue as a going concern.

Going Concern

What is Substantial Doubt?

So, how does FASB define substantial doubt? 

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.

What is Probable?

So, how does management determine if “it is probable that the entity will be unable to meet obligations when due within one year”?

Probable means likely to occur

If for example, a company expects to miss a debt service payment in the coming year, then substantial doubt exists. This initial assessment is made without regard to management’s plans to alleviate going concern conditions. 

But what factors should management consider?

Factors to Consider

Management should consider the following factors when assessing going concern:

  • The reporting entity’s current financial condition, including the availability of liquid funds and access to credit
  • Obligations of the reporting entity due or new obligations anticipated within one year (regardless of whether they have been recognized in the financial statements)
  • The funds necessary to maintain operations considering the reporting entity’s current financial condition, obligations, and other expected cash flows
  • Other conditions or events that may affect the entity’s ability to meet its obligations

Moreover, management is to consider these factors for one year. But from what date?

Timeframe

The financial statement preparer (i.e., management or a party contracted by management) should assess going concern in light of one year from the date “the financial statements are issued or are available to be issued.”

So, if December 31, 2017, financial statements (for a nonpublic company) are available to be issued on March 15, 2017, the preparer looks forward one year from March 15, 2017. Then, the preparer asks, “Is it probable that the company will be unable to meet its obligations through March 15, 2018?” If yes, substantial doubt is present and disclosures are necessary. If no, then substantial doubt does not exist. As you would expect, the answer to this question determines whether going concern disclosures are to be made and what should be included.

Substantial Doubt Answer Determines Disclosures

If substantial doubt does not exist, then going concern disclosures are not necessary.

If substantial doubt exists, then the company needs to decide if management’s plans alleviate the going concern issue. This decision determines the disclosures to be made. The required disclosures are based upon whether:

  1. Management’s plans alleviate the going concern issue
  2. Management’s plans do not alleviate the going concern issue

1. What if Management’s Plans Alleviate the Going Concern Issue?

If conditions or events raise substantial doubt about an entity’s ability to continue as a going concern, but the substantial doubt is alleviated as a result of consideration of management’s plans, the entity should disclose information that enables users of the financial statements to understand all of the following (or refer to similar information disclosed elsewhere in the footnotes):

  1. Principal conditions or events that raised substantial doubt about the entity’s ability to continue as a going concern (before consideration of management’s plans)
  2. Management’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations
  3. Management’s plans that alleviated substantial doubt about the entity’s ability to continue as a going concern

Management’s plans should be considered only if is it probable that they will be effectively implemented. Also, it must be probable that management’s plans will be effective in alleviating substantial doubt.

So, if management’s plans are expected to work, does the company have to explicitly state that management’s plans will alleviate substantial doubt? No. 

When management’s plans alleviate substantial doubt, companies need not use the words going concern or substantial doubt in the disclosures. And as Sears discovered, it may not be wise to do so (their shares dropped 16% after using the term substantial doubt even though management had plans to alleviate the risk). Rather than using the term substantial doubt, consider describing conditions (e.g., cash flows are not sufficient to meet obligations) and management plans to alleviate substantial doubt.

Sample Note – Substantial Doubt Alleviated

An example note follows:

Note 2 – Company Conditions

The Company had losses of $4,525,123 in the year ending March 31, 2017. As of March 31, 2017, its accumulated deficit is $11,325,354. 

Management believes the Company’s present cash flows will not enable it to meet its obligations for twelve months from the date these financial statements are available to be issued. However, management is working to obtain new long-term financing. It is probable that management will obtain new sources of financing that will enable the Company to meet its obligations for the twelve-month period from the date the financial statements are available to be issued.

Notice this example does not use the words substantial doubt.

2. What if Management’s Plans Do Not Alleviate the Going Concern Issue?

If conditions or events raise substantial doubt about an entity’s ability to continue as a going concern, and substantial doubt is not alleviated after consideration of management’s plans, an entity should include a statement in the notes indicating that there is substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are available to be issued (or issued when applicable). Additionally, the entity should disclose information that enables users of the financial statements to understand all of the following:

  1. Principal conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern
  2. Management’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations
  3. Management’s plans that are intended to mitigate the conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern

Sample Disclosure – Substantial Doubt Not Alleviated

An example disclosure follows:

Note 2 – Going Concern
 
The financial statements have been prepared on a going concern basis which assumes the Company will be able to realize its assets and discharge its liabilities in the normal course of business for the foreseeable future.  The Company had losses of $1,232,555 in the current year. The Company has incurred accumulated losses of $2,891,727 as of March 31, 2017. Cash flows used in operations totaled $555,897 for the year ended March 31, 2017.
 
Management believes these conditions raise substantial doubt about the Company’s ability to continue as a going concern within the next twelve months from the date these financial statements are available to be issued. The ability to continue as a going concern is dependent upon profitable future operations, positive cash flows, and additional financing.
 
Management intends to finance operating costs over the next twelve months with existing cash on hand and loans from its directors. Management is also working to secure new bank financing. The Company’s ability to obtain the new financing is not known at this time.
 
Notice this note includes a statement that substantial doubt is present. Though management’s plans are disclosed, the probability of success is not provided.

ASU 2014-15 Summary

ASU 2014-15 focuses on management’s assessment regarding whether substantial doubt exists. If substantial doubt exists, then disclosures are required. Here’s a short video summarizing 2014-15:

Thus far, we’ve addressed the stage 1. management decisions. As you can see management’s considerations focus on disclosures. By contrast, auditors focus on the audit opinion. Now, let’s look at what auditors must do.

Stage 2. Auditor Decisions

 

SAS 132 provides guidance concerning the auditor’s consideration of an entity’s ability to continue as a going concern.

Going Concern

Objectives of the Auditor

SAS 132, paragraph 10, states the objectives of the auditor are as follows:

  • Obtain sufficient appropriate audit evidence regarding, and to conclude on, the appropriateness of management’s use of the going concern basis of accounting, when relevant, in the preparation of the financial statements
  • Conclude, based on the audit evidence obtained, whether substantial doubt about an entity’s ability to continue as a going concern for a reasonable period of time exists
  • Evaluate the possible financial statement effects, including the adequacy of disclosure regarding the entity’s ability to continue as a going concern for a reasonable period of time
  • Report in accordance with this SAS

These objectives can be summarized as follows:

  1. Conclude about whether the going concern basis of accounting is appropriate
  2. Determine whether substantial doubt is present
  3. Determine whether the going concern disclosures are adequate
  4. Issue an appropriate opinion 

In light of these objectives, certain audit procedures are necessary.

Risk Assessment Procedures

In the risk assessment phase of an audit, the auditor should consider whether conditions or events raise substantial doubt. In doing so, the auditor should examine any preliminary management evaluation of going concern. If such an evaluation was performed, the auditor should review it with management. If no evaluation has occurred, then the auditor should discuss with management the appropriateness of using the going concern basis of accounting (the liquidation basis of accounting is required by ASC 205-30 when the entity’s liquidation is imminent) and whether there are conditions or events that raise substantial doubt. 

The auditor is to consider conditions and events that raise substantial doubt about an entity’s ability to continue as a going concern for a reasonable period of time. What is a reasonable period of time? It is the period of time required by the applicable financial reporting framework or, if no such requirement exists, within one year after the date that the financial statements are issued (or within one year after the date that the financial statements are available to be issued, when applicable). The governmental accounting standards require an evaluation period of “12 months beyond the date of the financial statements.”

Auditors should consider negative financial trends or factors such as:

  • Working capital deficiencies
  • Negative cash flows from operating activities
  • Default on loans
  • A denial of trade credit from suppliers
  • Need to restructure debt
  • Need to dispose of assets
  • Work stoppages or other labor problems
  • Need to significantly revise operations
  • Legal problems
  • Loss of key customers or suppliers
  • Uninsured catastrophes
  • The need for new capital

The risk assessment procedures are a part of planning an audit. You may obtain new information as you perform the engagement.

Remaining Alert Throughout the Audit

The auditor should remain alert throughout the audit for conditions or events that raise substantial doubt. So, after the initial review of going concern issues in the planning stage, the auditor considers the impact of new information gained during the subsequent stages of the engagement.

Audit Procedures When Substantial Doubt is Present

If events or conditions do give rise to substantial doubt, then the audit procedures should include the following (SAS 132, paragraph 16.):

  1. Requesting management to make an evaluation when management has not yet performed an evaluation
  2. Evaluating management’s plans in relation to its going concern evaluation, with regard to whether it is probable that: 
    1. management’s plans can be effectively implemented and 
    2. the plans would mitigate the relevant conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time
  3. When the entity has prepared a cash flow forecast, and analysis of the forecast is a significant factor in evaluating management’s plans: 
    1. evaluating the reliability of the underlying data generated to prepare the forecast and 
    2. determining whether there is adequate support for the assumptions underlying the forecast, which includes considering contradictory audit evidence
  4. Considering whether any additional facts or information have become available since the date on which management made its evaluation

Sometimes management’s plans to alleviate substantial doubt include financial support by third parties or owner-managers (usually referred to as supporting parties). 

Financial Support by Supporting Parties

When financial support is necessary to mitigate substantial doubt, the auditor should obtain audit evidence about the following:

  1. The intent of such supporting parties to provide the necessary financial support, including written evidence of such intent, and
  2. The ability of such supporting parties to provide the necessary financial support

If the evidence in a. is not obtained, then “management’s plans are insufficient to alleviate the determination that substantial doubt exists.”

Intent of Supporting Parties

The intent of supporting parties may be evidenced by either of the following:

  1. Obtaining from management written evidence of a commitment from the supporting party to provide or maintain the necessary financial support (sometimes called a “support letter”)
  2. Confirming directly with the supporting parties (confirmation may be needed if management only has oral evidence of such financial support)

If the auditor receives a support letter, he can still request a written confirmation from the supporting parties. For instance, the auditor may desire to check the validity of the support letter.

If the support comes from an owner-manager, then the written evidence can be a support letter or a written representation.

Support Letter

An example of a third party support letter (when the applicable reporting framework is FASB ASC) is as follows:

(Supporting party name) will, and has the ability to, fully support the operating, investing, and financing activities of (entity name) through at least one year and a day beyond [insert date] (the date the financial statements are issued or available for issuance, when applicable). 

You can specify a date in the support letter that is later than the expected date. That way if there is a delay, you may be able to avoid updating the letter.

The auditor should not only consider the intent of the supporting parties but the ability as well.

Ability of Supporting Parties

The ability of supporting parties to provide support can be evidenced by information such as:

  • Proof of past funding by the supporting party
  • Audited financial statements of the supporting party
  • Bank statements and valuations of assets held by a supporting party

After examining the intent and ability of supporting parties regarding the one-year period, you might identify potential going concern problems that will occur more than one year out.

Conditions and Events After the Reasonable Period of Time

So, should an auditor inquire about conditions and events that may affect the entity’s ability to continue as a going concern beyond management’s period of evaluation (i.e., one year from the date the financial statements are available to be issued or issued, as applicable)? Yes.

Suppose an entity knows it will be unable to meet its November 15, 2018, debt balloon payment. The financial statements are available to be issued on June 15, 2017, so the reasonable period goes through June 15, 2018. But management knows it can’t make the balloon payment, and the bank has already advised that the loan will not be renewed. SAS 132 requires the auditor to inquire of management concerning their knowledge of such conditions or events. 

Why? Only to determine if any potential (additional) disclosures are needed. FASB only requires the evaluation for the year following the date the financial statements are issued (or available to be issued, as applicable). Events following this one year period have no bearing on the current year going concern decisions. Nevertheless, additional disclosures may be merited.

Thus far, the requirements to evaluate the use of the going concern basis of accounting and whether substantial doubt is present have been explained. Now, let’s see what the requirements are for:

  • Written representations from management
  • Communications with those charged with governance
  • Documentation

Written Representations When Substantial Doubt Exists

When substantial doubt exists, the auditor should request the following written representations from management:

  1. A description of management’s plans that are intended to mitigate substantial doubt and the probability that those plans can be effectively implemented
  2. That the financial statements disclose all the matters relevant to the entity’s ability to continue as a going concern including conditions and events and management’s plans

Communications with Those Charged with Governance

Remember that you may need to add additional language to your communication with those charged with governance.

When conditions and events raise substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time, the auditor should communicate the following (unless those charged with governance manage the entity):

  1. Whether the conditions or events, considered in the aggregate, that raise substantial doubt about an entity’s ability to continue as a going concern for a reasonable period of time constitute substantial doubt
  2. The auditor’s consideration of management’s plans
  3. Whether management’s use of the going concern basis of accounting, when relevant, is appropriate in the preparation of the financial statements
  4. The adequacy of related disclosures in the financial statements
  5. The implications for the auditor’s report

Documentation Requirements

When substantial doubt exists before consideration of management’s plans, the auditor should document the following (SAS 132, paragraph 32.):

  1. The conditions or events that led the auditor to believe that there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time.
  2. The elements of management’s plans that the auditor considered to be particularly significant to overcoming the conditions or events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern, if applicable.
  3. The audit procedures performed to evaluate the significant elements of management’s plans and evidence obtained, if applicable.
  4. The auditor’s conclusion regarding whether substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time remains or is alleviated. If substantial doubt remains, the auditor should also document the possible effects of the conditions or events on the financial statements and the adequacy of the related disclosures. If substantial doubt is alleviated, the auditor should also document the auditor’s conclusion regarding the need for, and, if applicable, the adequacy of, disclosure of the principal conditions or events that initially caused the auditor to believe there was substantial doubt and management’s plans that alleviated the substantial doubt.
  5. The auditor’s conclusion with respect to the effects on the auditor’s report.

Opinion – Emphasis of Matter Regarding Going Concern

If the auditor concludes that there is substantial doubt concerning the company’s ability to continue as a going concern, an emphasis of a matter paragraph should be added to the opinion.

An example of a going concern paragraph is as follows:

The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the financial statements, the Company has suffered recurring losses from operations, has a net capital deficiency, and has stated that substantial doubt exists about the company’s ability to continue as a going concern. Management’s evaluation of the events and conditions and management’s plans regarding these matters are also described in Note 2. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. Our opinion is not modified with respect to this matter.

The auditor should not use conditional language regarding the existence of substantial doubt about the entity’s ability to continue as a going concern. 

Opinion – Inadequate Going Concern Disclosures

Paragraph 26. of SAS 132 states that an auditor should issue a qualified opinion or an adverse opinion, as appropriate, when going concern disclosures are not adequate.

SAS 132 Summary 

Now, let’s circle back to where we started and review the objectives of SAS 132.

The objectives are as follows:

  • Conclude about whether the going concern basis of accounting is appropriate
  • Determine whether substantial doubt is present
  • Determine whether the going concern disclosures are adequate
  • Issue an appropriate opinion 

Conclusion

As you can see ASU 2014-15 and SAS 132 are complex. So, make sure you are using the most recent updates to your disclosure checklists and audit forms and programs.

Group Financial Statement Audits: An Overview

When do the group audit standards apply?

Do you audit financial statements that contain subsidiaries or equity method investments? Then the group audit standards apply, even if you audit all components. Peer reviewers are looking for the required group audit documentation, and they, in many cases, are not seeing what they should.

Audits of Group Financial Statements (AU-C 600) provides guidance for group audits. This article gives an overview of those standards.

Group Audits

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When is AU-C 600 Applicable?

AU-C 600 applies whenever there is an audit of group financial statements (meaning financial statements that include the financial information of more than one component). A component is an entity or business activity whose financial statements are required to be included in the group financial statements under the applicable reporting framework (e.g., U.S. GAAP).

AU-C 600 does apply even if a firm audits all of the components that comprise consolidated financial statements.

What is a Component?

A component includes:

  • Subsidiary
  • Joint venture
  • Division of a company
  • Geographic or functional activity (e.g., program in a not-for-profit organization)
  • Equity-method investment

Why the Group Audit Standard?

When there are multiple components audited by different firms, the risk of error–specifically, an incorrect opinion–increases. AU-C 600 decreases this risk by providing the group audit firm with guidance for group audit situations. Here are a couple of examples where the group audit standards are in play.

Consider, for example, a group audit in which a significant unaudited subsidiary is located in California, but the parent company is in Georgia. Since the subsidiary is not audited, the group auditor does not have the option to reference another audit firm (see below). Nevertheless, he has to obtain audit evidence to support the group audit opinion. The group auditor might direct a California-based audit firm to perform certain audit procedures and provide the results. These procedures provide audit evidence for the group audit opinion.

Likewise, if the California subsidiary is audited, AU-C 600 provides the group auditor with the ability to get the information necessary to render an appropriate audit opinion. In this instance, the component auditor issues an opinion on the California subsidiary, and the group auditor can rely on that work. There is no need for the group auditor to request certain procedures of the California audit team. The group audit firm communicates with the component audit firm concerning issues such as materiality, competence, and independence.

The Auditing Standards Board created AU-C 600 to give the group audit firm and partner the resources and information to get things right.  

When multiple firms audit various components, the group auditor can assume responsibility for the related audits or he can reference the component audit firm in his audit opinion.

The Big Decision: Referencing Another Audit Firm

While AU-C 600 applies to group audits when the same firm audits all components, it also applies when the group auditor does not audit a component–for example, the group audit firm audits the parent company and another audit firm audits a subsidiary (a component).

The group engagement partner (the partner responsible for the group audit) will decide if he or she will make reference to the component auditor. An example opinion can be seen here

If reference is made, the auditing standards state:

  1. The auditor’s report on the group financial statements should clearly indicate that the component was not audited by the auditor of the group financial statements but was audited by the component auditor.
  2. The group auditor’s report should also communicate the magnitude of the component audited by the component auditor.

If reference is not made, then the group audit firm is responsible for the full audit and related audit evidence. 

The group auditor has the option to name or not name the component audit firm. Typically the group audit firm will not name the component audit firm, but will reference the other firm with opinion language such as “those statements were audited by other auditors.”

Requirements for Referencing a Component Auditor

The group auditor can make reference to the component auditor only if the following is true:

  1. The component auditor must meet independence requirements 
  2. The group audit team must not have serious concerns about whether the component auditors will understand and comply with ethical requirements (including independence)
  3. The group audit team must not have serious concerns about the component audit team’s professional competence
  4. The component financial statements must be presented using the same financial reporting framework as the group financial statements
  5. The component auditor must audit the component in accordance with GAAS (or when required, PCAOB standards)
  6. The component auditor’s report must not be restricted as to use

Requirements to Communicate with Component Auditor 

Regardless of whether reference is made, the group audit team should obtain an understanding of the following:

  1. Whether a component auditor understands and will comply with the ethical requirements that are relevant to the group audit and, in particular, is independent
  2. A component auditor’s professional competence
  3. The extent, if any, to which the group engagement team will be able to be involved in the work of the component auditor
  4. Whether the group engagement team will be able to obtain information affecting the consolidation process from a component auditor
  5. Whether a component auditor operates in a regulatory environment that actively oversees auditors

Peer Review

The group audit standards are in the crosshairs of peer reviews, so make sure your audit documentation (especially your planning documents) is appropriate.

Audit Lessons from a Brain Tumor

Life teaches us unexpected lessons

I said to my wife, “Am I driving straight?” I felt as if I was weaving, not quite in control. I felt dizzy and heard clicking noises in my ears.

The mystery only increased over the next two years as I visited three different doctors. They stuck, prodded, and probed me–but no solution.

Frustrating.

Doctor Looking at Head Xray on blue

Picture is courtesy of istockphoto.com

Meanwhile, I felt a growing numbness on the right side of my face. So one night I started Googling health websites (the thing they tell you not to do) and came upon this link: Acoustic Neuroma Association. I clicked it. It was like reading my diary. It couldn’t be. A brain tumor.

The next day I handed my doctor the acoustic neuroma information and said, “I think this is what I have. I want a brain scan.”

Two days after the scan, while on the golf course, I received the doctor’s call: “Mr. Hall, you were right. You have a 2.3-centimeter brain tumor.” (I sent him a bill for my diagnosis but he never paid–just kidding.) My golfing buddies gathered around and prayed for me on the 17th green, and I went home to break the news to my wife. I had two children, two and four at the time. I was concerned.

Shortly after that, I was in a surgeon’s office in Atlanta. The doctor said they’d do a ten-hour operation; there was a 40% chance of paralysis and a 5% chance of death. The tumor was too large for radiation–or so I was told.

I didn’t like the odds, so I prayed more and went back to the Internet. There I located Dr. Jeffrey Williams at Johns Hopkins Hospital in Baltimore. I emailed the good doctor, telling him of the tumor’s size. His response: “I radiate tumors this size every day.” He was a pioneer in fractionated stereotactic radiation, one of the few physicians in the world using this procedure (at the time).

A few days later, I’m lying on an operating table in Baltimore with my head bolted down, ready for radiation. They bolt you down to ensure the cooking of the tumor (and not the brain). Fun, you should try it. Four more times I visited the table. Each time everyone left the room–a sure sign you should not try this at home.

Each day I laid there silently, talking to God and trusting Him.

Three weeks later I returned to work. Eighteen years later, I have had one sick day.

I’ve watched my children grow up. They are twenty-one and twenty-three now–both finished college. My daughter is engaged to be married. My wife is still by my side, and I’m thankful for each day.

Cades Cove, Tennessee with my wife

So what does a brain tumor story tell us about audits? (You may, at this point, be thinking: they did cook the wrong part.)

Audit Lessons Learned from a Brain Tumor

1. Pay Attention to Signs

It’s easy to overlook the obvious. Maybe we don’t want to see a red flag (I didn’t want to believe I had a tumor). It might slow us down. But an audit is not purely about finishing and billing. It’s about gathering proper evidential matter to support the opinion. To do less is delinquent and dangerous.

2. Seek Alternatives

If you can’t gain appropriate audit evidence one way, seek another. Don’t simply push forward, using the same procedures year after year. The doctor in Atlanta was a surgeon, so his solution was surgery. His answer was based on his tools, his normal procedures. If you’ve always used a hammer, try a wrench.

3. Seek Counsel

If one answer doesn’t ring true, see what someone else thinks, maybe even someone outside your firm. Obviously, you need to make sure your engagement partner agrees (about seeking outside guidance), but if he or she does, go for it. I often call the AICPA hotline. I find them helpful and knowledgeable. I also have relationships with other professionals, so I call friends and ask their opinions–and they call me. Check your pride at the door. I’d rather look dumb and be right than to look smart and wrong.

4. Embrace Change

Fractionated stereotactic radiation was new. Dr. Williams was a pioneer in the technique. The only way your audit processes will get better is to try new techniques: paperless software (we use Caseware), data mining (we use IDEA), real fraud inquiries (I use ACFE techniques), electronic bank confirmations (I use Confirmation.com), project management software (I use Basecamp). If you are still pushing a Pentel on a four-column, it’s time to change.

Postscript

Finally, remember that work is important, but life itself is the best gift. Be thankful for each moment, each hour, each day.

How to Lessen Segregation of Duties Problems in Two Easy Steps

Fraud prevention in two easy steps

Darkness is the environment of wrongdoing.

Why?

No one will see us–or so we think.

As you’ve seen many times, fraud occurs in darkness.

In J.R.R. Tolkien’s Hobbit stories, Sméagol, a young man murders another to possess a golden ring, beautiful in appearance but destructive in nature. The possession of the ring and Sméagol’s hiding of self and his precious (the ring) transforms him into a hideous creature–Gollum. I know of no better or graphic portrayal of how that which is alluring in the beginning, is destructive in the end.

Fraud opportunities have those same properties: they are alluring and harmful. And, yes, darkness is the environment of theft. What’s the solution? Transparency. It protects businesses, governments, and nonprofits. And while we desire open and understandable processes, often businesses have just a few employees that operate the accounting system. And many times they alone understand how it works.

It is desirable to divide accounting duties among various employees, so no one person controls the entire process. This division of responsibility creates transparency since multiple eyes see the accounting processes–but this is not always possible.

Lacking Segregation of Duties

Many small organizations lack appropriate segregation of duties and believe that solutions do not exist or that fixing the problem is too costly. But is this true? Can we create greater transparency and safety with simple procedures and without significant cost?

Yes.

Below I propose two processes to reduce fraud:

  1. Bank account transparency and
  2. Surprise audits.

1. Bank Account Transparency

Here’s a simple and economical control: Provide all bank statements to someone other than the bookkeeper. Allow this second person to receive the bank statements before the bookkeeper. While no silver bullet, it has power.

Persons who might receive the bank statements first (before the bookkeeper) include the following:

  • A nonprofit board member
  • The mayor of a small city
  • The owner of a small business
  • The library director
  • A church leader

What is the receiver of the bank statements to do? Merely open the bank statements and review the contents for appropriateness (mainly cleared checks).

In many small entities, accounting processes are a mystery to board members or owners since only one person (the bookkeeper) understands the disbursement process, the recording of journal entries, billing and collections, and payroll.

One set of eyes on an accounting process is not a good thing. So how can we shine the light?

Fraud Prevention

Picture courtesy of DollarPhoto.com

Second Person Sees the Bank Statements

Allow a second person to see the bank statements.

Fraud decreases when the bookkeeper knows someone is watching. Suppose the bookkeeper desires to write a check to himself but realizes that a board member will see the cleared check. Is this a deterrent? You bet.

Don’t want to send the bank statements to a second person? Request that the bank provide read-only online access to the second person, and let the bookkeeper know that the other person will review bank activity.

Even the appearance of transparency creates (some) safety.

Suppose the second person reviewer opens the bank statements (before providing them to the bookkeeper) and does nothing else. The perception of reviews enhances safety. I am not recommending that you don’t perform the review, but if the bookkeeper even thinks someone is watching, fraud will lessen.

2. Surprise Audits

Another way to create small-entity transparency is to perform surprise audits. These reviews are not opinion audits (such as those issued by CPAs) but involve random inspections of various areas such as viewing all checks clearing the May bank statement. Such a review can be contracted out to a CPA or performed by someone other than the bookkeeper–such as a board member.

Segregation of Duties

Picture courtesy of DollarPhoto.com

Adopt a written policy stating that the surprise inspections will occur once or twice a year.

The policy could be as simple as the following:

Twice a year a board member (or designee other than the bookkeeper) will inspect the accounting system and related documents. The scope and details of the inspection will be at the judgment of the board member (or designee). An inspection report will be provided to the board.

Why word the policy this way? You want to make the system general enough that the bookkeeper has no idea what will be inspected but distinct enough that an actual review occurs with regularity (thus the need to specify the minimum number of times the review will be performed).

Sample Inspection Ideas

Here are some sample inspection ideas:

  • Inspect all cleared checks that clear a particular month for appropriate payees and signatures and endorsements
  • Agree all receipts to the deposit slip for three different time periods
  • Review all journal entries made in a two week period and request an explanation for each
  • Review two bank reconciliations for appropriateness
  • Review one monthly budget to actual report (to see that the report was appropriately created)
  • Request a report of all new vendors added in the last six months and review for appropriateness

The reviewer may not perform all of the procedures and can perform just one. What is done is not as important as the fact that something is done. In other words, the primary purpose of the surprise audit is to make the bookkeeper think twice about whether he or she can steal and not be caught.

Again multiple people seeing the accounting processes reduces the threat of fraud.

Shine the Light

The beauty of these two procedures (bank account transparency and surprise audits) is they are straightforward and cheap to implement but nevertheless powerful. So shine the light.

What other procedures do you recommend for small entities?

For more information about preventing fraud, check out my book: The Little Book of Local Government Fraud Prevention.

Audit Documentation: If It’s Not Documented, It’s Not Done

Here are suggestions to communicate clearly with your work papers

Peer reviewers are saying, “If it’s not documented, it’s not done.” Why? Because standards require sufficient audit documentation. And if it’s not documented, the peer reviewer can’t give credit for performance. 

But what does sufficient documentation mean? What should be in our work papers? How much is necessary? This article answers these questions.

Audit documentation

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In the AICPA’s Enhanced Oversight program, one in four audits is nonconforming due to a lack of sufficient documentation. This has been and continues to be a hot-button peer review issue. And it’s not going away. 

But auditors ask, “What is sufficient documentation?” That’s the problem, isn’t it? The answer is not black and white. We know good documentation when we see it–and poor as well. It’s the middle that fuzzy. Too often audit files are poor-to-midland. Why? 

First, many times it boils down to profit. Auditors can make more money by doing less work. So, let’s go ahead and state the obvious: Quality documentation takes more time and may lessen profit. But what’s the other choice? Poor work.

Second, the auditor may not understand what the audit requirements are. So, in this case, it’s not motive (more profit), it’s a lack of understanding.

Thirdly, another contributing factor is that firms often bid for work–and low price usually carries the day. Then, when it’s time to do the work, there’s not enough budget (time)–and quality suffers. Corners are cut. Planning is disregarded. Audit programs are poorly designed. Confirmations, walkthroughs, fraud inquiries are omitted. It’s easier, at least in the short run.

Even though these reasons may be true, we all know that quality is the foundation of every good CPA firm. And work papers tell the story–the real story–about a firm’s character. How would you rate your work paper quality? Is it excellent, average, poor? If you put your last audit file on this website and everyone could see it, would you be proud? Or does it need improvement?

Insufficient Audit Documentation

First, let’s look at examples of poor documentation:

  • Signing off on audit steps with no supporting work papers (and no explanation on the audit program)
  • Placing a document in a file without explaining why (what is its purpose?)
  • Not signing off on audit steps
  • Failing to reference audit steps to supporting work papers
  • Listing a series of numbers on an Excel spreadsheet without explaining their source (where did they come from? who provided them?)
  • Not signing off on work papers as a preparer
  • Not signing off on work papers as the reviewer
  • Failing to place excerpts of key documents in the file (e.g., debt agreement)
  • Performing fraud inquiries but not documenting who was interviewed (their name) and when (the date)
  • Not documenting the selection of a sample (why and how)
  • Failing to explain the basis for low inherent risk assessments
  • Key bank accounts and debt are not confirmed
  • Not documenting the reason for not sending receivable confirmations
  • A lack of retrospective reviews
  • A failure to document the current year walkthroughs for significant transaction cycles (the file contains a generic description of controls with no evidence of a current year review)
  • Not documenting COSO deficiencies (e.g., tone at the top, management’s risk assessment procedures)
  • A failure to document risk assessments
  • Low control risk assessments without a test of controls
  • A lack of linkage from the risk assessment to the audit plan
  • No independence documentation though nonattest services are provided

This list is not comprehensive, but it provides examples to consider. This list is based on my past experiences. Probably the worst offense (at least in my mind) is signing off on an audit program with no support.

AICPA Findings

Additionally, the AICPA has identified the following deficiencies. Work papers lack:

  • Tests of controls over compliance in a single audit
  • Determinations of direct and material Single Audit compliance requirements 
  • Eligibility testing in Employee Benefit Plan audits

Sufficient Audit Documentation According to AU-C 230

Now, let’s examine what constitutes sufficient documentation.

AU-C 230 Audit Documentation defines how auditors are to create audit evidence. It says that an experienced auditor with no connection to the audit should understand:

  • Nature, timing, and extent of procedures performed
  • Results and evidence obtained
  • Significant findings, issues, and professional judgments

While most auditors are familiar with this requirement, the difficulty lies in how to accomplish this. What does it look like?

Experienced Auditor’s Understanding

Here’s the key: When an experienced auditor reviews the documentation, does she understand the work?

Any good communicator makes it her job to speak or write in an understandable way. The communicator assumes responsibility for clear messages. In creating work papers, we are the communicators. The responsibility for transmitting messages lies with us (the auditors creating work papers).  

A Fog in the Work Papers

So what creates fogginess in work papers? We forget we have an audience. Others will review the audit documentation to understand what was done. As we prepare work papers, we need to think about those who will read our work. All too often, the person creating a work paper understands what he is doing, but the reviewer doesn’t. Why? The message is not clear.

Just because I know why I am doing something does not mean that someone else will.

Creating Clarity

This is why most work papers should include the following:

  • A purpose statement (what is the reason for the work paper?)
  • The source of the information (who provided it? where did they obtain it and how?)
  • An identification of who prepared and reviewed the work paper
  • The audit evidence (what was done)
  • A conclusion (does the audit evidence support the purpose of the work paper?)

When I make these suggestions, some auditors push back saying, “We’ve already documented some of this information in the audit program.” That may be true, but I am telling you–after reviewing thousands of audit files–the message (what is being done and why) can get lost in the audit program. The reviewer often (speaking for myself) has a difficult time tieing the work back to the audit program and understanding its purpose and whether the documentation provides sufficient audit evidence.

Remember, the work paper preparer is responsible for clear communication. 

And here’s another thing to consider. You (the work paper preparer) might spend six hours on one document. So, you are keenly aware of what you did. The reviewer, on the other hand, might spend five minutes–and she is trying (as quickly as she can) to understand. 

Help Your Reviewers

To help your less informed reviewers:

  1. Tell them what you are doing (purpose statement)
  2. Do it (document the test work)
  3. Then, tell them how it went (the conclusion)

Sample Work Paper from AICPA

Here’s a sample work paper from the AICPA. What do I like about it?

It communicates (clearly):

  • That it was not prepared by the client
  • Who prepared it and who reviewed it
  • The dates prepared and reviewed
  • The objective (purpose)
  • What the tickmarks mean

I also note there is no extraneous information, no clutter.

work paper documentation

So far, we’ve discussed insufficient documentation. Let’s take a minute to review an opposite problem, having too much.

Too Much Audit Documentation

It’s funny, but many CPAs say to me, “I feel like I do too much,” meaning they believe they are auditing more than is necessary. To which I often respond, “I agree.”

In looking at audit files, I see:

  • The clutter of unnecessary work papers
  • Files received from clients that don’t support the audit opinion
  • Unnecessary work performed on these extraneous documents

For whatever reason, clients usually provide more information than we request. And then–for some other reason–we retain those documents, even if not needed.

If auditors add purpose statements to each work paper, then they will discover that some work papers are unnecessary. In writing the purpose statement, we realize it has none. Which is nice–now, we can deep-six it.

One healthy exercise is to pretend we’ve never audited the company and that we have no prior year audit files. Then, with a blank page, we plan the audit. Once done, we compare the new plan to prior year files. If there’s any fat, start cutting. 

The key to eliminating unnecessary work lies in performing the following steps (in the order presented):

  1. Perform risk assessment
  2. Plan your audit based on the identified risks
  3. Perform the audit procedures

Too often, we roll the prior year file forward and rock on. If the prior year file has extraneous audit procedures, then we repeat them. This creates waste.

Summary

In summary, audit documentation continues to be a significant peer review problem. We can enhance the quality of our work papers by remembering we are not just auditing. We are communicating. It is our responsibility to provide a clear message.

Below is a short video summarizing this article.

Disbursement Fraud Audit Tests: Five Powerful But Simple Ideas

Here are five fraud tests you can use on your audits

You are leading the audit team discussion concerning disbursements, and a staff member asks, “Why don’t we ever perform fraud tests? It seems like we never introduce elements of unpredictability.”

You respond by saying, “Yes, I know the audit standards require unpredictable tests, but I’m not sure what else to do. Any fresh ideas?”

The staff member sheepishly responds, “I’m not sure.” 

You remember a blog post addressing how fraud can sting auditors, and you think, “What can we do?”

disbursement fraud audit tests

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Five Disbursement Fraud Tests

Here are five disbursement fraud tests that you can perform on most any audit.

1. Test for duplicate payments

Why test?

Theft may occur as the accounts payable clerk generates the same check twice, stealing and converting the second check to cash. The second check may be created in a separate check batch, a week or two later. This threat increases if (1) checks are signed electronically or (2) the check-signer commonly does not examine supporting documentation and the payee name.

How to test?

Obtain a download of the full check register in Excel. Sort by dollar amount and vendor name. Then investigate same-dollar payments with same-vendor names above a certain threshold (e.g., $25,000).

2. Review the accounts payable vendor file for similar names

Why test?

Fictitious vendor names may mimic real vendor names (e.g., ABC Company is the real vendor name while the fictitious name is ABC Co.). Additionally, the home address of the accounts payable clerk is assigned to the fake vendor (alternatively, P.O. boxes may be used).

The check-signer will not recognize the payee name as fictitious.

How to test?

Obtain a download of all vendor names in Excel. Sort by name and visually compare any vendors with similar names. Investigate any near-matches.

3. Check for fictitious vendors

Why test?

The accounts payable clerk may add a fictitious vendor (one in which no similar vendor name exists, as we saw in the preceding example).

The fictitious vendor address? You guessed it: the clerk’s home address (or P.O. Box).

Pay particular attention to new vendors that provide services (e.g., consulting) rather than physical products (e.g., inventory). Physical products leave audit trails; services, less so.

How to test?

Obtain a download in Excel of new vendors and their addresses for a period of time (e.g., month or quarter). Google the businesses to check for validity; if necessary, call the vendor. Or ask someone familiar with vendors to review the list (preferably someone without vendor set-up capabilities).

4. Compare vendor and payroll addresses

Why test?

Those with vendor-setup ability can create fictitious vendors associated with their own home address. If you compare all addresses in the vendor file with addresses in the payroll file, you may find a match. (Careful – sometimes the match is legitimate, such as travel checks being processed through accounts payable.) Investigate any suspicious matches.

How to test?

Obtain a download in Excel of (1) vendor names and addresses and (2) payroll names and addresses. Merge the two files; sort the addresses and visually inspect for matches.

5. Scan all checks for proper signatures and payees

Why test?

Fraudsters will forge signatures or complete checks with improper payees such as themselves.

How to test?

Pick a period of time (e.g., two months), obtain the related bank statements, and scan the checks for appropriate signatures and payees. Also, consider scanning endorsements (if available).

Your Ideas

Those are a few of my ideas. Please share yours.

My fraud book provides more insights into why fraud occurs, how to detect it, and–most importantly–how to prevent it. Check it out on Amazon by clicking here. The book focuses on local government fraud, but most of the information is equally applicable to small businesses.