If you're near graduation, you may wonder, "Which is best for me? Tax or audit?”
In this article, I provide questions and facts for you to consider as you decide. This decision is one of the most important ones you'll make in your career.
Tax and Audit Career Decision
Here are some thoughts about that decision:
1. Do you like subjectivity or objectivity? Audits tend to have more subjective elements like risk assessment. Tax, on the other hand, tends to be more objective (it's compliance-oriented).
2. Are you willing to work long hours for four months each year? Tax season is an annual marathon. Auditing also has busy seasons, depending on the industries your firm services, but you can more easily distribute your workload in audits.
3. Do you like to travel? Audits usually involve some travel. Tax CPAs spend most of their time in the office, though not all.
4. Do you like accounting? If you work in public accounting, you must understand accounting well to do audits (and other A&A work). You also need to understand accounting for tax purposes, but tax work is more compliance-oriented.
5. Do you like saving individuals and companies money? Tax allows you to have a direct impact on taxes paid (and your clients will love you if you can save them money).
6. Do you like short-term or long-term projects? Tax work tends to be short-term, and audit work tends to be long-term. For instance, you might complete a tax return in four or five hours (sometimes less). Audits can take several hundred hours.
7. Do you like technology? Audits can involve technology more than tax work, though this is a generalization. With audits, you might, for example, use data mining software or Excel for advanced purposes.
Tax and Audit Compensation
You may be wondering which field offers the more significant compensation opportunities. I've seen auditors and tax folks make plenty of money through the years. So, you can do well with either. But being in the field best suited to you will enhance your ability to generate income. Why? Because happy people are more productive and effective. That's one reason choosing the right field--tax or audit--is critical.
Tax and Audit Work Hours
If you've worked in public accounting, you've seen tax people working late into the evenings and on weekends throughout tax season. The tax deadlines lead to compressed work schedules, especially in the early part of the calendar year. But tax people usually get relief in the summer or late in the year.
Audit personnel tend to have steadier workloads, though their work can also be seasonal. For instance, if you work with a firm that does governmental audits, there may be a substantial number of engagements with June 30 and September 30 year-ends, leading to increased workloads later in the calendar year. So check with the firms you interview with to see how the audit workloads vary.
Talk to Auditors and Tax Persons
Talking to auditors and tax people with real-world experience will give you more insight than almost anything you can do. Make a list of questions and ask them as you interview prospective CPA firms.
Journal entry testing is required in all audits. Why? The use of journal entries to manipulate financial statements is always present–even in accounting systems with good internal controls. Thus the journal entry test requirement in AU-C 240, Consideration of Fraud in a Financial Statement Audit.
In this article, I explain how auditors can understand and test journal entries to ensure management is not cooking the books.
Understand the Journal Entry Process
First, auditors should gain an understanding of the journal entry process. Ask questions such as:
Can one person post a journal entry without a second-person approval? If yes, who?
How often are journal entries posted, and for what purpose?
Have there been any unusual journal entries during the year?
Are estimates adjusted or recorded with journal entries? If yes, who makes those entries, and how often?
Does the company have a separate journal entry software package (such as Blackline) that interfaces with the general ledger?
What journal entries are made in creating the financial statements, including those after the trial balance is taken from the accounting package (for example, the company downloads the trial balance to Excel)?
Are all journal entries in the financial statement creation phase reviewed and approved by a second person? If yes, by whom?
Has management asked anyone to override journal entry controls or protocols?
Inspect sample documents and journal entries. Also, observe who is doing what. Then document your inquiries, the records inspected, and your observations as a part of your walkthrough process. Also, document who you talked with and on what date.
Scan a Month’s Journal Entries
Consider downloading all journal entries for a particular month and scanning those. Doing so will enable you to see the typical entries made. Most accounting systems differentiate journal entries from other transactions, so it’s usually easy to segregate all journal entries for review.
Scanning a month’s journal entries is not a required procedure, but one that I suggest.
So, as you scan the journal entries, what are you looking for? What types of entries might imply that fraud is present?
Indicators of Fraud Risk
The following are potential indicators of fraud risk:
Nonstandard journal entries made at year-end, especially those for round numbers
Entries made to seldom-used accounts
Post-closing entries with no explanation
Entries made by persons that seldom do so
Entries made to force accounts to balance without performing proper reconciling procedures
Plan Your Journal Entry Responses
Plan to test journal entries based on your risk assessment procedures. If you notice particular risks, then audit those areas.
Here are examples of risks and responses:
Test more entries if one person records journal entries without a second-person approval. Why? There’s more risk.
If you note unusual logical access rights, consider downloading all journal entries and sorting them by persons to see if there are any unusual journal entries.
If significant revenue entries are made in the last month, test those.
If one person consolidates the financial statements in Excel, making adjustments without a second-person review, test that process.
Journal entries may be appropriate throughout the year because they are subject to good controls. Even so, someone might inflate the numbers in the financial statement creation process (after exporting the original numbers to a spreadsheet, for example).
Test Journal Entries in Every Audit
AU-C 240, Consideration of Fraud in a Financial Statement Audit, requires auditors to test journal entries in every audit. Why? There is always a possibility that management might override controls, and journal entries are an easy way to make the company look better than it is. Think about it: one journal entry in the last month of the year can increase revenues and receivables by millions.
Test Entries Late in the Year
It is wise to test journal entries made late in the year. As management approaches year-end, they might realize the company needs to meet specific targets (e.g., a certain level of net income) for them to earn bonuses. If true, management has a potential motivation to manipulate the numbers, especially at year-end.
See my article about management override of controls for more information about manipulation of financial statements and potential theft.
We'll look at the objectives of SAS 143, auditor responsibilities (including risk assessment and responses), the nature of estimates, documentation requirements, and overall evaluation of your work to ensure appropriateness and completeness.
Estimate Examples
To get us started, here are a few examples of estimates:
So, what is an accounting estimate? It's a monetary amount for which the measurement is subject to estimation uncertainty. Of course, you need to consider the financial reporting framework as you think about the estimate. For example, an estimate might be significantly different when using GAAP versus a regulatory basis.
But what is estimation uncertainty? It's the susceptibility of an estimate to an inherent lack of precision in measurement. In layperson's terms, it's an estimate that is hard to pin down.
SAS 143 Objectives
The objective of SAS 143 is to see if the accounting estimate and related disclosures are reasonable by obtaining sufficient appropriate audit evidence.
Nature of Estimates
Some estimates are simple, while others are difficult. For example, estimating the economic life of a vehicle is straightforward, but computing an allowance for uncollectible receivables might be complex.
But even one type of estimate, such as an allowance for uncollectible, can vary in complexity. For example, the allowance computation for uncollectible receivables is usually more complex for a healthcare entity (e.g., more payor types) than for a small business. Why? Because it is more complex and more challenging to determine. Therefore, the estimation uncertainty for a healthcare entity (with many payor types) is higher than that of a small business with one type of customer. Additionally, the volume of transactions could be higher for a healthcare entity versus a small business.
Estimation Uncertainty
So, the inherent subjectivity of an estimate creates estimation uncertainty.
Consider estimation uncertainty in this manner: ask twenty people to compute the allowance for a hospital and then ask them to do the same for the small business's uncollectible estimate. How much variation would you expect? Yes, much more for the hospital because the inherent risk is higher.
SAS 143 tells us to increase our risk assessment procedures and further audit procedures as the estimation uncertainty increases. We perform more risk assessment work concerning the hospital's allowance than that of the small business. Moreover, we complete more extensive further audit procedures for the hospital's allowance than for the small business's estimate.
More risk, more work.
To understand SAS 143, we need to know the underlying concepts.
SAS 143 Concepts
Relevant Assertions
You need to assess the risk of material misstatement at the relevant assertion level. Further, you are required to assess inherent risk and control risk separately. And as you assess inherent risk, you might encounter significant risks.
The Spectrum of Inherent Risk
Usually, a hospital's valuation assertion related to receivables is relevant, and the inherent risk is often high due to its subjectivity, complexity, and volume of transactions (i.e., inherent risk factors). Therefore, the valuation assertion's risk might fall toward the end of the spectrum of inherent risk. On a ten-point scale, we might assess the inherent risk as a nine or a ten. And if we do, it is a significant risk, affecting our professional skepticism.
Professional Skepticism and Estimates
Our professional skepticism increases as the estimation uncertainty rises (or at least, it should). Why? The potential for management bias may be present since it's easier to manipulate complex estimates. And complexity can be a smokescreen to hide bias, increasing the need for internal controls.
Estimate Controls
As estimates become more complex, entities increase internal controls (or at least, they should). And consequently, auditors need to evaluate the design and implementation of those controls. Additionally, auditors must determine whether they will test the controls for effectiveness.
Another SAS 143 concept is the reasonableness of the estimate.
Reasonableness of Estimates
For an estimate to be reasonable, the applicable financial reporting framework must be its basis. Additionally, management should consider the facts and circumstances of the entity and the related transactions. In creating a reasonable estimate, management will often use the following:
A method
Certain assumptions
Data
Let's consider these elements using the allowance for uncollectible receivables.
First, management considers the financial reporting framework. If the entity uses GAAP, it makes sense to create the estimate. No allowance is necessary if the cash basis of accounting is in use. In this example, we'll assume the company is using GAAP.
Estimate Method
In computing an allowance for uncollectible, an entity might calculate the estimate as a total of the following:
20% of receivables outstanding for more than 60 days
60% of receivables outstanding for more than 90 days
90% of receivables outstanding for more than 120 days
Estimate Assumptions
And what assumptions might management consider? Bad debt percentages have stayed the same over time. The company needs to increase the percentages if collectible amounts erode.
Estimate Data
Finally, consider the allowance data. In this example, it would typically be an aged receivable listing. Such a listing breaks receivables into aging categories (e.g., 0 to 30 days; 31 to 60 days; etc.). Such data should be consistent. Suppose the company purchases new software that computes the aged amounts differently using different data than previously. If this occurs, management and the auditors need to consider the reasonableness of the new data.
Is the Estimate Reasonable?
Most importantly, estimates need to make sense (to be reasonable) in light of the circumstances. While consistent methods, assumptions, and data are desirable, change, such as a slowdown in the economy, can require new ways of computing estimates.
One more concept is that of management's point estimate and disclosure.
Management's Point Estimate and Disclosure
The auditor will examine management's point estimate and the related disclosures to see if they are reasonable. How? Review the estimate's development (how was it computed?) and the nature, extent, and sources of estimation uncertainty.
If circumstances are similar to the prior year, then the estimate's method, assumptions, and data will typically be similar. Likewise, the disclosure will be much like the preceding period.
But if, for example, the economy slows significantly, the percentages applied to the aged receivable categories (see above) may need to increase so that the allowance for uncollectible is higher. The auditor might question the estimate if management did not raise these percentages.
The company should disclose how the estimate is created and the nature, extent, and sources of estimation uncertainty.
Now, let's see what the SAS 143 requirements are.
SAS 143 Requirements
The requirements for estimates are conceptually the same as in any area. The auditor does the following:
Perform risk assessment procedures
Identify and assess the risk of material misstatement
Develop responses to the identified risks and carry those out
1. Perform Risk Assessment Procedures for Estimates
As you consider the entity and its environment, consider the following:
Transactions and other events that give rise to the need for estimates and changes in estimates
The applicable financial reporting framework as it relates to estimates
Regulatory factors affecting estimates, if any
The nature of estimates and related disclosures
Next, as you consider internal control, ask about the following:
Nature and extent of estimate oversight (who oversees the estimate? how often is the estimate being reviewed?)
How does management identify the need for specialized skills or knowledge concerning the estimate?
How do the entity's risk assessment protocols identify and address risks related to estimates?
What are the classes of transactions, events, and conditions giving rise to estimates and related disclosures?
How does management identify the estimate's methods, assumptions, and data sources?
Regarding the degree of estimation uncertainty, how does management determine the range of potential measurement outcomes?
How does management address the estimation uncertainty, including a point estimate and related disclosures?
What are the control activities relevant to the estimate? (e.g., second-person review of the computation)
Does management review prior estimates and the outcome of those estimates? How does management respond to that review?
Additionally, the auditor reviews the outcome of prior estimates for potential management bias.
If there are any significant risks (inherent risk falling toward the end of the spectrum of risk), the auditor should understand the related controls and, after that, see if they are designed appropriately and implemented.
And finally, the auditor considers if specialized skills or knowledge are needed to perform risk assessment procedures related to estimates.
Of course, after you do your risk assessment work, it's time to assess the risk.
2. Identify and Assess the Risk of Material Misstatement
SAS 143, as we have already seen, requires a separate assessment of inherent risk and control risk for each relevant assertion.
In assessing inherent risk, the auditor will consider risk factors such as complexity, subjectivity, and change. It's also important to consider the estimate method and the data used in computing management's point estimate.
Some estimates represent significant risks. So, for example, if the computation of warranty liability is complex or has a high degree of estimation uncertainty, then identify the liability as a significant risk since the valuation assertion is high risk (toward the upper end of the spectrum of inherent risk).
3. Responses to Assessed Risk of Material Misstatement
Once the assessment of risk is complete, you are in a position to create responses. As usual, document linkage from the risk level to the planned procedures. Higher risk calls for more extensive actions.
If, for example, the auditor identifies an estimate as a significant risk, go beyond basic techniques (i.e., more than a basic audit program).
Additionally, base those responses on the reasons for the assessments. In other words, create audit procedures based on the nature of the risk. Performing more procedures unrelated to the identified risk is of no help.
Three Responses to Risks Related to Estimates
The audit procedures need to include one or more of the following three steps:
Obtain audit evidence from events occurring up to the date of the auditor's report
Test how management made the accounting estimate by reviewing the following:
Methods in light of:
Reporting framework
Potential management bias
The estimation computation (is it mathematically correct?)
Use of complex modeling, if applicable
Maintenance of the assumptions and data integrity (does this information have integrity?)
Assumptions; address the following:
Whether the assumptions are appropriate
Whether the judgments made in selecting the assumptions give rise to potential bias
Whether assumptions are consistent with each other
When applicable, whether management has the intent and ability to carry out specific courses of action
Data; address the following:
Whether the data is appropriate
Whether judgments made in selecting the data give rise to management bias
Whether the data is relevant and reliable
Whether management appropriately understands and interprets the data
Management's point estimate and related disclosure; address the following:
How management understands estimation uncertainty
See if management took appropriate steps in developing the point estimate and related disclosure
If the auditor believes management has not sufficiently addressed estimation uncertainty, the following should occur:
Request management perform additional procedures to understand the estimation uncertainty; consider disclosing more information about the estimation uncertainty
Develop an auditor's point estimate or range if management's response to the auditor's request in the prior step is not sufficient
Develop an auditor's point estimate or range; do the following:
Include procedures to evaluate whether methods, assumptions, or data are appropriate
When the auditor develops a range,
Determine whether the range includes only amounts supported by sufficient audit evidence and are reasonable in the context of the reporting framework
Review disclosures related to estimation uncertainty, design and perform procedures regarding the risk of material misstatement (i.e., determine if the disclosure provides sufficient information regarding estimation uncertainty)
Once you complete your audit work related to estimates, evaluate what you've done.
Overall Evaluation of Estimate Work
Evaluate the sufficiency of your estimate work by considering the following:
Are the risk assessments at the relevant assertion level still appropriate?
Do management's decisions regarding recognition, measurement, presentation, and disclosure of the estimates agree with the financial reporting framework?
Has sufficient appropriate evidential matter been obtained?
Significant judgments related to estimates and related disclosures in light of the reporting framework
Governance Communication Regarding Estimates
Finally, consider whether you should communicate estimate matters to those charged with governance, especially if a high estimation uncertainty is present.
SAS 143 Summary
While SAS 143 requires that auditors understand the estimation process and then perform procedures to ensure the reasonableness of the numbers and disclosures, there's nothing unusual about this. We gain an understanding of the estimates, assess the risk, and create responses.
Many estimates, such as plant, property, and equipment depreciation, are simple. In those areas, there's little to do. But as always, our risk assessment and responses will increase as complexity and uncertainty increase.
In this article, I explain how you can stop over auditing and wasting precious time. You’ll soon know why to leave in and what to leave out.
Are You Over Auditing?
Ten audit engagements.
Each audit file with a different risk profile.
Each with a different audit plan.
Each file begging for attention in certain areas.
This afternoon I met with two CPAs to discuss ten audits they perform. Specifically we were looking to see what needed to be done, and maybe more importantly, what was not needed.
The concern was “over auditing.”
For as long as I can remember, CPAs have asked, “what am I doing that is not necessary?”
My answer is always the same: audit areas that have a risk of material misstatement. Drop everything else.
Removing Unnecessary Audit Steps
Well, how do you know if an audit procedure is not needed?
Look at the prior year workpaper and ask, “what relevant assertion and in what transaction cycle does this procedure address?” If you can’t connect the workpaper to a risk, then it’s probably not needed.
You can “reverse engineer” an audit by looking at the prior year workpapers and asking this same question over and over again: “what risk of material misstatement does this workpaper address?”
Adding Necessary Audit Steps
Then—and more importantly—“forward engineer” the audit plan by assessing your risk for each relevant assertion and planning (and linking) a procedure to satisfy (lower) the risk of material misstatement.
Brevity of Audit File
An audit file needs to be tight, without waste.
Moreover, let it speak of the important—and nothing else. An audit file is somewhat like a good speech: There are no wasted words.
So, can excessive work papers create problems?
Excessive Work Papers Create (at least) Two Problems
Excessive (or unneeded) work papers can create problems, including:
1. Clutter (which degrades the message)
2. Legal exposure
Why do I say legal exposure? If your work papers are subpoenaed and there are unnecessary work papers, the opposing party may find contradictory information that works against you.
Then you know what would come next: the opposing attorney holding up a damning document as she asks, “did this work paper come from YOUR audit file?”
Keep things lean.
Right Audit Steps
In summary, say what needs to be said, and nothing more.
Segregation of duties is key to reducing fraud. But smaller entities may not be able to do so. Today, I tell you how overcome this problem, regardless of the entity’s size.
The Environment of Fraud
Darkness is the environment of wrongdoing.
Why?
No one sees us. Or so we think.
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 transforms Sméagol into a hideous creature–Gollum.
And what does this teach us? That which is alluring in the beginning can be destructive in the end.
Fraud opportunities have those same properties: they are alluring and harmful. And, yes, darkness is the environment where fraud happens.
What’s the solution? Transparency. It protects businesses, governments, and nonprofits.
But while we desire open and understandable processes, our businesses often have just a few employees that perform the accounting duties. And, many times, no one else understands how the system works.
It is desirable to divide accounting duties among various employees, so no one person controls the whole process. This division of responsibility creates transparency. How? By providing multiple eyes to see what’s going on.
But this segregation of duties is not always possible.
Lacking Segregation of Duties
Some people says here are three key duties that must always be separated under a good system of internal controls: (1) custody of assets, (2) record keeping or bookkeeping, and (3) authorization. I add a fourth: reconciliation. The normal recommendation for lack of segregation of duties is to separate these four accounting duties to different personnel. But many organizations are unable to do so, usually due to a limited number of employees.
Some small organizations believe they can’t overcome this problem. But is this true? I don’t think so.
Here’s two easy steps to create greater transparency and safety when the separation of accounting duties is not possible.
1. Bank Account Transparency
First, consider this simple 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 statementsfirst (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. Why? Only one person (the bookkeeper) understands the disbursement process, the recording of journal entries, billing and collections, and payroll.
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.
Even the appearance of transparency creates (at least some) safety. Suppose the second person reviewer opens the bank statements (before providing them to the bookkeeper) and does nothing else. The perception of a review enhances safety. I am not recommending that the review not be performed. Butif the bookkeeper even thinks someone is watching, fraud will lessen.
When you audit cash, see if these types of controls are in place.
Now, let’s look at the second step to overcome a lack of segregation of duties. Surprise audits.
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). They 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 they can be performed by someone in the company. For example, a board member.
Additionally, adopt a written policy stating that the surprise inspections will occur once or twice a year.
The policy could be as simple as:
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 examined but distinct enough that a regular review occurs.
Surprise Audit Ideas
Here are some surprise audit 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
Inspect two bank reconciliations for appropriateness
Review one monthly budget to actual report (look for unusual variances)
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 get caught.
I will say it again. Having multiple people involved reduces the threat of fraud.
Segregation of Duties Summary
In summary, the beauty of these two procedures (bank account transparency and surprise audits) is they are straightforward and cheap to implement. Even so, they are powerful. So shine the light.