Casting Your Characters Correctly
Sep 23

Episode 15 – Casting Your Characters (CPA Firm Employees) Correctly

By Charles Hall | Accounting and Auditing

Casting your characters (CPA Firm Employees) correctly is important.

Early in my career, I felt like a square peg in a round hole. Why?

The partners in that firm insisted that I do tax work, something I loathed. You see, I’m naturally an audit kind of guy. I know it’s strange, but I get into risk assessments, planning for and performing audit procedures. I enjoy compilations and reviews. But tax work–not my thing. 

While I love my friends who do tax work, I’m not shaped that way. 

Placing your employees in positions that fit them (they like the work) makes your firm more productive and your staff happier.

This short podcast simply asks, “are you placing your folks in their natural areas of strength?”

Auditing Receivables and Revenues
Sep 09

Auditing Receivables and Revenues: The Why and How Guide

By Charles Hall | Auditing

Today we take a look at auditing receivables and revenues.

Revenues are the lifeblood of any organization. Without cash inflows, the entity may cease to exist. So, it’s important that each business generate sales or some type of revenue. For you, the auditor, it’s important to verify the revenue.  

Along with revenues, auditors need to prove receivables. Why? Some companies manipulate their earnings by inflating their period-end receivables.  When trade receivables increase, revenues increase. So, a company can increase its net income by recording nonexistent receivables.

In this post, we’ll answer questions such as, “should I confirm receivables or examine subsequent receipts?” and “why should I assume that revenues are overstated?"

Auditing Receivables and Revenues

Auditing Receivable and Revenues — An Overview

In this post, we will cover the following:

  1. Primary accounts receivable and revenue assertions
  2. Accounts receivable and revenue walkthrough
  3. Directional risk for accounts receivable and revenues
  4. Primary risks for accounts receivable and revenues
  5. Common accounts receivable and revenue control deficiencies
  6. Risk of material misstatement for accounts receivable and revenues
  7. Substantive procedures for accounts receivable and revenues
  8. Common accounts receivable and revenue work papers

Primary Accounts Receivable and Revenue Assertions

First, let’s look at assertions. The primary relevant accounts receivable and revenue assertions are:

  • Existence and occurrence
  • Completeness
  • Accuracy
  • Valuation
  • Cutoff

Of these assertions, I believe—in general—existence (of receivables), occurrence (of revenues) and valuation (of receivables) are most important. So, clients assert that:

  • Receivables exist 
  • Receivables are properly valued, and 
  • Revenues occurred

Accuracy comes into play if the customer has complex receivable transactions. Additionally, the cutoff assertion is often relevant, especially if the client has incentives to inflate the receivables balance (e.g., bonuses triggered at certain income levels).

Accounts Receivable and Revenue Walkthrough

Second, think about performing your risk assessment work in light of the relevant assertions.

As we perform walkthroughs of accounts receivable and revenue, we are looking for ways they are overstated (though they can also be understated as well). We are asking, “What can go wrong, whether intentionally or by mistake?”

In performing accounts receivable and revenue walkthroughs, ask questions such as:

  • Are receivables subsidiary ledgers reconciled to the general ledger?
  • Is a consistent allowance methodology used?
  • What method is used to compute the allowance and is it reasonable?
  • Who records and approves the allowance?
  • Who reviews aged receivables?
  • What controls ensure that revenues are recorded in the right period?
  • Is there adequate segregation of duties between persons recording, billing, and collecting payments? Who reconciles the related records?
  • What software is used to track billings and collections?
  • Are there any decentralized collection locations?
  • When are revenues recognized and is the recognition in accordance with the reporting framework?
  • What receivables and revenue reports are provided to the owners or the governing body?

As we ask questions, we also inspect documents (e.g., aged receivable reports) and make observations (e.g., who collects the payments?).

If controls weaknesses exist, we create audit procedures to respond to them. For example, if—during the walkthrough—we see inconsistent allowance methods, we will perform more substantive work to prove the allowance balances.

Directional Risk for Accounts Receivable and Revenues

Third, consider the directional risk of accounts receivable and revenues.

Auditing receivables and revenues

The directional risk for accounts receivable and revenue is an overstatement. So, in performing your audit procedures, perform procedures to ensure that accounts receivables and revenues are not overstated. For example, review the cutoff procedures at period-end. Be sure that no subsequent period revenues are recorded in the current fiscal year. 

Audit standards require that auditors review estimates for management bias. So, consider the current year allowance and bad debt write-offs in light of the prior year allowance. This retrospective review allows the auditor to see if the current estimate is fair. The threat is that management might reduce allowances to inflate earnings.

Moreover, the audit standards state there is a presumption (unless rebutted) that revenues are overstated. Therefore, we are to assume revenues are overstated, unless we can explain why they are not.

Primary Risks for Accounts Receivable and Revenues

Fourth, think about the risks related to receivables and revenues.

The main risks are:

  1. The company intentionally overstates accounts receivable and revenue 
  2. Company employees steal collections 
  3. Without proper cutoff, an overstatement of accounts receivables and revenue occurs 
  4. Allowances are understated
  5. Revenue recognition

Risks related to revenue also vary from company to company. For example, one telecommunications company might sell bundled services while another may not. Revenue recognition is more complex (risky) for the company selling bundled services.

Also, revenue risks vary from industry to industry. For example, the allowance for uncollectible is normally a high risk area for healthcare entities, but may not be so for other industries.

Common Accounts Receivable and Revenue Control Deficiencies

Fifth, think about the control deficiencies noted during your walkthroughs and other risk assessment work.

In smaller entities, the following control deficiencies are common:

  • One person performs one or more of the following: 
    • bills customers
    • receipts monies
    • makes deposits 
    • records those payments in the general ledger
    • reconciles the related bank account
  • The person computing allowances doesn’t possess sufficient knowledge to do so correctly
  • No surprise audits of receivables and revenues 
  • Multiple people work from one cash drawer
  • Receipts are not appropriately issued
  • Receipts are not reconciled to daily collections
  • Daily receipts are not reviewed by a second person
  • No one reconciles subsidiary receivable ledgers to the general ledger
  • Individuals with the ability to adjust customer receivable accounts (with no second-person approval or review) also collect cash 
  • Inconsistent bad debt recognition with no second-person review process
  • The revenue recognition policy may not be clear and may not be in accordance with the reporting framework

Risk of Material Misstatement for Accounts Receivable and Revenues

Sixth, now it’s time to assess your risks.

In smaller engagements, I usually assess control risk at high for each assertion. Controls must be tested to support any lower control risk assessments. Assessing risks at high is often more efficient than testing controls.

When control risk is assessed at high, inherent risk becomes the driver of the risk of material misstatement (inherent risk X control risk = risk of material misstatement). The assertions that concern me the most (those with higher inherent risks) are existence, occurrence, and valuation. So my RMM for these assertions is usually moderate to high.

My response to higher risk assessments is to perform certain substantive procedures: namely, receivable confirmations and tests of subsequent collections. As RMM increases, I send more confirmations and examine more subsequent collections.

Additionally, I thoroughly test management’s allowance computation. I pay particular attention to uncollected amounts beyond 90 days. Uncollected amounts beyond 90 days should usually be heavily reserved. And amounts beyond 120 days should—generally—be fully reserved.  

Substantive Procedures for Accounts Receivable and Revenues

And finally, it’s time to determine your substantive procedures in light of your identified risks.

auditing receivables and revenues

My customary audit procedures are as follows:

  1. Confirm accounts receivable balances (especially larger amounts)
  2. Vouch subsequent period collections, making sure the subsequent collections relate to the period-end balances (sampling can be used)
  3. Thoroughly review allowance computations to see if they are consistent with prior years; compare allowance percentages to industry averages; agree to supporting documentation (e.g., histories of uncollectible amounts); recompute the related numbers
  4. Create comparative summaries of all significant revenue accounts, comparing the current year amounts with historical data (three or more years if possible)
  5. Create summaries of average per customer income and compare with prior years (you may want to do this by specific revenue categories)
  6. Compute average profit margins by sales categories and compare with previous years

Common Accounts Receivable and Revenue Work Papers

My accounts receivable and revenue work papers frequently include the following:

  • An understanding of accounts receivable and revenue-related internal controls
  • Risk assessment of accounts receivable and revenue at the assertion level
  • Documentation of any control deficiencies
  • Accounts receivable and revenue audit program
  • A detail of receivables comprising amounts on the general ledger
  • Copies of confirmations sent
  • A summary of confirmations received
  • Subsequent collections work papers
  • Allowance work paper
  • Revenue comparison work papers

In Summary

In this chapter, we’ve looked at the following for receivables and revenues:

  • How to perform risk assessment procedures, 
  • Relevant assertions, 
  • Risk assessments (as a result of the risk assessment procedures), and
  • Substantive procedures

Next, we’ll see how to audit plant, property, and equipment.

auditing cash
Sep 05

Auditing Cash: The Why and How Guide

By Charles Hall | Auditing

Auditing cash tends to be straightforward. We usually just obtain the bank reconciliations and test them. We send confirmations and vouch the outstanding reconciling items to the subsequent month’s bank statement. But are such procedures always adequate? Hardly. 

Recall the Parmalat and ZZZZ Best Carpet Cleaning frauds. In those businesses, the theft of cash was covered up with fake bank statements and fake confirmation responses. Millions were lost and reputations of those audit firms were tarnished.

auditing cash

How to Audit Cash

In this post, we will take a look at the following:

  • Primary cash assertions
  • Cash walkthrough
  • Directional risk for cash
  • Primary risks for cash
  • Common cash control deficiencies
  • Risk of material misstatement for cash
  • Substantive procedures for cash
  • Common cash work papers

Primary Cash Assertions

The primary relevant cash assertions are:

  • Existence
  • Completeness
  • Rights
  • Accuracy
  • Cutoff

Of these assertions, I believe existence, accuracy, and cutoff are most important. The audit client is asserting that the cash balance exists, that it’s accurate, and that only transactions within the period are included.

Classification is normally not a relevant assertion. Cash is almost always a current asset. But when bank overdrafts occur, classification can be in play. The negative cash balance can be presented as cash or as a payable depending on the circumstances. 

Cash Walkthrough

As we perform walkthroughs of cash, we normally look for ways that cash might be overstated (though it can also be understated as well). We are asking, “What can go wrong?” whether intentionally or by mistake.

Cash Walkthrough

In performing cash walkthroughs, ask questions such as:

  • Are timely bank reconciliations performed by competent personnel?
  • Are all bank accounts reconciled?
  • Are the bank reconciliations reviewed by a second person?
  • Are all bank accounts on the general ledger?
  • Are transactions appropriately cut off at period-end (with no subsequent period transactions appearing in the current year)?
  • Is there appropriate segregation between persons handling cash, recording cash, making payments, and  reconciling the bank statements
  • What bank accounts were opened in the period?
  • What bank accounts were closed in the period?
  • Are there any restrictions on the bank accounts?
  • What persons are on the bank signature cards?
  • Who has the authority to open and/or close bank accounts?
  • What is the nature of each bank account (e.g., payroll bank account)?
  • Are there any cash equivalents (e.g., investments of less than three months)
  • Were there any held checks (checks written but unreleased) at the end of the period being audited?

As we ask questions, we also inspect documents (e.g., bank reconciliations) and make observations (who is doing what?).

If controls weaknesses exist, we create audit procedures to address them. For example, if during the walkthrough we review three monthly bank reconciliations and they all have obvious errors, we will perform more substantive work to prove the year-end bank reconciliation. For example, we might vouch every outstanding deposit and disbursement.

Directional Risk for Cash

What is directional risk? It’s the potential bias that a client has regarding an account balance. A client might desire an overstatement of assets and an understatement of liabilities  since each makes the balance sheet appear healthier.

The directional risk for cash is overstatement. So, in performing your audit procedures, perform procedures such as testing the bank reconciliation to ensure that cash is not overstated.

Primary Risks for Cash

The primary risks are:

  1. Cash is stolen
  2. Cash is intentionally overstated to cover up theft
  3. Not all cash accounts are on the general ledger
  4. Cash is misstated due to errors in the bank reconciliation
  5. Cash is misstated due to improper cutoff

Common Cash Control Deficiencies

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

  • One person receipts and/or disburses monies, records those transactions in the general ledger, and reconciles the related bank accounts
  • The person performing the bank reconciliation does not possess the skill to properly perform the duty
  • Bank reconciliations are not timely performed

Risk of Material Misstatement for Cash

In my smaller audit engagements, I usually assess control risk at high for each assertion. If control risk is assessed at less than high, then controls must be tested to support the lower risk assessment. Assessing risks at high is usually more efficient than testing controls.

Risk of material misstatement for cash

When control risk is assessed at high, inherent risk becomes the driver of the risk of material misstatement (control risk X inherent risk = risk of material misstatement). For example, if control risk is high and inherent risk is moderate, then my RMM is moderate. 

The assertions that concern me the most are existence, accuracy, and cutoff. So my RMM for these assertions is usually moderate to high. 

My response to higher risk assessments is to perform certain substantive procedures: namely, bank confirmations and testing of the bank reconciliations. As RMM increases I examine more of the period-end bank reconciliations and more of the outstanding reconciling items. Also, I am more inclined confirm the balances.

When the RMM is moderate, I use standard audit procedures.

Substantive Procedures for Cash

My customary audit tests are as follows:

  1. Confirm cash balances
  2. Vouch reconciling items to the subsequent month’s bank statement
  3. Ask if all bank accounts are included on the general ledger
  4. Inspect final deposits and disbursements for proper cutoff

The auditor should send confirmations directly to the bank. Some individuals create false bank statements to cover up theft. Those same persons provide false confirmation addresses. Then the confirmation is sent to an individual (the fraudster) rather than a bank. Once received, the company replies to the confirmation as though the bank is doing so. You can lessen the chance of fraudulent confirmations by using Confirmation.com, a company that specializes in bank confirmations. Also, you might Google the confirmation address to verify its existence.

Agree the confirmed bank balance to the period-end bank reconciliation (e.g., December 31, 20X9). Then, agree the reconciling items on the bank reconciliation to the bank statement subsequent to the period-end. For example, examine the January 20X0 bank statement activity when clearing the December 20X9 reconciling items. Finally, agree the reconciled balance to the general ledger cash balance for the period-end (e.g., December 31, 20X9).

Cut-off bank statements (e.g., January 20, 20X9 bank statement) may be used to test the outstanding items. Such statements, similar to bank confirmations, are mailed directly to the auditor. Alternatively, the auditor might examine the reconciling items by viewing online bank statements. (Read-only rights can be given to the auditor.)

Common Cash Work Papers

My cash work papers normally include the following:

  • An understanding of cash-related internal controls 
  • Risk assessment of cash assertions at the assertion level
  • Documentation of any control deficiencies
  • Cash audit program
  • Bank reconciliations for each significant account
  • Bank confirmations

In Summary

We’ve discussed how to perform cash risk assessment procedures, the relevant cash assertions, the cash risk assessments, and substantive cash procedures. 

Next we’ll examine how to audit receivables and revenues.

white collar crime
Sep 04

White Collar Crime is Knocking at Your Door: Are You Prepared?

By Charles Hall | Fraud

If your business has money and employees, then you’re a candidate for white-collar crime.

white collar crime

White Collar Crime Happens!

For most organizations, it’s not a matter of if fraud will occur, it’s a question of how much will be taken. The Association of Certified Fraud Examiners’ biennial survey shows that the average business loses 5% of its revenues to fraud. Imagine adding that amount to your bottom line, because when theft occurs, your net income is reduced by the amount taken.

Learn About Fraud Prevention

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No One Steals from My Business

Most business owners, board members, governments, and nonprofits think “fraud may happen in other organizations, but not in our place. Our people are honest.” Well, let me say I’ve seen plenty of “honest” people steal.

In almost every fraud I’ve seen, the business owners and fellow employees are greatly surprised by the theft–usually by a trusted employee

And these trusted people steal because they can. You may be thinking, “What?” Let me repeat, the reason people steal is because they can. In fraud prevention parlance, we call it “opportunity.”

Fraud Cycle

And, how do trusted employees steal? Here’s the typical cycle:

  • We hire a likable, trustworthy person
  • The employee serves the organization well
  • He moves to higher positions (where he has greater opportunity to steal)
  • No one monitors the employee because he is honest–or at least, he appears that way
  • The employee believes he can steal without detection
  • Small amounts of money are taken to test the water
  • Larger amounts are taken when he is sure no one is watching

So, the employee goes from trusted employee to fraudster. The transformation occurs gradually. Then when the discovery of fraud occurs, everyone is shocked.

Examples of People Who Steal

And what kinds of trusted people steal?

I have seen the following individuals take money:

  • Chief executive officer
  • Board member
  • Pastor
  • Church secretary
  • Healthcare executive
  • A lady who was dying
  • Doctor
  • College president
  • Swim club volunteer
  • Seminary Foundation employee
  • School principal

I could go on, but you get my point. People who we think would never steal, do.

So, how can we prevent–or at least lessen–the threat of fraud? Transparency is a key.

Transparency Lessens Fraud

If transparency is important, why don’t businesses create it?

Small businesses often lack the ability to segregate accounting duties, and this lack of segregation creates opportunities for theft. Why? One employee controls several critical accounting processes, resulting in the ability to steal without detection.

To lessen the possibility of fraud, we must create transparency in accounting processes. Employees are less likely to steal when their actions are visible to others. That’s why segregation of duties is necessary–more eyes see the accounting activity, making it more difficult for theft to occur without detection. Even if an organization has few employees, it’s possible to create transparency and lessen the threat of theft. 

How CPA Hall Talk Helps

CPA Hall Talk is designed to provide you with fraud prevention information.

While I can’t visit everyone that needs fraud prevention assistance, I can provide (free) information about how theft occurs and how you can lessen the threat of fraud.

Here are some of my fraud prevention posts (each with a clickable link):

I hope you find these articles helpful in fighting fraud in your organization. 

Finally, I hope you’ll join us here at CPA Hall Talk for more information about fraud prevention, accounting, and auditing. See the subscription box below.

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