Twenty-four percent of governmental frauds are billing schemes such as fictitious vendor theft, so says the Association of Certified Fraud Examiners. Fictitious vendor fraud is usually committed by a person with the ability to establish new vendors in the accounting system (often the accounts payable clerk). If you are going to prevent this fraud, you need to know how it works.
Fictitious Vendor Fraud
First, the clerk creates the fictitious vendor in the accounts payable system using his own address (or that of an accomplice). Alternatively, he may use a personal P.O. box (which is more common). Second, the clerk creates fictitious vendor invoices to support the payments; often, these invoices are for services rather than for a physical product. Since no shipped asset will be received by the government, it’s easier to conceal the fraud. Finally, the accounts payable clerk issues the vendor checks: since the fictitious vendor check address is that of the accounting clerk, the check is mailed directly to the fraudster (or his accomplice).
Here’s an example of how this fraud might happen.
Accounts Payable Clerk Fraud
John, the accounts payable clerk, sets up the fictitious vendor, Rutland Consulting, and keys his (John’s) address (P.O. Box 798, Atlanta, Georgia, 99890) into the vendor master file. To save time, the city has elected to have all checks signed electronically by the computerized system, so printed checks have signatures on them, and it just so happens that John prints all checks. John records an accounts payable amount of $53,322 to Rutland Consulting.
To conceal the fraud, John creates a fictitious consulting services invoice from Rutland Consulting (especially designed for the auditors), and he codes the expense to an account which has plenty of remaining budgetary appropriation. Now John prints and mails the checks (including the fictitious vendor check).
Two days later John picks up his check at his P.O. box. John has opened a bank account for—you guessed it—Rutland Consulting; he is the only authorized check signer for the account. After depositing the city-issued check to the Rutland Consulting checking account, he writes checks to himself. Soon John’s friends are impressed with his shiny new bass boat.
Other Fraudulent Disbursement Schemes
While reading about John’s fraud, you may be thinking, “Not a problem in my government. Our checks are physically signed.” Consider, however, that signed checks can be created by:
Forging signatures on manual checks
Signing checks with signature stamps
The fraudster might also, in another twist to this scheme, just wire the money electronically and record the transaction with a journal entry. If the fraudster can get a fake vendor added to the payables system and create a signed check or wire funds, then the fictitious vendor scheme becomes a possibility.
Banks generally do not visually inspect checks as they clear (how could they, given the volume of daily checks?), so a forged signature will usually suffice. John’s theft described above becomes easier if he also reconciles the related bank statement—no second pair of eyes will inspect the cleared checks.
Department Head Fraud
City or county department heads can also use a fictitious vendor scheme if they can submit believable new-vendor documentation. Many governments do not verify the existence of new vendors; therefore, a department head can merely send a fake invoice to the payables clerk and receive payment.
Oftentimes when an accounts payable clerk receives an invoice, he will add the new vendor to the accounts payable master file without verifying that the vendor is real. Since department heads often code and approve invoices (by writing the expense account number on the invoice and initialing the same), the payment will be recorded in an account of the department head’s choice.
Again, such invoices are usually for services (e.g., electrical repair)—that way, the accounts payable department is not waiting for receiving documents (e.g., packing slips) before payment is made.
Fictitious Vendor Fraud Factors
The fictitious vendor fraud hinges on three factors:
Getting the fictitious vendor added to the accounts payable vendor list (along with the false address)
Getting the payment made (either by controlling the whole payment process or by having the authority to approve disbursements)
Getting the payment posted to an account where its presence goes unnoticed
Lessen Fictitious Vendor Threat
To mitigate the risk of fictitious vendors, do the following:
Require vendors to provide a physical address (even if payments are to be mailed to a P.O. box)
Require the accounts payable clerk to verify the existence of the new vendor (by calling the vendor or googling the vendor’s address)
Have someone outside of accounts payable (e.g., controller) review new vendors added
Segregate duties (namely the ability to add new vendors and the power to authorize payments); have at least two persons involved in processing all payables
Have someone other than an accounts payable person reconcile the bank statement and require that that person compare the payee on cleared checks to the general ledger; if this suggestion is not viable, periodically review all cleared checks for a month and review the payees on the checks
Periodically review the list of vendors in your accounts payable system
While this is not a comprehensive article about fictitious vendor fraud, hopefully it will prompt you to consider whether your internal controls are sufficient in relation to this threat.
Do you know how to assess inherent risk? Knowing when this risk is low is a key to efficient audits. In this article, I tell you how to assess inherent risk--and how lower risk assessments (potentially) decrease the amount of work you perform.
While audit standards don't require a separate assessment on inherent risk (IR) and control risk (CR), it's wise to do so. Why? So you know what drives the risk of material misstatement (RMM).
Many auditors assess control risk at high (after performing their risk assessment procedures). Why? So they don't have to test controls.
If control risk is high, then inherent risk is the only factor that can lower your risk of material misstatement. For example, a high control risk and a low inherent risk results in a moderate risk of material misstatement. Why is this important? Lower RMMs provide the basis for less substantive work.
The Audit Risk Model
Before we delve deeper into inherent risk assessment, let's do a quick review of the audit risk model. Auditing standards (AU-C 200.14) define audit risk as “The risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. Audit risk is a function of the risks of material misstatement and detection risk.”
Audit risk is defined as follows:
Audit Risk = IR X CR X Detection Risk
Inherent risk and control risk live within the entity to be audited.
Detection risk lies with the auditor.
A material misstatement may develop within the company because the transaction is risky or complex. Then, controls may not be sufficient to detect and correct the misstatement.
If the auditor fails to detect the material misstatement, audit failure occurs. The auditor issues an unmodified opinion when a material misstatement is present.
If the RMM is high, more substantive work is needed. Why? To reduce detection risk.
But if the RMM is low to moderate, less substantive work is needed.
Inherent Risk Definition
What is inherent risk? The susceptibility of an assertion about a class of transaction, account balance, or disclosure to a misstatement that could be material, either individually or when aggregated with other misstatements, before consideration of any related controls.
The risk for cash is greater than that of a building. Cash is easily stolen. Buildings are not.
The risk of a hedge transaction is greater than that of a trade receivable. Hedges can be complicated to compute. Trade receivables are not.
Post-retirement liabilities are inherently risky. Why? It's a complex accounting area. The numbers usually come from an actuary. There are estimates in the form of assumptions.
Inherent Risk Factors
Consider factors such as the following in assessing risk:
Susceptibility to theft or fraudulent reporting
Complex accounting or calculations
Accounting personnel’s knowledge and experience
Need for judgment
Difficulty in creating disclosures
Size and volume of accounts balance or transactions
Susceptibility to obsolescence
Prior year period adjustments
Inherent risk is not an average of the above factors. Just one risk factor can make an account balance or transaction cycle or disclosure high risk.
Inherent Risk at Less Than High
When inherent risk is less than high, you can perform fewer or less rigorous substantive procedures.
An example of a low inherent risk is the existence assertion for payables. If experienced payables personnel accrue payables, then the existence assertion might be assessed at low. (The directional risk of payables is an understatement, not an overstatement.) The lower risk assessment for existence allows the auditor to perform little if any procedures in relation to this assertion.
Conversely, the completeness assertion for accounts payable is commonly a high inherent risk. Businesses can inflate their profits by accruing fewer payables. Fraudulent reporting of period-end payables is possible. Therefore, the risk of completeness for payables is often high. That's why auditors perform a search for unrecorded liabilities.
Base your risk assessment on factors such as those listed above. If inherent risk is legitimately low, then great. You can perform less substantive work. But if the assertion is high risk, then it should be assessed accordingly--even if that means more work. (The AICPA has included questions in peer review checklists regarding the basis for lower risk assessments. Their concern (I think) is that auditors might manipulate this risk in order to perform less work. I've heard no one from the AICPA say this. But I can see how they might be concerned about this possibility.)
So, what is the relationship between inherent risk and control risk?
Companies develop internal controls to manage areas that are inherently risky.
A business might create internal controls to lessen the risk that payables are understated. Examples of such controls include:
The CFO reviews the payables detail at period-end, inquiring about the completeness of the list
A payables supervisor reviews all invoices entered into the payables system
The payables supervisor inquires of all payables clerks about any unprocessed invoices at period-end
A budget to actual report is provided to department heads for review
Inherent risk exists independent of internal controls.
Control risk exists when the design or operation of a control does not remove the risk of misstatement.
Audit Risk Assessment Book
My new book, Audit Risk Assessment Made Easy, is now available on Amazon. If you struggle with internal control walkthroughs, preliminary analytics, understanding the entity and its environment, risk assessment and linkage, then this book is for you. Click the book cover to see it now on Amazon.
This video provides an overview of the four opinions:
If there are no material misstatements, then you will issue an unmodified opinion. The unmodified opinion says the financial statements are presented fairly.
Example SAS 134 Unmodified Opinion
A sample unmodified audit opinion follows:
INDEPENDENT AUDITOR’S REPORT
We have audited the financial statements of [Entity Name], which comprise the balance sheets as of December 31, 2020 and 2019, and the related statements of income, changes in stockholders’ equity, and cash flows for the years then ended, and the related notes to the financial statements.
In our opinion, the accompanying financial statements present fairly, in all material respects, the financial position of [Entity Name] as of December 31, 2020 and 2019, and the results of its operations and its cash flows for the year then ended in accordance with accounting principles generally accepted in the United States of America.
Basis for Opinion
We conducted our audits in accordance with auditing standards generally accepted in the United States of America (GAAS). Our responsibilities under those standards are further described in the Auditor’s Responsibilities for the Audit of the Financial Statements section of our report. We are required to be independent of [Entity Name] and to meet our other ethical responsibilities, in accordance with the relevant ethical requirements relating to our audit. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion.
Responsibilities of Management for the Financial Statements
Management is responsible for the preparation and fair presentation of the financial statements in accordance with accounting principles generally accepted in the United States of America, and for the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error.
In preparing the financial statements, management is required to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about [Entity Name]’s ability to continue as a going concern for one year after the date that the financial statements are available to be issued.
Auditor’s Responsibilities for the Audit of the Financial Statements
Our objectives are to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, and to issue an auditor’s report that includes our opinion. Reasonable assurance is a high level of assurance but is not absolute assurance and therefore is not a guarantee that an audit conducted in accordance with GAAS will always detect a material misstatement when it exists. The risk of not detecting a material misstatement resulting from fraud is higher than for one resulting from error, as fraud may involve collusion, forgery, intentional omissions, misrepresentations, or the override of internal control. Misstatements are considered material if there is a substantial likelihood that, individually or in the aggregate, they would influence the judgment made by a reasonable user based on the financial statements.
In performing an audit in accordance with GAAS, we:
Exercise professional judgment and maintain professional skepticism throughout the audit.
Identify and assess the risks of material misstatement of the financial statements, whether due to fraud or error, and design and perform audit procedures responsive to those risks. Such procedures include examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements.
Obtain an understanding of internal control relevant to the audit in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of [Entity Name]’s internal control. Accordingly, no such opinion is expressed.
Evaluate the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluate the overall presentation of the financial statements.
Conclude whether, in our judgment, there are conditions or events, considered in the aggregate, that raise substantial doubt about [Entity Name]’s ability to continue as a going concern for a reasonable period of time.
We are required to communicate with those charged with governance regarding, among other matters, the planned scope and timing of the audit, significant audit findings, and certain internal control-related matters that we identified during the audit.
If material misstatements are present, then a modified audit opinion is necessary. Modifications can also occur when you are unable to obtain sufficient appropriate audit evidence; for instance, when a scope limitation is present.
AU-C 705 defines a modified opinion as a (1) qualified opinion, (2) an adverse opinion, or (3) a disclaimer of opinion.
Another key definition in AU-C 705 is that of pervasiveness. This term is used in the context of misstatements; so if a material misstatements are present, you’ll want to know if they are pervasive. Two factors–material misstatements and pervasiveness–affect the type of opinion to be issued. Additionally, the ability or inability to obtain sufficient appropriate audit evidence affects the type of opinion to be issued. A misstatement (or possible misstatement) is pervasive if:
It’s not confined to specific accounts or items of the financial statement, or
If confined, the amount represents a substantial portion of the financial statements, or
If in relation to disclosures, the information is fundamental to the users’ understanding of the financial statements
For example, if material misstatements are present for inventory, receivables, and debt, they are pervasive. Or if, in another example, inventory makes up 60% of total assets and a material misstatement is present in that area, then it’s pervasive. Lastly, if key disclosures are not appropriately communicated or if they are omitted, then that is pervasive.
Now, let’s look at the three modified opinions.
1. Qualified Opinion
Suppose your audit reveals inventories are materially misstated, the client does not record your proposed audit adjustment, and there are no other material misstatements. If this is your situation (a material misstatement exists that is not pervasive), then audit standards allow for the issuance of a qualified opinion.
Here is sample qualified opinion language (this is not the full opinion):
We have audited the financial statements of ABC Company, which comprise the balance sheets as of December 31, 20X1 and 20X0, and the related statements of income, changes in stockholders’ equity, and cash flows for the years then ended, and the related notes to the financial statements.
In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion section of our report, the accompanying financial statements present fairly, in all material respects, the financial position of ABC Company as of December 31, 20X1 and 20X0, and the results of its operations and its cash flows for the years then ended in accordance with accounting principles generally accepted in the United States of America.
Basis for Qualified Opinion
The Company has property with impaired value. The impairment occurred in 20X9. Accounting principles generally accepted in the United States of America require that impaired assets be written down to their fair market value. The Company continues to reflect the property at cost. If the property was stated at fair value upon impairment, total assets and stockholder’s equity would have been reduced by $X,XXX,XXX as of December 31, 20X1 and 20X0, respectively.
2. Adverse Opinion
Now let’s suppose that you are auditing a consolidated entity, and your client is not willingto include a material subsidiary and which, if included, would have a pervasive impact on the statements.
Here is sample adverse opinion language (this is not the full opinion):
We have audited the consolidated financial statements of ABC Company and its subsidiaries, which comprise the consolidated balance sheet as of December 31, 20X1, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for the year then ended, and the related notes to the financial statements.
In our opinion, because of the significance of the matter discussed in the Basis for Adverse Opinion section of our report, the accompanying consolidated financial statements do not present fairly the financial position of ABC Company and its subsidiaries as of December 31, 20X1, or the results of their operations or their cash flows for the year then ended in accordance with accounting principles generally accepted in the United States of America.
Basis for Adverse Opinion
As described in Note X, The Golfing Company has not consolidated the financial statements of its subsidiary Easy-Go Company that it acquired during 20X1. This investment is accounted for on a cost basis by The Golfing Company. Under accounting principles generally accepted in the United States of America, the subsidiary should have been consolidated. Had Easy-Go Company been consolidated, many elements in the accompanying consolidated financial statements would have been materially affected. The effects on the consolidated financial statements of the failure to consolidate have not been determined.
3. Disclaimer of Opinion
Finally, let’s suppose you are performing an audit in which insufficient audit information is provided with regard to receivables and inventories (both of which are material) and that the misstatements have a pervasive impact on the financial statements as a whole.
Here is sample disclaimer of opinion language (this is not the full opinion):
Disclaimer of Opinion
We were engaged to audit the financial statements of ABC Company, which comprise the balance sheet as of December 31, 20X1, and the related statements of income, changes in stockholders’ equity, and cash flows for the year then ended, and the related notes to the financial statements.
We do not express an opinionon the accompanying financial statements of ABC Company. Because of the significance of the matters described in the Basis for Disclaimer of Opinion section of our report, we have not been able to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion on these financial statements.
Basis for Disclaimer of Opinion
The Company’s accounting system was hacked during the year by an unknown party, resulting in a series of changes in accounting entries. Additionally, the Company was unable to restore the accounting system. As a result of these matters, we were unable to determine the adjustments that were necessary to correct the balance sheet, statement of income, changes in stockholder’s equity, and cash flow statement as of and for the year ended December 31, 20X1.
Effective Date of SAS 134
The new SAS 134 opinions are required for periods ending on or after December 15, 2021.
Resolving Conflict with Clients
If, as described above, you have a client that is unwilling to post a material audit adjustment, consider creating a draft of the opinion and providing it to them. This is not a threat, just a way to clearly communicate the effect of not posting the adjustment.
Before doing anything, allow the client to fully explain their position. A modified opinion may not be necessary once you understand the facts. But if after the discussion, the you are still convinced there is a material misstatement, a modified opinion may be necessary.
In some cases, you may want to consider withdrawing from the engagement. Consult with your legal counsel before doing so.
Audit Opinion Research
Deciding on the opinion is often the most important decision you will make in an audit. So, do your research, and, if needed, consult with others to gain assurance about your decisions. AU-C 705: Modifications to the Opinion in the Independent Auditor’s Report provides several sample opinions; so refer to those as you create any modified opinions including qualified, adverse, or disclaimer. See AU-C 700: Forming an Opinion and Reporting on Financial Statements for information about unmodified opinions.
There is no Evernote just for CPAs; even so, it’s a game-changer for beancounters. I’ve used this tool for about twenty years and it is one of my favorites software packages. In this article I tell you what Evernote is, how you can use it, how to feed information into it, and how to search it using Evernote operators.
Evernote is a cloud-based storage system that allows you to capture and file voice recordings, documents (including Word, Excel, PDFs), pictures, and videos. Once information is placed in Evernote, it is searchable in a Google-like fashion. Even hand-written notes are searchable.
What can CPAs do with this app?
Things CPAs Can Do with Evernote
Here are examples of what you can do with Evernote:
Create a personal digital library (e.g., use an Evernote notebook to store research information, Journal of Accountancy articles, CPE material, videos of class instruction)
Share individual files or notebooks (a compilation of files) with others
So, what are the main components of an Evernote storage system?
The Skeletal Framework: Notes, Notebooks, and Tags
The skeletal framework for Evernote has three elements: Notes, notebooks, and tags.
1. The primary element of Evernote is a note.
Think of a note as a blank piece of paper on which you can type. You can also attach other files to the note (e.g., an Excel spreadsheet or a picture taken with your cell phone or a voice message recorded with your cell phone or a note you’ve jotted down). Once you create your notes, organize them in notebooks.
2. Notes are placed in notebooks.
Think of a notebook as a three-ring binder.
For example, if I want to create a note about comprehensive income, I can do so. Then I can attach related files (e.g., PDFs) to the note. Next, I might add a note about other comprehensive income and another about reclassifications from other comprehensive income. The separate notes can, for example, be a text file, an Excel file, and a voice message.
All three notes can be added to a notebook titled Comprehensive Income.
I could place the comprehensive income notes in a notebook titled accounting (a more generic category) and tag each note as comprehensive income. Then I can search and find all comprehensive income notes by using the comprehensive income tag. When I type tag:”comprehensive income” in the Evernote search bar, all notes tagged in this manner appear. (See below for information about operators such as tags.) Use both folders and tags to help you more readily find information.
And how do you put information into Evernote?
Getting Information Into Evernote
First Set Up Your Default Evernote Notebook
Before sending information from one of your devices (e.g., smartphone) to Evernote, specify where it should go. My default landing area is my Often Used notebook. (You will need to create the Often Used notebook—or whatever you’d like to call it—in your Evernote account.)
Since I send information from a variety of devices, I initially send information to the Often Used notebook; later, when I have time, I tag each note (e.g., Fair Value) and then move each to an appropriate notebook (e.g., Accounting).
Tip – If you put asterisks in front of the folder name (e.g., **Often Used), Evernote will present it (the folder) at the top of your folder list. This will make it easier to locate your default folder.
Here’s a screenshot of Evernote from my iPad.
In short, my standard operating procedure: (1) capture on the fly and (2) classify with a block of time (it usually takes me less than five minutes each day to tag and move the new notes).
Seven Ways to Feed Evernote
1. Smart Phones
You can use your smartphone to create and send pictures, text files, and voice messages to Evernote.
To download Evernote for an Android phone, click here.
Here’s a screenshot of my iPhone Evernote app. Notice the note names at the top of each note and the tags (in the oval shapes) at the bottom of each note.
I use a Fujitsu scanner (model iX500) to scan documents directly to Evernote. (The iX500 costs about $780 from Amazon.)
3. Web Clippers
Evernote provides web clippers for browsers including Safari, Explorer, Google Chrome, and Firefox. If you click this web clipper link, Evernote will automatically recognize your browser; then you can download the clipper software to your browser. While browsing, click the Elephant icon to clip a portion of the web page, the full page, or the full article.
Evernote allows you to use hotkeys to capture information from any program (as long as Evernote is running in the background). To activate screen clipping, use the key combination (e.g., for Windows: Win+PrintScreen). See Preferences to change your hotkeys.
So if you are working on an Excel spreadsheet, for example, and would like to capture the information into Evernote, use the hotkey combination and select the portion of the screen you wish to save. The screenshot will go to your default Evernote location.
You can do the same with an email, a Word document, and anything else that appears on your screen.
5. Email Directly to Evernote Account
One of my favorite ways to feed Evernote is to email a document (e.g., Excel, Word, PDF) directly to Evernote; when you set up your Evernote account, you will be provided a private Evernote email address. Set this address up in your email contact list; then you can send any email or document (attached to an email) to your Evernote default notebook.
6. Drag and Drop
With Evernote open, you can create a new note and then drag a document (e.g., Word or Excel file) onto the open note. The material is added to the note. You can add multiple documents to one note.
7. Import Folder
An even easier way to get files into Evernote is to use an “import folder.” After you specify in Evernote where the “import folder” is located on your computer (i.e., a particular Windows folder), you can drop files into the designated folder, and they will automatically feed into your default Evernote notebook.
Searching Your Evernote Account
Once you’ve used Evernote for some time, you’ll have several thousand notes, so many it can be difficult to find the information you’ve stored. That’s when operators can help. Use these to locate the notes you are looking for.
You can use Evernote operators in the search box to locate particular information. Some of the more commonly used operators are:
1. And 2. Any 3. Tag 4. Notebook 5. Intitle 6. Created
And – Normally you will not type the word “and” as an operator; it’s implied. So if you type: comprehensive income in the search box, Evernote will locate all notes with the words comprehensive and income. If you want to see all notes with the phrase “comprehensive income,” then type: “comprehensive income”–using quotation marks.
Any – Typing the words “any: compilation review” will provide all notes with either the word “compilation” or the word “review.” If a note has the word “compilation” (and not “review”), then it will appear in your search list. If a note has the word “review” (and not “compilation”), then it will also appear in the list.
Tag – By typing “tag:Bank” into the search box, you’re telling Evernote that you want to see all notes tagged “Bank.” (You can tag each note regardless of which notebook it is in; for example, you might have four different notes in four different notebooks, but each tagged “Bank.”)
Notebook – Let’s say you have a notebook titled: Auditing (along with 70 other notebooks). You can type: “notebook:Auditing” in the search box and Evernote will locate your auditing notebook.
Intitle – Typing intitle:”fair value” will yield all notes with the words “fair value” in the title.
Created – “created:day-1” will provide you with a list of all notes created yesterday and today. You can substitute “day” with “week,” “month,” or “year”. If you want to see all the notes created in the last two weeks, issue a search with “created:week-1.”
Combining Evernote Operators
Searching becomes even more powerful when you combine operators.
For example, typing:
Intitle:derivative swap “cash flow hedge”
will provide you with all notes that have the word “derivative” in the title and the words (1) “swap” and (2) “cash flow hedge” as a phrase.
Another example, typing:
Notebook:Accounting any:swap “cash flow hedge”
will provide you with a list of all notes from your accounting notebook that have either the word “swap” or the words “cash flow hedge” as a phrase.
Notebook:Bank tag:Deposits FDIC “Due to Due from”
will provide you with notes from your Bank notebook that have a “Deposits” tag and that contain the words FDIC and “Due to Due from” as a phrase.
Create Your Evernote Account
To create your account, go to the Evernote website and follow the directions. There is a free version if you want to try it out. You can see a comparison of their plans here. I have not received any type of commission for this recommendation.
Peer reviewers are saying, “If it’s not documented, it’s not done.” Why? Because standards requiresufficient audit documentation in AU-C 230. And if it’s not documented, the peer reviewer can’t give credit. Work papers are your vehicle of communication.
But what does sufficient documentation mean? What should be in our work papers? How much is necessary? This article answers these questions.
Insufficient Audit Documentation
Insufficient audit documentation 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 is fuzzy. Too often audit files are poor-to-midland. But 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 (make more money), 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. Confirmations, walkthroughs, fraud inquiries are omitted. And yes, it’s easier–at least in the short run.
But we all know that qualityis 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 a website and everyone could see it, would you be proud? Or does it need improvement?
Sufficient Audit Documentation According to AU-C 230
Let’s see what constitutes sufficient documentation.
AU-C 230Audit 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? Here are some pointers for complying with AU-C 230.
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 see 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. So how can we create clarity?
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 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 your work.
Help Your Reviewers
To help your reviewers:
Tell them what you are doing (purpose statement)
Do it (document the test work)
Then, tell them how it went (the conclusion)
Now let’s move from proper to improper documentation.
Examples of Poor Work Paper Documentation
So, what does insufficient audit documentation look like? In other words, what are some of the signs that we are not complying with AU-C 230?
Here are examples of poor audit work paper 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 and the sample size)
Failing to explain the basis for low inherent risk assessments
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.
Strangely, however, poor work papers are not the result of insufficient documentation, but too much documentation.
Too Much Audit Documentation
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.”
Files received from clients that don’t support the audit opinion
Unnecessary work performed on 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 might realize it has none. Which is nice–now, we can eliminate it.
One healthy exercise is topretend 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):
Too often, we roll the prior year file forward and rock on. If the prior year file has extraneous audit procedures, we repeat them. This creates waste year after year after year.
Before I close this article, here is one good work paper suggestion from my friend Jim Bennett of Bennett & Associates: transaction area maps.
Transaction Area Maps
Include transaction area maps in your file. A summary creates organization and makes it easier to find your work papers. It also provides a birds-eye view of what you have done. Here’s an example:
ACCOUNTS RECEIVABLE WORKPAPER MAP
4-02 Audit Program
4-10 Risk Assessment Analyticals
ACCOUNTS RECEIVABLE AGING
4-20 Customer aging report
4-21 AR break-out of intercompany balances
4-23 AR aging tie in to TB
4-24 Review of AR aging
ACCOUNTS RECEIVABLE CONFIRMATIONS
4-50 Planning worksheet – substantive procedures
4-51 AR confirmation reconciliation
4-52 AR confirmation replies
4-60 Allowance for doubtful accounts
4-70 Intercompany balances and sales to significant customers
4-80 Sales analytics
4-90 Sales cut-off testing
4-95 Revenue recognition 606 support and disclosures
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. We need to do so to comply with AU-C 230, Audit Documentation.