Charles Hall is a practicing CPA and Certified Fraud Examiner. For the last thirty years, he has primarily audited governments, nonprofits, and small businesses.
He is the author of The Little Book of Local Government Fraud Prevention and Preparation of Financial Statements & Compilation Engagements. He frequently speaks at continuing education events.
Charles is the quality control partner for McNair, McLemore, Middlebrooks & Co. where he provides daily audit and accounting assistance to over 65 CPAs. In addition, he consults with other CPA firms, assisting them with auditing and accounting issues.
Earnings manipulation is easy with the right–or should I say wrong–accounting tricks such as cookie jar reserves. In this article, we explore how businesses inflate profits and sometimes decrease the same, depending on what the company desires. Financial statement fraud is common, so let’s see how these schemes work.
One Wall Street Journal article said a California company used “a dozen or more accounting tricks” including “one particularly bold one: booking bogus sales to fake companies for products that didn’t exist.” These machinations inflated earnings, making the company look more profitable than it really was.
Today I show you how fraudsters use financial statement fraud to magically transform a company’s appearance. Then you will better know how to prevent these earnings manipulations.
What does it mean to inflate earnings? Inflating earnings means a company uses fraudulent schemes to make their earnings look better than they really are.
Financial Statement Fraud
Companies can magically create earnings by:
Accruing fictitious income at year-end with journal entries
Recognizing sales for products that have not been shipped
Inflating sales to related parties
Recognizing revenue in the present year that occurs in the next year (leaving the books open too long)
Recognizing shipments to a re-seller that is not financially viable (knowing the products will be returned)
Accruing projected sales that have not occurred
Intentionally understating receivable allowances
Think about it: A company can significantly increase its net income with just one journal entry at the end of the year. How easy is that?
You may be thinking, “But no one has stolen anything.” Yes, true, but the purpose of manipulating earnings is to increase the company’s stock price. Once the price goes up, the company executives sell their stock and make their profits. Then the company can, in the subsequent period, reverse the prior period’s inflated entries.
Earnings Manipulation Control Weakness
Such chicanery usually flows from unethical owners, board members, or management. The “tone at the top” is not favorable. These types of accounting tricks usually don’t happen in a vacuum. Normally the top brass demands “higher profits,” often not dictating the particulars. (These demands are typically made in closed-door meetings with no recorders or written notes.) Then years later, once the fraud is detected, those same leaders will plead ignorance saying their lieutenants worked alone.
The fix is transparency. This sounds simple, but transparency will usually remove the temptation to inflate earnings. If you work for a company (or a boss) that is determined to “win at any cost,” and repeatedly hides things (“don’t tell anyone about what we’re doing”), it is time to look for another job. When people hide what they are doing, they know it’s wrong–otherwise, why they wouldn’t hide it?
A robust internal audit department can enhance transparency. The board should hire the internal auditors. Then these auditors should report directly to the board (not management). The company’s internal auditors should know that the board has their back. If not, then you’ll continue to have opaque reporting processes. Why? The internal auditors’ fear of reprisal from management (or the board itself).
And what if the leaders of an organization won’t allow transparency? If possible, remove them. Unethical leadership will destroy a business.
Deflating Earnings (Cookie Jar Reserves)
Though much less likely, some businesses intentionally decrease their earnings with fraudulent accounting. Why would they do so? Maybe the business has an exceptionally good year, and it would like to save some of those earnings for future periods. For instance, management bonuses might be tied to profit levels. If those thresholds have already been met, it’s possible that the company will defer some current year earnings in order to ensure bonuses in the following year.
Deferring earnings is often called a cookie jar reserve. For example, if a company’s allowance for uncollectibles accounts is acceptable within a range (say 1% to 2% of receivables), it might use the higher percent in the current year. The higher reserve decreases current year earnings (the allowance is credited and bad debt expense is debited, increasing expenses and decreasing net income). Then in the following year, the company might use 1% to increase earnings (even though 1.75% might be more appropriate). This is called smoothing.
Honest companies record their numbers based on what is correct, not upon desired results. But not all companies are honest.
Most auditors don’t perform a test of controls? But should they? Below I explain when such a test is required. I also explain why some auditors choose to use this test even when not required.
Once risk assessment is complete, auditors have three further audit procedures they can use to respond to identified risks:
Test of details
Test of controls
This article focuses on the third option.
Below you will see:
The Right Response
Not Testing Controls (including video about the same)
The Decision Regarding Testing
How to Test Controls
Which Controls to Test
Three-year Rotation of Testing
Interim or Period-End Testing
The Right Response
Which responses to risks of material misstatement are best? That depends on what you discover in risk assessment.
If, for example, your client consistently fails to record payables, then assess control risk for completeness at high and perform a search for unrecorded liabilities (a substantive procedure).
By contrast, if the internal controls for receivables are strong, then assess control risk for the existence assertion at less than high, and test controls for effectiveness. (You do, however, have the option to perform substantive tests rather than test controls, even when controls are appropriate. More about this in a moment.)
Not Testing Controls
Many auditors assess control risk at high (after risk assessment is complete) and use a fully substantive approach. That is fine, especially in audits of smaller entities. Why? Because smaller entities tend to have weaker controls. As a result, controls may not be effective. Therefore, you may not be able to assess control risk at less than high.
Control risk assessments of less than high must be supported with a test of controls to prove their effectiveness. But if controls are not effective, you must assess control risk at high. This is one reason why you might bypass testing controls: you know, either from prior experience or from current-year walkthroughs, that controls are not effective. If your test reveals ineffectiveness, you are back to square one: a control risk assessment of high. Then substantive procedures are your only option. In such a situation, the initial test was a waste of time.
The Decision Regarding Testing
But if controls are effective, why not test them? Doing so allows you to reduce your substantive procedures. There is one reason, however, why you might not test controls even though they appear appropriate: substantive tests may take less time.
Once risk assessment is complete, your responses—the further audit procedures—are based on efficiency and effectiveness. If control testing takes less time, then use this option. If substantive procedures takes less time, then perform a test of details or use substantive analytics. But, regardless of efficiency considerations, address all risks with appropriate responses.
How to Test Controls
Suppose you’ve decided to test controls for effectiveness. But how? Let’s look at an example starting with risk assessment.
Your approach to testing controls depends on risk.
For example, suppose your billing and collections walkthrough reveals appropriate segregation of duties. You see that authorized personnel issue receipts for each payment received. Additionally, you determine that total daily cash inflows are reconciled by the collections supervisor to the online bank statement, and she signs off on a reconciliation sheet as evidence of this procedure. Lastly, you note that a person not involved in cash collections reconciles the monthly bank statement. In other words, controls are properly designed and in use.
Furthermore, you believe completeness is a relevant assertion. Why? Theft of incoming cash is a concern since the business handles a high volume of customer checks. If checks are stolen, cash collections would not be complete. Consequently, the inherent risk for completeness is high. The fraud risk is a significant risk which requires a test of details in addition to the test of controls.
Test Supports Effectiveness
Now it’s time to test for effectiveness.
Test the receipt controls on a sample basis. But before doing so, document the controls you desire to test and the sample size determinations. (See AICPA’s Audit Sampling standard, AU-C 530.)
The first control you are testing is the issuance of receipts by an authorized person and your sample size might be sixty.
The second control you are testing is the daily reconciliation of cash to the bank statement. For example, you could agree total daily receipts to the bank statement for twenty-five days. As you do so, you review the daily sign-offs on the reconciliation sheets. Why? The collection supervisor’s sign-off is the evidence that the control was performed.
The third control you are reviewing is the reconciliation of the bank account by a person not involved in the receipting process. So, you review the year-end bank reconciliation and confirm that the person that reconciled the bank statement was not involved in cash collections.
Once the tests are performed, determine whether the controls are effective. If they are, assess control risk for the completeness assertion at less than high. Now you have support for that lower assessment.
And what about substantive tests?
You need to perform a test of details since a significant risk (the fraud risk) is present. You might, for example, reconcile the daily total receipts to the general ledger for a month.
Test Doesn’t Support Effectiveness
If your tests do not support effectiveness, expand your sample size and examine additional receipts. Or skip the tests (if you believe the controls are not effective) and move to a fully substantive approach. Regardless, if controls are not effective, consider the need to communicate the control deficiency to management and those charged with governance.
So, when should you test controls? First let’s look at required tests and then optional ones.
Required Audit Tests of Controls
Here are two situations where you must test controls:
When there is a significant risk and you are placing reliance on controls related to that risk
When substantive procedures don’t properly address a risk of material misstatement
Let me explain.
Auditing standards allow a three-year rotation for control testing, as long as the area tested is not a significant risk. But if the auditor plans to rely on a test of controls related to a significant risk, operating effectiveness must be tested annually.
Also a test of controls is necessary if substantive procedures don’t properly address a risk of material misstatement. For example, consider the controls related to reallocation of investments in a 401(k). The participant goes online and moves funds from one account to another. Other than the participant, there are no humans involved in the process. When processes are fully automated, substantive procedures may not provide sufficient audit evidence. If that is your situation, you must test of controls. Thankfully, a type 2 service organization control report is usually available in audits of 401(k)s. Such a report provides evidence that controls have already been tested by the service organization’s auditor. And you can place reliance upon those tests. In most cases, substantive procedures can properly address risks of material misstatement. So this test requirement is usually not relevant.
Optional Audit Test of Controls
We just covered the two situations when testing is required. All other control testing is optional.
Prior to making the decision about testing, consider the following:
Do you anticipate effectiveness? There’s no need to test an ineffective control.
Does the control relate to an assertion for which you desire a lower control risk?
Will it take less time to test the control than to perform a substantive procedure? Sometimes you may not know the answer to this question until you perform the test of controls. If the initial test does not prove effectiveness, then you have to expand your sample or just punt—in other words, use a fully substantive approach.
Will you use the control testing in conjunction with a test of details or substantive analytics? How would effective controls reduce these substantive tests? In other words, how much substantive testing time would you save if the control is effective?
Is the control evidence physical or electronic? For example, are the entity’s receipts in a physical receipt book or in a computer? It’s usually easier to test electronic evidence.
How large will your sample size be? Some controls occur once a month. Others, thousands of times in the period. The larger the population, the larger the sample. And, of course, the larger the sample size, the more time it will take to perform the test.
Can you test the population as a whole without sampling? Data analytics software—in some instances—can be used to test the entire population. For example, if a purchase order is required for all payments above $5,000, it might be easy to compare all payments above the threshold to purchase orders, assuming the purchase orders are electronic.
Three-Year Rotation of Testing
As I said earlier, audit standards allow a three-year rotation for testing. For example, if you test accounts payable controls in 2020, then you can wait until 2023 to test them again. In 2021 and 2022, you need to ensure that these controls have not changed. You also want to determine that those controls have continuing relevance in the current audit. How? See if the controls continue to address a risk of material misstatement. And as you perform your annual walkthroughs, inquire about changes, observe the controls, and inspect documents. Why? You want to know that everything is working as it was in 2020, when the initial test was performed. And, yes, you do need to perform those walkthroughs annually, if that is how you corroborate your understanding of controls.
In short, testing for effectiveness can, in most cases, occur every three years. But walkthroughs are necessary each year. If you tested sixty transactions for an appropriate purchase order in 2020, then you can wait until 2023 to do so again. But review of the purchase order process each year in your annual walkthroughs.
So should you test controls at interim or after year-end?
Interim or Period-End Testing
Some auditors test controls after the period-end (after year-end in most cases). Others at interim. Which is best?
Perform interim tests if this fits better in your work schedule. Here’s an example: You perform an interim test on November 1, 2021. Later, say in February 2022, consider whether controls have changed during the last two months of the year. See if the same people are performing those controls. And consider performing additional tests for the November 1 to December 31 period. Once done, determine if the controls are effective.
Testing on an interim date is not always the answer. For example, if management is inclined to manipulate earnings near year-end, then interim tests may not be appropriate.
If you choose to test after period-end, then do so for the full period being audited. Your sample should be representative of that timeframe.
So should you ever test controls at a point in time and not over a period of time? Yes, sometimes. For example, test inventory count controls at year-end only. Why? Well those controls are only relevant to the year-end count, a point in time. Most controls, however, are in use throughout the period you are auditing. Therefore, you need to test those controls over that period of time (e.g., year).
As I said above, many auditors tend to rely fully on substantive responses to the risks of material misstatement. But, in some cases, that may not be the best or wisest approach. If controls are designed well and functioning, why not test them? Especially if it takes less time than substantive procedures.
Are you using substantive analytical procedures in your audits? Many auditors rely solely on tests of details when a better option is available. Substantive analytics, in some cases, provide better evidential matter. And they are often more efficient than tests of details.
In this article, I provide:
Substantive Analytics – A Video Overview
Analytics in Three Stages
Responses to Risk of Material Misstatement
Substantive Analytical Assurance Level
Examples of Substantive Analytics
Documenting Substantive Analytical Procedures
Other Substantive Analytical Considerations
Professional standards define analytical procedures as evaluations of financial and non-financial data with plausible relationships. An example of such a relationship is salaries may be expected to be a certain percent of total expenses. In other words, numbers behave in particular ways. Because they do, we can use these relationships as evidential matter for our audit opinions.
Substantive Analytics – A Video Overview
This video provides an overview of substantive analytical procedures.
Before we look at what substantive analytics are and how we use them, let’s see how analytical procedures are used in audits.
Preliminary analytics are performed as a risk assessment procedure. We use them to locate potential material misstatements. And if we identify unexpected activity, we plan a response. For example, if we expect payroll to go up 5% but it goes down 8%, then we plan further audit procedures to see why: these can include tests of details, substantive analytics, and test of controls.
At the completion of the audit, we use final analytics to determine if we have addressed all risks of material misstatement. Here we compare our numbers and ask, “Have we dealt with all risks of material misstatement?” If yes, fine. If not, then we may need to perform additional further audit procedures.
Less precision is necessary for preliminary and final analytics as compared to substantive analytics. Preliminary analytics locate misstatements and final analytics confirm the results of the audit. But substantive analytics are used to prove material misstatements are not present.
Substantive analytical procedures can, in certain cases, be more effective and efficient than a test of details.
For example, if the ratio of salaries to total expenses has been in the 46% to 48% range for the last few years, then you can use this ratio as a substantive analytic to prove the payroll occurrence assertion. If your expectation is that payroll would be in this range and your computation yields 48%, then your substantive analytic provides evidence that salaries occurred. And this is much easier than a test of details such as a test of forty payroll transactions (where you might agree hours paid to time records and payroll rates to authorized amounts).
Disaggregation of Data
For a small entity with six employees, one payroll substantive analytic might be sufficient, but you may need to disaggregate the payroll information for a larger company with six hundred people. For instance, you might divide departmental salaries by total salaries and compare those ratios to the prior year. Disaggregation adds more precision to the analytic, resulting in better evidential matter.
Another example of disaggregation is in relation to revenues. If the company has four major sources of revenue, disaggregate the substantive analytical revenue sources. You might use a trend analysis by revenue source for the last three years. Or you might recompute an estimate of one or more revenue sources based of units sold or property rented.
The type of substantive analytic is dependent on the nature of the transaction or account balance. If a company rents fifty apartments at the same monthly rate, computing an estimate of revenue is easy. But if a company sells fifty different products at different prices, you may need to disaggregate the substantive analytical data.
Additionally, consider disaggregating substantive analytics by region if the company has different geographic locations.
Not for Significant Risk Areas (at least not alone)
Are there audit areas where substantive analytical procedures should not be used alone? Yes. When responding to a significant risk. A test of details must be used when a significant risk is present. For example, a bank’s allowance for loan losses. This allowance is a highly complex estimate; therefore, a test of details is required. You could not solely compare the allowance to prior years,for example, though such a comparison could complement a test of details. In other words, you could perform a test of details and use a substantive analytic. But a substantive analytic alone would not do.
Now let’s consider how auditors use substantive analytics to respond to the risk of material misstatement.
Responses to Risks of Material Misstatement
Once you identify a risk of material misstatement, you plan further audit procedures including (1) test of details, (2) substantive analytical procedures, and (3) test of controls. Many auditors use a test of details without performing substantive analytics. Why? For many, it’s habit. We’ve always tested bank reconciliations, for example, so we continue to do so. But maybe we’ve never used substantive analytics to prove revenues or expenses.
A test of details is often used in relation to balance sheet accounts such as cash, receivables, and debt.
Substantive Analytical Procedures as a Response
Substantive analytics, on the other hand, are sometimes more fitting for income statement accounts such as revenue or expenses. Why? Because income statement accounts tend to be more consistent from year to year. Here are some examples:
Property tax revenue (in a government)
So consider using substantive analytics when the volume of transactions is high and the account balance is predictable over time. Additionally, use substantive analytics in lower risk areas, including some balance sheet accounts such as:
Plant, property, and equipment (if no significant additions or retirements)
Debt (if no new debt or early payoffs)
Prepaid assets (e.g., prepaid insurance)
Audit standards tell us that substantive analytics are more appropriate when the risk of misstatement is lower. The higher the risk of misstatement, the more you should use a test of details. For instance, it’s better to use tests of details for significant receivable accounts. But substantive analytics may work well for prepaid insurance.
Additionally, substantive analytics can be combined with a test of details or a test of controls. If, for example, you’re planning a risk response for accounts payable and expenses, you might use a combined approach: a test of details for accounts payable (e.g., search for unrecorded liabilities) and substantive analytics for expense (e.g., departmental expenses divided by total expenses compared to the prior year).
Another common combined approach is a test of details sample along with substantive analytics. If the substantive analytics are effective, you can reduce the sample size, making the overall approach more efficient.
Substantive Analytical Assurance Level
Certain substantive analytics provide higher levels of assurance. For example, computing expected rental income provides high assurrance. If your client rents fifty identical apartments at $2,000 a month, the computation is easy and the assurance is high.
How to Increase Assurance When Using Substantive Analytics
Other types of analytics provide lower assurance: topside ratios or period-to-period comparisons at the financial statement level, as examples. You can, however, increase the substantive analytical assurance level by taking actions such as:
Using more comparative periods (e.g., years or months)
Comparing ratios to independently published industry statistics
Disaggregating the data (e.g., revenues by product line and units sold)
Documenting expectations prior to creating the analytics (to remove bias)
Documenting client responses regarding differences along with the follow up procedures and results
Comparing balances with a prior period and providing no explanations is not sufficient as a substantive analytic. Also, if the activity is unexpected, solely documenting client responses to questions is not sufficient. For example, these client answers will not do:
Client expected revenues to go up
Numbers declined because sales activity went down
Client said it’s reasonable
Vague responses are not evidential matter and can result in audit failure, or—worse yet—litigation against your firm.
Substantive analytics can be used in a wide variety of ways.
Examples of Substantive Analytics
Here are examples of substantive analytics:
Comparison of monthly sales for the current year with that of the preceding year (to test occurrence)
Comparison of profit margins for the last few months of the audit period with those subsequent to period-end (to test cutoff)
Percent of expenses to sales compared with the prior year (to test occurrence)
Current ratio compared to prior year (to test for solvency and going concern)
Comparing current year profit margins with prior periods (to test accuracy and occurrence)
For pension or postemployment benefit plans: actuarial value of plan assets divided by actuarial accrued liability compared to prior year (to test completeness and accuracy)
For debt: total debt divided by total assets compared to prior year (to test the financial strength of the entity and going concern)
For inventory: cost of goods sold divided by average inventory compared to prior year (to test existence and occurrence)
Now let’s see how to document your substantive analytics.
Documenting Substantive Analytical Procedures
In performing substantive analytical procedures, document the following:
1. The reliability of the data
Document why you believe the data is trustworthy. Reasons could include your prior experience with the client’s accounting system and internal controls related to the information you are using. Though a walkthrough sheds light on those controls, a test of controls for effectiveness provides even greater support for the reliability of the data. Testing controls is optional, however.
Document the assertions being addressed and the related risks of material misstatement.
Document a sufficiently precise expected result of the computation or comparison. You can use a range. Document the expectation prior to examining the recorded numbers. Why? To reduce bias. If the current year expectation is different from the prior year, explain why. For example, if payroll has been stable over the last three years but is expected to increase eight percent in the current year, document why. A less precise expectation may be acceptable if a test of details is performed along with the substantive analytic.
Document if the substantive analytic is to be used alone or in conjunction with a test of details.
5. Acceptable difference
The acceptable difference is the amount that requires no further investigation. So, for example, if the analytic is $30,000 different from the recorded amount and the acceptable difference is $50,000, you are done. No additional work is necessary. Unacceptable differences require further investigation such as inquiries of management and other audit procedures. Consider the performance materiality for the transaction or account balance as you develop the acceptable difference amount. Also, consider the assessed risk of material misstatement. Higher risk requires a lower acceptable difference.
Document whether the computation or comparison falls within your expectation. Perform and document other procedures performed if the result is not within your acceptable difference. Your conclusion should include a statement regarding whether you believe the account or transaction balance is materially correct. After all, that’s the purpose of the substantive analytic.
Here are some concluding thoughts about substantive analytics.
Other Substantive Analytical Considerations
Substantive analytics are not required. So, think of them as an efficient alternative to test of details.
If the company has weak internal controls or a history of significant misstatements, rely more on tests of details. Substantive analytics work better in stable environments. Additionally, if you, as the auditor, expect to make several material audit adjustments, record those prior to creating substantive analytics. This will help reduce the distortion from those misstatements.
Testing of controls for effectiveness lends strength to substantive analytics. If the controls are effective, you’ll have more confidence in the substantive analytics. For example, if you test the disbursement approval controls and find them to be effective, the expense analytics will be more trustworthy. If you are testing controls for effectiveness, you may want to do so before creating any related substantive analytics.
Do you know what you need to know about emphasis of matter and other matter paragraphs? Sometimes auditors elect to or are required to add an extra paragraph. You need to know why and when and how. This article provides information about emphasis of matter (EOM) paragraphs and other matter (OM) paragraphs. (This article is based on AU-C 706, Emphasis-of-Matter Paragraphs and Other-Matter Paragraphs in the Independent Auditor’s Report. See my prior EOM and OM article if you have not adopted SAS 134, 137, 140 and 141.)
Emphasis-of-matter paragraph. A paragraph included in the auditor’s report that is required by GAAS, or is included at the auditor's discretion, and that refers to a matter appropriately presented or disclosed in the financial statements that, in the auditor's professional judgment, is of such importance that it is fundamental to users’ understanding of the financial statements.
Other-matter paragraph. A paragraph included in the auditor’s report that is required by GAAS, or is included at the auditor's discretion, and that refers to a matter other than those presented or disclosed in the financial statements that, in the auditor's professional judgment, is relevant to users’ understanding of the audit, the auditor’s responsibilities, or the auditor’s report.
Notice that an EOM refers to “a matter appropriately presented or disclosed in the financial statements,” while an OM refers to “a matter other than those presented or disclosed in the financial statements.” So, EOMs are used in relation to information included in the financial statements, and OMs are used in reference to information outside the financial statements.
Now, let us take a look at sample EOM and OM paragraphs.
Sample Emphasis of Matter Paragraph
Here’s a sample EOM paragraph:
Emphasis of Matter
As discussed in Note X to the financial statements, subsequent to the date of the financial statements, there was flood damage to the Company’s inventory facilities. Our opinion is not modified with respect to that matter.
Sample Other Matter Paragraph
Here is a sample OM paragraph:
In our report dated April 18, 20X5, we expressed a qualified opinion since the Company’s main office had a material unrecognized impairment loss. As disclosed in Note 12, the Company has now recognized the impairment in conformity with accounting principles generally accepted in the United States of America. Accordingly, our present opinion on the restated 20X4 financial statements, as presented herein, is different from that expressed in our previous report.
You also need to know the presentation requirements for EOM and OM paragraphs.
Presentation Requirements for an Emphasis of Matter
The purpose of the EOM is to draw attention to information contained in the financial statements.
AU-C 706.08 and 706.09 provides EOM guidance. These paragraphs tell you how and when to provide an EOM paragraph.
How to Present an Emphasis of Matter
The auditor should:
Refer only to information presented or disclosed in the financial statements
Include the paragraph in a separate part of the auditor’s report with a heading (such as Emphasis of Matter)
Include in the heading Emphasis of Matter when key audit matters are communicated in the report
Include a clear reference to the matter being emphasized and the location of relevant disclosures
State that the auditor’s opinion is not modified with respect to the matter emphasized
The EOM can be located just after the Basis for Opinion paragraph unless there is a key audit matters section. If there is a key audit matter section, the EOM can be placed after the Basis for Opinion paragraph or after the Key Audit Matters section. (AU-C 706.A14 does not specify placement of the EOM or OM. It says placement depends on the auditor’s judgment about the significance of the information compared to other elements of the report.)
So, when should an EOM be provided?
When to Present an Emphasis of Matter Paragraph
The auditor presents an EOM when he or she believes the information is fundamental to a user’s understanding of the financial statements. But the auditor can only provide an EOM when (1) the auditor is not qualifying the opinion because of the matter, and (2) when the matter is not a key audit matter. EOMs are sometimes required by audit standards.
Exhibit B of AU-C 706, “List of AU-C Sections Containing Requirements for Emphasis-of-Matter Paragraphs” provides information about audit standards requiring an EOM. Those include:
AU-C 560.16c, Subsequent Events and Subsequently Discovered Facts
AU-C 708.08-.09 and 708.11-.13, Consistency of Financial Statements
Now let us look at other matter paragraph requirements.
Presentation Requirements for an Other Matter
An OM is used to highlight information external to the financial statements, usually regarding the auditor’s actions, responsibilities, or report. In other words, an OM addresses information not included in the financial statements or notes.
Include the paragraph within a separate part of the auditor’s report with the heading Other Matter or other appropriate wording
Not include an OM for an issue that is a key audit matter (such information is reported in the key audit matter section)
How to Present an Other Matter
AU-C 706.A14 does not specify where the OM is to be placed in the auditor’s report, saying the placement “depends on the nature of the information” and “the auditors judgement.” Nevertheless, see AU-C 706.A14 for guidance, especially if there are key audit matters, or legal or regulatory requirements. AU-C 706.A17 shows the OM paragraph following Key Audit Matters paragraph in Illustration 2. (The order in this illustration is Basis of Opinion, Emphasis of Matter, Key Audit Matters, and Other Matter. So, if there are no Emphasis of Matter or Key Audit Matter paragraphs, the OM could—based on this illustration—follow the Basis of Opinion paragraph.)
When to Present an Other Matter Paragraph
Auditors can elect to provide an OM paragraph to provide information about the audit, including the auditor’s responsibilities and report. However, there are instances where such a paragraph is required. Exhibit C of AU-C 706, “List of AU-C Sections Containing Requirements for Other-Matter Paragraphs” provides information about auditing standards that require an OM. Those include:
AU-C 700.55-.56 and .58-59, Forming an Opinion and Reporting on Financial Statements
AU-C 800.20, Special Considerations—Audits of Financial Statements Prepared in Accordance with Special Purpose Frameworks
Service organization control (SOC) reports are often necessary to understand outsourced accounting services. So, what are SOC reports and when are they needed?
What are SOC Reports?
When an entity provides services to other entities (e.g., ADP payroll services), the service organization desires to provide comfort to their clients. Why? Well the service organization wants to provide assurance regarding the safety and effectiveness of its services. Trust is foundational to the business relationship. Therefore, the service organization provides comfort to clients by hiring an outside independent auditor to review its accounting system. The result of that review is a service organization control report.
So if ADP desires to give comfort to its clients regarding the design and operation of its accounting system, it will hire an outside audit firm to review and render an opinion on its internal controls. While SOC reports provide comfort the service organization’s clients, they are also used in another manner.
Suppose ADP provides payroll services to Jet Sports, Inc. The auditors of Jet Sports will review ADP’s SOC report to see if their accounting system is appropriately designed and operating. After all, ADP, in this example, is an extension of Jet Sports, Inc.’s accounting system. Jet’s auditors view ADP’s services as a part of Jet’s accounting system: Jet has simply outsourced their payroll services to ADP. That’s why ADP’s SOC report is relevant to Jet Sports, Inc.’s audit.
When are SOC Reports Needed?
SOC reports are needed when:
The user entity’s complementary controls are not sufficient to lessen the possibility of material misstatements
The SOC report provides information concerning a significant transactions cycle
Many organizations outsource portions of their accounting to service organizations, such as ADP’s payroll services. External auditors need to understand a service organization’s system and related controls–particularly if that work could allow material misstatements in the user’s financial statements. This understanding is provided in SOC reports.
All financial statement audits focus upon whether material misstatements are occurring. Moreover, the auditor’s opinion is supported by audit evidence proving the financial statements are fairly stated. But does (some of this) audit evidence come from SOC reports? Sometimes, yes.
A financial statement auditor is concerned with material misstatements, regardless of how or where they occur, and regardless of who allows the misstatement. Therefore, auditors look for internal controls weaknesses in both the entity being audited and service organizations.
As we will see, the external auditor may not need all SOC reports. On the other hand, some SOC reports may be needed but don’t exist.
Definitions Related to Service Organizations
Before delving into the details of service organization controls, let’s define a few key words.
Complementary user entity controls. These are the controls performed by users of a service organization’s services. These entity controls complement the service organization’s controls: both are necessary to ensure the process is safe and effective. For example, your client might perform the complementary control of reviewing payroll hours reported before providing those to an outside payroll service organization.
Service auditor. The auditor that reports on controls at a service organization.
Service organization. An organization that provides services to user entities that impact the user entity’s financial reporting.
User auditor. The auditor that audits the financial statements of a user entity.
User entity. An entity that uses a service organization and its related SOC report.
Services provided by a service organization are relevant to the audit of a user entity’s financial statements when those services and the controls over them affect the user entity’s information system, including related business processes, relevant to financial reporting.
So if a service organization’s activities affect an entity’s information system, business processes, or financial reporting, then that activity is relevant.
When is a SOC report not needed?
When does the external auditor not need SOC reports or other information related to a service organization? Paragraph .05 of AU-C 402 answers that question as follows:
This section does not apply to services that are limited to processing an entity’s transactions that are specifically authorized by the entity, such as the processing of checking account transactions by a bank or the processing of securities transactions by a broker (that is, when the user entity retains responsibility for authorizing the transactions and maintaining the related accountability).
Additionally, complementary user entity controls may be strong enough to eliminate the need for information about the service organization’s controls.
Complementary User Entity Controls
The user entity–an entity that uses a service organization and whose financial statements are being audited–may have controls sufficient to eliminate the need for SOC reports or other information from the service organization. Sometimes the user entity has controls that mitigate the risk of material misstatements caused by service organization deficiencies. Such controls are referred to as complementary user entity controls. If the complementary controls operate effectively, the user auditor–the auditor who audits and reports on the financial statements of a user entity–may not need SOC reports or other service organization information.
Alternatively, if the service organization initiates, executes, and does the processing and recording of the user entity’s transactions and the complementary controls would not detect material misstatements, then the user auditor may need SOC reports or other service organization information.
When complementary controls are present, they should be reviewed in the walkthrough of controls by the user auditor. For example, if your client reviews payroll time recorded prior to submission to an outside payroll service provider, then determine if this control is designed appropriately and implemented (as you do for all key controls). SOC reports usually provide a list of complementary controls, so look there for potential client controls. Then see if they are in use.
Is the Placement of a SOC Report in the Audit File Sufficient?
Placing a SOC report in an audit file without reading and understanding it provides little-to-no audit evidence.
A SOC report provides information about how the service organization’s controls lessen the possibility of material misstatement. So, the user auditor needs to read and document how the service organization’s controls lessen the risk of material misstatement. This understanding of controls is necessary if the service organization’s work affects a significant transaction cycle such as payroll.
Think of SOC reports in this manner: Pretend there is no service organization and the company being audited performs the same processes and controls. If the audited entity performs these controls–and no service organization exists–the auditor gains an understanding of the controls using risk assessment procedures such as inquiry, observations, and inspections of documents. Potential control weaknesses are exposed by the risk assessment process. Thereafter, the identified risks are used to develop the audit program and substantive procedures. The same audit process is true when there is a service organization. But when a service organization is used, the user auditor is using the SOC report to gain the understanding of the service organization’s part of the entity’s accounting system.
If controls weaknesses are noted in the SOC report, the user auditor may–as a response–perform substantive procedures. By doing so the auditor lowers the overall audit risk (which is the risk that the auditor will issue an unmodified opinion when one is not merited).
Type 1 or Type 2 SOC Reports?
Service organization auditors can issue type 1 or type 2 reports.
A type1 SOC report provides a description of a service organization’s system and the suitability of the design of controls.
A type 2 SOC report includes a service organization auditor’s opinion on the fairness of the presentation of management’s description of the service organization’s system and the suitability of the design and operating effectiveness of the controls.
The type 1 report provides information about the service organization’s system and related controls. The type 2 report provides an opinion on the system description and the design and effectiveness of the controls. A type 1 or a type 2 report can be used to gain an understanding of the controls.
You may see, in some of these SOC reports, carve-outs.
Many SOC reports carve out services that are provided to the service organization by another service provider (a service provider to a service provider, if you will). In such a situation, consider whether you need to review the sub-service provider’s SOC report. (Sub-service providers are named in the SOC report along with what they do.)
So, should you (the user auditor) ever visit a service organization’s office?
Should the Auditor Visit the Service Organization?
Usually,the user auditor does not need to visit the service organization, but sometimes it is necessary to do so. If the service organization provides no SOC report and the complementary user controls are not sufficient, then the auditor may have no choice but to review the service organization’s system and controls. Only do so if the service organization handles significant parts of the accounting system.
SOC Reports Summary
In summary, if you audit an entity that uses a service organization, consider whether you need a SOC report. If the service organization provides services that impact a significant transaction cycle or account balance, then you probably need to review the related SOC report. Why? To see if there are any service organization internal control weaknesses that impact your client’s audit.