All Posts by Charles Hall

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About the Author

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.

Preparation of Financial Statements
Jan 30

AR-C 70: The Definitive Guide to Preparations

By Charles Hall | Preparation, Compilation & Review

Are you aware of the option in the SSARS titled Preparation of Financial Statements (AR-C 70)? Many CPAs still believe the lowest level of service in the SSARS is a compilation, but this is not true. CPAs can and do issue financial statements without a compilation report. Today I provide an in-depth look at AR-70, Preparation of Financial Statements

Preparation of Financial Statements

Preparation of Financial Statements

Guidance

AR-C 70, Preparation of Financial Statements, is the guidance for the preparation of financial statements.

Applicability - AR-C Section 70

AR-C section 70, Preparation of Financial Statements, is applicable when a public accountant is engaged to prepare financial statements or prospective financial information.

This section can also be applied to the preparation of other historical financial information (e.g., schedule of rents).

AR-C 70 does not apply when the accountant prepares financial statements or prospective financial information: 

  • And is engaged to perform an audit, review, or compilation of financial statements
  • Solely for submission to taxing authorities
  • For inclusion in written personal financial plans
  • In conjunction with litigation services that involve pending or potential legal or regulatory proceedings, or 
  • In conjunction with business valuation services

Are there other times when AR-C 70 is not applicable? Yes. The preparation guidance does not apply when the accountant is merely assisting in the preparation of financial statements; such services are considered bookkeeping.

Examples of bookkeeping services include:

  • Preparing or proposing certain adjustments, such as those applicable to deferred income taxes or depreciation
  • Drafting financial statement notes
  • Entering general ledger transactions or processing payments in the client’s accounting software

When AR-C 70 is applicable, certain compliance actions—such as the creation of a signed engagement letter—are required. If the accountant is merely assisting with bookkeeping services, AR-C 70 is not triggered, and compliance with the standard is not necessary.

If the accountant is only entering transactions into a general ledger and making journal entries, he is merely assisting with bookkeeping. Such assistance is often provided in an online bookkeeping software such as QuickBooks. If this is the only service provided, AR-C 70 is not applicable.

If the accountant is engaged to prepare financial statements and performs any of the following, then AR-C 70 applies.

  • The accountant prepares financial statements that are provided to another accountant (another firm) for audit purposes
  • The accountant prepares financial statements separately from a tax return (e.g., the accountant might prepare a tax return that includes financial statements and then—at the client’s request—creates financial statements separately from the return)
  • The accountant uses the client’s general ledger information to prepare financial statements outside of the accounting software (e.g., the accountant places information from a Quickbooks general ledger into Excel and creates financial statements)

As you can see, the preparation standard makes a distinction between:

  • Preparing financial statements (which triggers AR-C 70) and 
  • Merely assisting (which does not trigger AR-C 70)

Are there any other situations where AR-C 70 does not apply? Yes. The AICPA’s Center for Plain English Accounting addressed this question in the following question and answer:

Q: If financial statements are prepared by the accountant as a by-product of another engagement (for example, an engagement to prepare a tax return), is the accountant required to follow section 70 of SSARS No. 21 and include any special disclaimer or “no assurance” statement on those financial statements? 

A: No. The accountant is only required to perform the preparation engagement in accordance with section 70 of SSARS No. 21 when engaged to prepare financial statements. Therefore, because the accountant was not engaged to prepare the financial statements, there is no requirement to include a statement on each page of the financial statements indicating that no assurance is provided on the financial statements.

The author requested that the AICPA define the word engaged. They responded that a client’s request for the preparation of financial statements service is the trigger for being “engaged.” In other words, a client’s request for the preparation of financial statements means we are “engaged,” provided we accept the work. Once the client makes the request, the accountant will create an engagement letter in compliance with AR-C 70.

If the client does not request the preparation of financial statements and the accountant creates the statements as a byproduct of another service (e.g., tax return), he is not subject to the requirements of AR-C 70. 

So when is AR-C 70 applicable? When a public accountant is engaged to prepare financial statements

AR-C 70 Objective

The objective of the accountant is to prepare financial statements in accordance with the chosen reporting framework.

AR-C 70 Reports 

A compilation report from the accountant is not required (and should not be provided) when preparing financial statements under AR-C 70.

Financial Statements

The accountant can prepare financial statements as directed by management or those charged with governance. The financials should be prepared using an acceptable reporting framework such as the following:

  • Cash basis
  • Tax basis
  • Regulatory basis
  • Contractual basis
  • Other basis (as long as the basis uses reasonable, logical criteria that are applied to all material items) 
  • Generally accepted accounting principles (GAAP)

When preparing financial statements in accordance with a special purpose framework (e.g., tax basis), the accountant is required to include a description of the financial reporting framework either on the face of the financial statements or in a note. Here’s a sample disclosure in a financial statement title: Statement of Assets, Liabilities, and Equity—Tax Basis.

Management determines the financial statements to be prepared. Financial statements normally include the following:

  • Balance sheet
  • Income statement
  • Cash flow statement

The accountant can, if so directed by management, create and issue just one financial statement (e.g., income statement). 

The financial statements can be for an annual period or for a shorter or longer period. So, financial statements can be for a fiscal year, quarterly, or monthly, for example.

The accountant should also obtain an understanding of the significant accounting policies to be used in the preparation of the financial statements.

In preparing the financial statement, the accountant may need to assist management with judgements regarding amounts or disclosures. The accountant should discuss these judgments with management. Why? So management can understand and accept responsibility for the financial statements.

Documentation Requirements - AR-C 70

preparation of financial statements

The accountant should prepare and retain the following documentation:

  • Engagement letter (or contract)
  • The financial statements 

Documentation related to significant consultations or professional judgments are to be included in the engagement file. Also, if the accountant departs from a relevant presumptively mandatory requirement, he should document the justification for the departure and how the alternative procedures performed were sufficient to achieve the intent of the requirement. (The SSARSs use the word should to indicate a presumptively mandatory requirement.)

AR-C 70 Engagement Letter

Is an engagement letter required for a preparation service? Yes. Moreover, the letter should be signed by the accountant or the firm and management or those charged with governance. A verbal understanding is not sufficient. Though AR-C 70 does not specify how often the engagement letter should be updated, it is best to do so annually. 

The engagement letter should specify:

  • The objectives of the engagement
  • The responsibilities of management
  • The responsibilities of the accountant
  • The limitations of the preparation engagement
  • Identification of the applicable financial reporting framework 
  • The agreement of management that: 
    • Each page of the financial statements will include a statement that no assurance is provided, or
    • The accountant will issue a disclaimer stating that no assurance is provided
  • Whether the financial statements will:
    • Contain known departures from the applicable reporting framework, and 
    • Whether substantially all disclosures will be omitted

No Report

As noted above, no compilation report will be issued for a preparation service. The preparation service is considered a nonattest, nonassurance service, and no compilation, review, or audit procedures are required.

The accountant will do one of the following:

  1. On each financial statement page (including the related notes), indicate, at a minimum, that “no assurance is provided,” or
  2. Provide a disclaimer (see example below)

If the accountant uses the first option, wording such as the following should be included on each page of the financial statements (including the related notes):

  • No assurance is provided on these financial statements
  • These financial statements have not been subjected to an audit or review or compilation engagement, and no assurance is provided on them, or
  • ABC CPAs prepared these financial statements in accordance with professional standards of the AICPA, and no assurance is provided

Other statements can be used to communicate that no assurance is provided, but the minimum wording must include “No assurance is provided.” The “no assurance” wording is made at management’s discretion, and the accountant’s firm name is not required to be included. The wording is normally placed at the bottom of each page. If the client does not allow the accountant to include such a statement on each page of the financial statements, the accountant should:

  • Issue a disclaimer (see below)
  • Perform a compilation in accordance with AR-C 80, or
  • Withdraw from the engagement

Preparation of Financial Statements Disclaimer

If the disclaimer option is used, AR-C 70 provides the following language:

The accompanying financial statements of XYZ Company as of and for the year ended December 31, 20XX, were not subjected to an audit, review, or compilation engagement by me (us) and I (we) do not express an opinion, a conclusion, nor provide any assurance on them.

[Signature of accounting firm or accountant, as appropriate] 

[Accountant’s city and state]

[Date] 

Though not required, the disclaimer can be placed on firm letterhead. Notice that the disclaimer language above has no disclaimer title. While the standard is silent about providing a title, the accountant may add one. For example, Accountant’s Disclaimer. A salutation is not required, but may be added.

Some accountants prefer to provide a disclaimer on letterhead. Why? Any third party reader can see that the accounting firm is involved in the preparation of the statements and that no assurance is provided. 

A third party may not know that an external accountant was involved in preparing the statements if the “no assurance is provided” legend is used and the firm’s name is not included. Remember, however, it is the client’s decision as to whether the “no assurance” legend is added or a disclaimer is provided.

Independence

Preparation of financial statements is a nonattest, nonassurance service. When an accountant performs only a preparation engagement, consideration of independence is not necessary. 

If an accountant signs client checks and performs bookkeeping services, independence is not required. Moreover, if the accountant prepares financial statements for the same client, independence is not required. Signing checks, bookkeeping, and the preparation of financial statements are all nonattest services.

But what happens if the accountant prepares financial statements and issues a compilation report?

Suppose an accountant issues monthly financial statements for January through November with no compilation report (using the preparation option), but in December issues financial statements with a compilation report. Providing the monthly preparation services and the December compilation service triggers a requirement to consider independence. 

Just remember this for now: Independence is not required for preparation engagements, and there are no requirements to disclose a lack of independence in a preparation engagement.

Omission of Substantially All Disclosures

Can the accountant omit all disclosures (notes to the financial statements) in a preparation engagement? Yes. Alternatively, the accountant can provide selected disclosures or if needed, full disclosure. In short, the accountant can do any of the following:

  1. Omit all disclosures
  2. Provide selected disclosures
  3. Provide full disclosure

Regardless, the engagement letter should describe the level of disclosure to be provided in the financial statements. Also, the omission of substantially all disclosures should be communicated either on the face of the financial statements or in a selected note. There is no provision in the preparation standard to report the omission of disclosures in the accountant’s disclaimer that precedes the financial statements. 

The accountant can communicate the omission of disclosures by including wording such as the following at the bottom of each financial statement page or in a note:

  • Substantially all disclosures required by accounting principles generally accepted in the United States are not included.
  • Substantially all disclosures ordinarily included in financial statements prepared in accordance with the tax-basis of accounting are not included.

The accountant can also communicate the omission of disclosures in the title of the financial statements. For example:

ABC Company

Statement of Income

Substantially All Disclosures Omitted

December 31, 2020

Information Provided is Incomplete or Inaccurate

Deficiencies in the information provided to the accountant should be communicated to management, and the inaccuracy or incompleteness of such information should be corrected. Deficiencies in the information include insufficient records, documents, explanations, and judgments.

Reporting Known Departures from the Applicable Financial Reporting Framework

How should a departure from the applicable financial reporting framework be reported? Discuss the departure with management to see if it can be corrected. If it is not corrected, disclose the departure. How?

A departure from the applicable financial reporting framework should be disclosed either on the face of the financial statements or in a note. If it takes more than a few words to describe the departure, note disclosure may be the better option—you’ll have more room there. There is no provision in the preparation standard to disclose departures in the accountant’s disclaimer that precedes the financial statements.

AR-C 70 Other Historical or Financial Information

In addition to historical financial statements, AR-C 70 may be applied to the following:

  • Specified elements, accounts, or items of a financial statement, including schedules of:
    • Rents
    • Royalties
    • Profit participation, or
    • Income tax provisions
  • Supplementary information
  • Required supplementary information
  • Pro forma financial information

AR-C 70 Prospective Financial Information

prospective financial statements

AR-C 70 can be applied to prospective information.

Prospective financial information is defined as any financial information about the future. 

Prospective financial information can be presented as:

  • A complete set of financial statements, or
  • One or more elements, items, or accounts

If you prepare prospective financial information, the summary of significant assumptions must be included Why? It is considered essential to the user’s understanding of such information.

If you prepare a financial projection, you should not exclude:

  • The identification of hypothetical assumptions, or
  • The description of the limitations on the usefulness of the presentation

AR-C 70 references the AICPA Guide Prospective Financial Information as suitable criteria for the preparation and presentation of prospective financial information.

AR-C 70 Prescribed Forms

Is it permissible to perform a preparation of financial statement engagement with regard to prescribed forms?

Yes. There is nothing in AR-C 70 that prohibits the accountant from performing a preparation engagement with regard to prescribed forms (e.g., bank personal financial statement). However, the accountant is required to follow all of the preparation guidance. Clients may not want to add wording to the prescribed forms such as “no assurance is provided” or “substantially all disclosures are omitted.” As an alternative to adding such wording, the accountant can provide a disclaimer before the prescribed form. 

Selected notes can follow the form if needed. If this option is used, the order of the deliverable is as follows:

  • Disclaimer 
  • Prescribed form 
  • Selected notes

When a bank, credit union, regulatory or governmental agency, or other similar entity designs a prescribed form to meet its needs, there is a presumption that the required information is sufficient. What should be done if the prescribed form conflicts with the applicable basis of accounting? For example, what if the prescribed form requires all numbers to be in compliance with GAAP with the exception of receivables? Follow the form. In effect, the prescribed form is the reporting framework. Report departures from the prescribed form and its related instructions on the face of the financial statements (the form) or in a note. 

Draft Financial Statements

The client may request a draft copy of the financial statements prior to final issuance. To avoid confusion, mark statements with words like:

  • Draft Financial Statements
  • Working Draft
  • Draft - Subject to Change

Preparation of Financial Statements - A Simple Summary

  • AR-C 70 is applicable when the accountant is engaged to prepare financial statements and is not applicable when the accountant is engaged to perform a compilation or if the accountant is merely assisting with bookkeeping
  • The objective of the accountant is to prepare financial statements in accordance with the chosen reporting framework
  • The financial statements can be prepared in accordance with GAAP or a special purpose reporting framework
  • The financial statements can be distributed to third parties (and not just management)
  • The accountant must either:
    • State on each financial statement page that “no assurance is provided,” or
    • Provide a disclaimer
  • Documentation requirements include:
    • The engagement letter, and 
    • The financial statements  
  • An engagement letter must be signed by:
    • The accountant or the accountant’s firm, and
    • Management or those charged with governance
  • No report (e.g., compilation report) is attached to the financial statements
  • Consideration of independence is not required
  • Substantially all disclosures can be omitted 
  • The omission of substantially all disclosures should be:
    • Disclosed on the face of the financial statements, or
    • In a note
  • Selected disclosures can be provided 
  • Departures from the applicable financial reporting framework should be:
    • Disclosed on the face of the financial statements, or
    • In a note
  • A preparation engagement can be applied to historical financial statements and historical information (e.g., specified items of a financial statement).
  • A preparation engagement can be applied to prospective financial information. The summary of significant assumptions must be included.
  • A preparation engagement can be performed in relation to prescribed forms (e.g., bank personal financial statements)
  • Mark draft financial statements with appropriate wording (e.g., Draft Financial Statements)

Also, see my article The Definitive Guide to Compilations.

Differences in Preparation and Compilation Engagements

How do preparation engagements compare to compilations? Here's a video that explains the differences.

CPA Ethics
Jan 23

CPA’s Ethics: Four Questions for Better Decisions

By Charles Hall | Accounting and Auditing

In this article, I address CPA’s ethics and the benefits of making good decisions.

Men are alike in their promises. It is only in their deeds that they differ. Molière

CPA Ethics

We’ve all been there.

Your client wants you to sign off on an issue, one that is in the land of gray–you know, that place where there is no black or white. And, of course, the issue has significant dollars attached to it, so it’s important.

Your anguish rises, so you try to see the Great Oz, but he’s hiding behind that curtain, smoke billowing, lighting crashing–but no advice. Since the wizard has no wise words of wisdom, you need someone, or at least something, to help you. Here are four questions you can ask yourself when you face ethical decisions.

CPA Ethics: Four Questions for Better Decisions

Here are four questions to ask:

  1. How would I feel if my choice was placed on the front-page of the local newspaper (or in the Journal of Accountancy)?
  2. What would my father do (or anyone else I greatly respect)?
  3. What would I advise my child to do? (If your child is three, pretend she is thirty.)
  4. What’s the worst thing that could happen? 

Can questions such as these really help? Let’s see. 

County Fires Auditor

Many years ago I was doing an audit of a local county government. I discovered the county commission chairman had arranged for a material purchase of property from his son without using the required bid process, and the transaction was illegal in our state. (I had recently started a CPA firm, so this was one of my few clients. I needed the audit fee.) When I discovered the irregularity, I met with the county commission chairman and told him I would report the transaction in the audit report. He leaned over and quietly said to me, “if you do, you’ll no longer be the auditor.” No one else was in the room.

Later I was physically threatened, and for some time I feared what might happen to me. The decision of what to do, however, had already been made. In asking myself questions such as those above, the right course of action was obvious. 

I reported the illegal transaction and was immediately fired. It cost me, but I knew it was the right thing to do. (Interestingly, when the news broke, a reporter contacted the county commission chairman and the county manager. The county manager stated that I had “my hand in the till,” and that the auditor–that’s me–had stolen money, though they never said how.)

Because of situations like this one, client acceptance has become important to me. We need clients with integrity. Yes, we do. 

When you face a decision such as this one, here are four actions that may help. 

CPA’s Ethics: Four Actions for Better Decisions

Here are four actions to take:

  1. Call the AICPA Ethics Hotline or the AICPA Technical Hotline (877-242-7212). (They are independent of the issue, so they will give you a straight-up answer.)
  2. Call a CPA with knowledge in the area of concern, and ask his or her opinion.
  3. Create a memo supporting your proposed decision, and share it with a partner, quality control department, or whoever is in charge. (I find that writing creates clarity.)
  4. Sit on it (if you can). I gain clarity as I allow the issue to percolate, and as I pray about it. I try not to make a high-stakes decision quickly. Hurried decision are usually poor ones.

Do the Right Thing

As you consider this article, remember, a clear conscience is a precious commodity. If you believe a particular course of action is going to keep you awake at night, your conscience is talking to you. Listen, even if it means less money–especially if it means less money.  

Do the right thing. You’ll be glad you did.

A CPA’s ethics are, and will always be, important.

Use of a specialist
Jan 23

Use of a Specialist: How to Document

By Charles Hall | Auditing

As an auditor, you often use the work of specialists such as actuaries, appraisers, and engineers. Such work can seem mystical, like something conjured up from a mathematical soup. And since we don’t always understand their incantations, we wonder, “Can we rely on the information?” and “How do I document my use of an expert?” Thankfully, the audit standards provide guidance in AU-C 500 (management’s specialist) and AU-C 620 (auditor’s specialist). Below I unpack these requirements. 

Use of a specialist

Picture is courtesy of DollarPhotoClub.com

Who Hires the Specialist?

A specialist can be hired by your audit firm or by management. If you audit banks, you might hire an appraiser to assist with loan collateral reviews–an example of an auditor’s specialist. If your client uses an actuary, then you will obtain audit evidence from a specialist hired by management.

As we begin our look into the use of experts, here are two definitions to help differentiate the types.

Specialist Definitions

AU-C 620 defines an auditor’s specialist and management’s specialist. Both definitions include “expertise in a field other than accounting and auditing.” 

An auditor’s specialist can include an internal person such as a partner or staff member or an external contract person. This person works for the audit firm. 

Information from a management specialist is used by the entity in the preparation of their financial statements. This person works for the audit client. 

Now, let’s take a look at each.

1. Auditor’s Specialist

AU-C Section 620–Using the Work of an Auditor’s Specialist provides guidance.

Is the Specialist Needed?

AU-C 620 states that auditors should consider the use of a specialist when expertise in a field other than accounting or auditing is needed. Before using the services of a specialist, consider the significance of the information for which you might need such a person. If the information has little impact on the financial statements, then usage of their reports or skills is of less importance.

AU-C 620 Considerations

AU-C 620 also says the auditor should evaluate the competence, capability, and objectivity of the specialist. So if you hire an investment pricing expert, you want to know if she is reputable, what her experience is, whether she can perform the work appropriately, and whether she is objective.

Use of a Specialist

Picture is courtesy of Adobe Stock

According to AU-C 620, information regarding the competence, capabilities, and objectivity may come from sources such as the following:

  • Personal experience with previous work of the expert
  • By talking to the specialist
  • Talking with other auditors or others who are familiar with their work
  • Knowledge of their qualifications, professional memberships, licenses to practice, or other forms of recognition (often available on their website)
  • Books or other publications of the expert

If you’ve previously worked with the aforementioned pricing expert, you have personal experience with her work. This helps. You might call her with regard to current year issues, and since you already know her, you probably know her qualifications.

Regarding objectivity, the auditor should inquire about any relationships that the specialist may have with the client. And if necessary, obtain a signed representation letter concerning their objectivity. Continuing with our pricing expert example, you want to ask her if she has any business relationships with the auditee. Are there any family relationships? Is there anything that might impair her objectivity?

Additionally, if the expert is hired by your firm, consider an engagement letter. 

Engagement Letter with Specialist

Though not required, the auditor can use a written engagement letter to define the work of the specialist. AU-C 620 provides suggestions for the engagement letter such as:

  • Nature, scope, and objectives of the assistance
  • The roles and responsibilities of the auditor and the specialist
  • How information will be communicated
  • The need for confidentiality

Document the specialist’s work in a memorandum if an engagement letter is not obtained.

Adequacy of  Work

Auditors must evaluate the adequacy of the work.

AU-C 620 requires that you evaluate the adequacy of the work, including the reasonableness of the findings and conclusions, the reasonableness of assumptions and methods, and the relevance and accuracy of the information. 

Bottom line: Does the work of the expert provide sufficient and appropriate audit evidence with regard to the issue at hand (e.g., investment pricing)?

When should an auditor begin thinking about specialist usage? Before the engagement is accepted. Why? If we accept an audit without the necessary skill sets, we have a problem. As you consider the acceptance of an audit engagement, think about whether a specialist is needed, and whether such a person is available at a reasonable price.

Reference to a Specialist in an Auditor’s Opinion

AU-C 620 states that an auditor should not refer to the work of an auditor’s specialist in an unmodified audit opinion. The auditor can, however, make reference to a specialist when the opinion is modified (to explain the reason for the modification). But, if reference is made, the audit opinion should state the auditor’s responsibility is not lessened. 

What does this mean? Regardless of the situation, the opinion is the auditor’s (and not the specialist’s). We may use the expert’s work as audit evidence, but the audit opinion (and the corresponding responsibility) belongs to us.

Confidentiality Language in the Client Engagement Letter

When an auditor hires an external specialist, should the audit engagement letter change?

When an audit firm hires an external specialist, the firm should follow the Code of Conduct section ET 1.700.040, Disclosing Information to a Third-Party Service Provider. How can you comply with this ethical requirement? By including additional language in your engagement letter advising the client that you might provide confidential information to an outside party. In effect, you are gaining consent to share client information. If you are not using an outside person, but someone who works for your firm, then no such consent is necessary.

Now, let’s take a look at management’s specialist. 

2. Management’s Specialist

AU-C Section 500, Audit Evidence, provides guidance on the use of information from a management specialist.

Your audit client might use their own expert such as a pension plan actuary. To rely on the actuary, you need to know if she is competent and objective. You also need to understand–at least in a general sense–what the actuary does. You do not need to recompute the actuarial computations, for example. But a review of assumptions for reasonableness is appropriate.

AU-C 500 Considerations

AU-C 500 requires considerations similar to those of an auditor’s specialist. For instance, you need to evaluate the competence and objectivity of management’s expert. Obtain an understanding of their work, and evaluate it in light of relevant assertions. For example, is the pension disclosure, based on actuarial information, understandable and accurate?

As with an auditor’s specialist, the sources of information regarding a management specialist can come from prior experience with the person, discussions with the expert, and knowledge of their certifications and experience. 

Additionally, consider including relevant language in management’s representation letter.

Representation Letter

AU-C 580, Written Representations, provides the following example of language that an auditor might include in the representation letter:

We agree with the findings of specialists in evaluating the [describe assertion] and have adequately considered the qualifications of the specialists in determining the amounts and disclosures used in the financial statements and the underlying accounting records. We did not give or cause any instructions to be given to specialists with respect to the values or amounts derived in an attempt to bias their work, and we are not otherwise aware of any matters that have had an effect on the independence or objectivity of the specialists.

Conclusion

So how do you document your use of these experts? As you can tell, the audit standards provide a framework, and the documentation will vary depending on the type of specialist used and the importance of the information. At a minimum, consider documenting:

  1. Why you need the expert (or their work product)
  2. What they are doing
  3. Their abilities, reputation, and experience 
  4. Their objectivity 
  5. The adequacy of the work provided

Peer review checklists include questions regarding your documentation of such information. Therefore, you need to make sure you do so. 

At the end of the day, auditing is all about obtaining reasonable assurance by obtaining audit evidence. As you consider the use of these experts, ask yourself how their work impacts your risk assessment, your audit procedures, and finally your opinion.

Cash overdraft
Jan 21

Cash Overdrafts: Accounting for Negative Cash

By Charles Hall | Accounting

How should you account for cash overdrafts (also called negative cash balances) on a balance sheet and in a cash flow statement?

It is year-end and your audit client has three bank accounts at the same bank. Two of the accounts have positive balances (the first with $50,000 and the second with $200,000). The third account has a negative cash balance of $400,000. Since a net overdraft of $150,000 exists, how should we present cash in the financial statements?

Cash overdraft

Cash Overdraft in Balance Sheet

In the balance sheet, show the negative cash balance as Cash Overdraft in the current liabilities. Or you can also include the amount in accounts payable.

If you are netting the three bank accounts, consider using the Cash Overdraft option. If you bury the overdraft in accounts payable, the financial statement reader may think, “there is a mistake, where is cash?” Using Cash Overdraft communicates more clearly. (The right of offset must exist in order to net bank accounts. The right of offset commonly exists for multiple bank accounts with one bank.)

Some companies have multiple bank accounts with multiple banking institutions. In such cases, the net balance of one bank might be positive and the net balance of the second bank might be negative. Then the company would reflect the positive balance as cash and the negative cash balance (of the second bank) as an overdraft.  

Suppose a company has bank accounts with two different banks and the net balance of the first bank is $1,350,000 and the net balance of the second bank is an overdraft of $5,000. Then show cash as one amount on the balance sheet ($1,345,000). The $5,000 is not material.

Cash Overdraft in Cash Flow Statement

Some companies do not include overdrafts in the definition of cash; instead, they include it in accounts payable. Consequently, the company treats the overdraft as an operating activity (change in accounts payable). So, the company includes the negative cash as a change in a liability in the operating section of the cash flow statement. (Some accountants treat overdrafts as a financing activity, but they clear quickly. Therefore, an operating activity classification is more appropriate.)

Alternatively, include the negative cash in the definition of cash (rather than in accounts payable). In doing so, you combine the cash overdraft with other cash (that with positive balances) in the cash flow statement. The beginning and ending cash–in the cash flow statement–should include the negative cash amounts.

FASB ASC 230-10-45-4 requires that the total amounts of cash and cash equivalents in the cash flow statement agree with similarly titled line items or subtotals in the balance sheet. If negative cash is included in the definition of cash, the cash captions in the statement of cash flows should be revised accordingly (e.g., Cash (Cash Overdraft) at end of year).

If the balance sheet contains a positive cash balance in assets and a cash overdraft in liabilities, provide a reconciliation at the bottom of the cash flow statement (or in a disclosure). In the reconciliation, show the composition of the balance–one line titled Cash, one line titled Cash Overdraft, and a total line titled Total Cash (Cash Overdraft)

One Other Consideration

If checks are created but not released by year-end, reverse the payment. Merely printing checks does not relieve payables. Payables are relieved when payment is made (checks are printed and mailed, or electronic payments are processed).

See my post about auditing cash.

Unpredictable audit procedure
Jan 13

Unpredictable Audit Procedures

By Charles Hall | Auditing

In this article I explain how you can use unpredictable audit procedures.

The audit standards require elements of unpredictability. Why? So clients can’t guess what the auditor is going to do. Clients naturally observe and learn what auditors normally do. The client’s knowledge of what is audited (and what is not) makes it easier to steal. The client takes from unaudited areas. This knowledge also enables the company to manipulate numbers. The client alters unaudited balances.

The purpose of the unpredictable element is to create uncertainty–in the client’s mind–regarding audit procedures. We do so by using unpredictable audit procedures.

Unpredictable audit procedureElements of Unpredictability – The Audit Standards

AU-C 240.29 states the following:

In determining overall responses to address the assessed risks of material misstatement due to fraud at the financial statement level, the auditor should…incorporate an element of unpredictability in the selection of the nature, timing, and extent of audit procedures.

AU-C 240.A42 states:

Incorporating an element of unpredictability in the selection of the nature, timing, and extent of audit procedures to be performed is important because individuals within the entity who are familiar with the audit procedures normally performed on engagements may be better able to conceal fraudulent financial reporting. This can be achieved by, for example,

  • performing substantive procedures on selected account balances and assertions not otherwise tested due to their materiality or risk.
  • adjusting the timing of audit procedures from that otherwise expected.
  • using different sampling methods.
  • performing audit procedures at different locations or at locations on an unannounced basis.

Unpredictable Audit Procedures 

To introduce elements of unpredictability, perform procedures such as these:

  • Examine payments less than your normal threshold in your search for unrecorded liabilities (e.g., in the last three years your threshold was $7,000; this year, it’s $3,000)
  • Perform a surprise unannounced review of teller cash (for a bank client)
  • Make a physical visit to the inventory location one month after the end of the year and review inventory records (assuming you don’t normally do so)
  • Review payroll salary authorization sheets for ten employees and agree to amounts in the payroll master table (in the payroll software)
  • Test a bank reconciliation for the seventh month in the year being audited (in addition to the year-end bank reconciliation)
  • Confirm an immaterial bank account that you haven’t confirmed in the past
  • Pick ten vendors at random and perform procedures to verify their existence (as a test for fictitious vendors)

Document Your Unpredictable Audit Procedures

Since unpredictable tests are required in every audit, document where you performed this procedure. Reference your audit program step for unpredictable tests to the work performed. Title your work paper, “Unpredictable Test,” and then add a purpose statement such as, “Purpose: To confirm the immaterial bank account with ABC Bank as an unpredictable test.” Doing so will eliminate the potential for a peer reviewer to say, “that’s a normal procedure.” You are overtly stating the purpose of the test is to satisfy the unpredictable test requirement.

Change Your Unpredictable Tests Annually

Change your unpredictable tests annually. Otherwise, they will–over time–become predictable.

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