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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.

significant risk
Feb 08

Significant Risks in Audits of Financial Statements

By Charles Hall | Auditing

Peer reviews find that many CPA firms don't identify significant risks in audits, and that's a problem. Why? Because they are the seedbed of many material misstatements. And when material misstatements are not identified, audit failure often occurs.

Below, I will tell you how to identify, assess, and respond to significant risks.

I also explain the new requirement to communicate significant risks to those charged with governance.  

significant risk

Defining Significant Risk

The Auditing Standards Board previously defined significant risks as those deserving special audit consideration. They've amended this definition in SAS 145 to focus on the inherent risk characteristics rather than the response

For example, a highly complex receivable allowance is inherently risky because it's subjective and complicated. Yes, we will give it special audit consideration. But it's a significant risk because of its nature (subjective and complex), not because of our response (re-computing the estimate and comparing it with prior periods, for example). 

How Many Significant Risks?

At least one significant risk exists in most audits, and frequently there are more. The number depends on the entity, its environment, the types of services it provides or goods it sells, the complexity of its accounts, the subjectivity of determining balances, the susceptibility of accounts to bias or fraud, and the level of change.

Defined in SAS 145

SAS 145, Understanding the Entity and Its Environment and Assessing the Risk of Material Misstatement, defines significant risk in terms of likelihood and magnitude. The threat must be likely, and the result must be material. (See my SAS 145 article.)

The audit standard defines the risk as one close to the upper end of the spectrum of inherent risk without regard for controls. In other words, we consider the inherent risk factors, and we disregard internal controls as we identify these risks.

Align Inherent Risk with Significant Risk

Notice that significant risks are based solely upon inherent risk. So don’t make the mistake of identifying such a risk and then assessing inherent risk below high. After all, the definition says close to the upper end of the spectrum of inherent risk.

Suppose, for example, you identify a significant risk for the allowance for uncollectible receivables, an estimate, due the concerns about the valuation assertion (because it's complex and subjective; see inherent risk factors below). Then the inherent risk for the valuation assertion must be high (or max). 

It's useful to think of inherent risk on a scale of 1 to 10, with 10 being high risk. If you believe the inherent risk is a 9 or a 10 (close to the upper end of the spectrum of inherent risk), then a significant risk is present. Though auditors commonly use low, moderate, high to measure inherent risk, the audit standards don't specify how this is to be done. I'm not saying don't use low, moderate, high, only that thinking of inherent risks on scale of 1 to 10 helps me evaluate risk and to determine whether a significant risk is present.

Inherent Risk Factors

And what are the inherent risk factors? 

  • Complexity
  • Subjectivity
  • Change
  • Uncertainty
  • Susceptibility to misstatement due to management bias or other fraud risk factors (in terms of how they affect inherent risk)

Two Questions to Consider

So the auditor reviews an assertion and asks, "In light of these risk factors, what is the probability of misstatement without regard for controls?" The auditor also asks, "Would a material misstatement occur?" So we consider two things:

  • Is it highly likely that a misstatement will occur for the assertion (without regard for controls)?
  • Will the misstatement be material?

If both answers are yes, it's a significant risk.

Responses to Significant Risks

Peer reviews find that auditors sometimes identify these risks but plan inadequate responses. If the risk is significant, then a strong response is necessary. 

For example, if inventory obsolescence is an issue, the auditor should plan procedures to identify the impaired items and test for appropriate valuation. You may need a specialist in such a situation. So, what would be an inadequate response?  Performing basic inventory procedures. Additional procedures, sometimes referred to as extended steps, are necessary to address the inventory valuation assertion.

As you plan the additional audit procedures, link them from the identified risk (usually on your summary risk assessment form) to your responses (usually on your audit program). In the inventory example, you would link the risk for the valuation assertion to the inventory audit steps (the extended steps to identify and value the impaired items).


You must also communicate these risks to those charged with governance. 

Communicating Significant Risks

Communicate the significant risks to those charged with governance as you implement SAS 134, Auditor Reporting and Amendments, Including Amendments Addressing Disclosures in the Audit of Financial Statements (required for December 31, 2021 year-end engagements and after).

(See my SAS 134 article to understand the types of audit opinions.)  

Present guidance states that significant risks are those that deserve special audit consideration, so you'll use that definition until SAS 145 is implemented. (Even so SAS 145 will help you understand these risks now.)

significant risk

How to Communicate 

You can communicate significant risks in one of three ways:

  1. Engagement letter
  2. Planning letter to those charged with governance
  3. Verbally to the board with documentation of that communication in the audit file--this could be a separate Word document that says who you talked with, when, and the significant risk areas communicated. 

The Communication Change

SAS 134 amended AU-C 260.11 (AU-C 260 The Auditor's Communication with Those Charged with Governance) as follows (amended language is underlined):

The auditor should communicate with those charged with governance an overview of the planned scope and timing of the audit, which includes communicating about the significant risks identified by the auditor.

Sample Significant Risk Language 

Here's an example of the language to be used in any of the three options above:

The anticipated significant risk areas in the audit are:

  1. receivables/revenues,
  2. the allowance for uncollectibles 
  3. the pension liability and disclosure. 

Aligning the Communication with Workpapers

The significant risk areas communicated to the board during planning should align with those identified in your workpapers. You could, however, not know all of the risk areas when you create your initial communication. It's even possible you might not identify a these risks until you are well into the engagement. So the initial significant risk communication and the identified risks in the audit file could be different. You can communicate any additional risks in your final communication to those charged with governance. 

Why are we making this communication the board? Well the board governs the entity, so they need to be aware of areas with a higher risk of potential misstatements. 

Optional Communication 

The explanatory information that accompanies AU-C 260 (specifically .A21) states you may include in the governance communication how you (as the auditor) are going to address the significant risks, but this is optional.  

Audit Risk Assessment Book on Amazon

See my book on Amazon: Audit Risk Assessment Made Easy, Seeing What Others Miss.

 

Auditing accounts payable
Feb 02

Auditing Accounts Payable and Expenses

By Charles Hall | Auditing

Accounts payable is usually one of the more important audit areas. Why? Risk. First, it’s easy to increase net income by not recording period-end payables. Second, many forms of theft occur in the accounts payable area.

Auditing accounts payable

In this post, I’ll answer questions such as, “how should we test accounts payable?” And “should I perform fraud-related expense procedures?” We’ll also take a look at common payables-related risks and how to respond to them. In short, you will learn what you need to know about auditing accounts payable.

Auditing Accounts Payable and Expenses — An Overview

What is a payable? It’s the amount a company owes for services rendered or goods received. Suppose the company you are auditing receives $2,000 in legal services in the last week of December 2019, but the law firm sends the related invoice in January 2020. The company owes $2,000 as of December 31, 2019. The services were provided, but the payment was not made until after the year-end. Consequently, the company should accrue (record) the $2,000 as payable at year-end.

In determining whether payables exist, I like to ask, “if the company closed down at midnight on the last day of the year, would it have a legal obligation to pay for a service or good?” If the answer is yes, then record the payable even if the invoice is received after the year-end. Was a service provided or have goods been received by year-end? If yes (and the amount has not already been paid), accrue a payable.

In this chapter, we will cover the following things an accounts payable auditor need to consider:

  • Primary accounts payable and expense assertions
  • Accounts payable and expense walkthroughs
  • Directional risk for accounts payable and expenses
  • Primary risks for accounts payable and expenses
  • Common accounts payable and expense control deficiencies
  • Risks of material misstatement for accounts payable and expenses
  • Search for unrecorded liabilities
  • Auditing for accounts payable and expense fraud
  • Substantive procedures for accounts payable and expenses
  • Typical accounts payable and expense work papers

So, let’s begin our journey of auditing accounts payable and expenses.

Primary Accounts Payable and Expense Assertions

The primary relevant accounts payable and expense assertions are:

  • Existence
  • Completeness
  • Cutoff
  • Occurrence

Of these assertions, I believe completeness and cutoff (for payables) and occurrence (for expenses) are usually most important. When a company records its payables and expenses by period-end, it is asserting that they are complete and that they are accounted for in the right period. Additionally, the company is implying that amounts paid are legitimate.

Accounts Payable and Expense Walkthroughs

As we perform walkthroughs of accounts payable and expenses, we are looking for understatements (though they can also be overstated as well). We are asking, “what can go wrong?” whether intentionally or by mistake.

Walkthrough in accounts payable

In performing accounts payable and expense walkthroughs, ask questions such as:

  • Who reconciles the accounts payable summary to the general ledger?
  • Does the company use an annual expense budget?
  • Are budget/expense reports provided to management or others? Who receives these reports?
  • What controls ensure the recording of payables in the appropriate period?
  • Who authorizes purchase orders? Are any purchases authorized by means other than a purchase order? If yes, how?
  • Are purchase orders electronic or physical?
  • Are purchase orders numbered?
  • How does the company vet new vendors?
  • Who codes invoices (specifies the expense account) and how?
  • Are three-way matches performed (comparison of purchase order with the receiving document and the invoice)?
  • Are paid invoices marked “paid”?
  • Does the company have a purchasing policy?
  • Can credit cards be used to bypass standard purchasing procedures? Who has credit cards and what are the limits? Who reviews credit card activity?
  • Are bids required for certain types of purchases or dollar amounts? Who administers the bidding process and how?
  • Do larger payments require multiple approvals?
  • Which employees key invoices into the accounts payable module?
  • Who signs checks or makes electronic payments?
  • Who is on the bank signature card?
  • Are signature stamps used? If yes, who has control of the signature stamps and whose signature is affixed?
  • How are electronic payments made (e.g., ACH)?
  • Is there adequate segregation of duties for persons:
    • Approving purchases,
    • Paying payables,
    • Recording payables, and
    • Reconciling the related bank statements
  • Which persons have access to check stock and where is the check stock stored?
  • Who can add vendors to the payables system?
  • What are the entity’s procedures for payments of travel and entertainment expenses? 
  • Who reconciles the bank statements and how often?

As we ask these questions, we inspect documents (e.g., payables ledger) and make observations (e.g., who signs checks or makes electronic payments?). So, we are inquiring, inspecting, and observing. 

If controls weaknesses exist, we create audit procedures to respond to them. For example, if--during the walkthrough--we see that one person prints and signs checks, records payments, and reconciles the bank statement, then we will perform fraud-related substantive procedures (more about this in a moment).

Here's a short video about risk assessment for accounts payable auditors. 

Directional Risk for Accounts Payable and Expenses

The directional risk for accounts payable and expenses is an understatement. So, perform procedures to ensure that invoices are properly included. For example, perform a search for unrecorded liabilities (see below).

Primary Risks for Accounts Payable and Expenses

The primary risks for accounts payable and expenses are:

  1. Accounts payable and expenses are intentionally understated 
  2. Payments are made to inappropriate vendors
  3. Duplicate payments are made to vendors 

Keep these in mind as you audit accounts payable.

Common Payable and Expense Control Deficiencies

payables control deficiencies

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

  • One person performs two or more of the following:
    • Approves purchases,
    • Enters invoices in the accounts payable system,
    • Issues checks or makes electronic payments, 
    • Reconciles the accounts payable bank account,
    • Adds new vendors to the accounts payable system
  • A second person does not review payments before issuance
  • No one performs surprise audits of accounts payable and expenses 
  • Bidding procedures are weak or absent
  • No one reconciles the accounts payable detail to the general ledger
  • New vendors are not vetted for appropriateness
  • The company does not create a budget
  • No one compares expenses to the budget
  • Electronic payments can be made by one person (with no second-person approval or involvement)
  • The bank account is not reconciled on a timely basis
  • When bank accounts are reconciled, no one examines the canceled checks for appropriate payees (the dollar amount on the bank statement is agreed to the general ledger but no one compares the payee name on the cleared check to the vendor name in the general ledger)

When segregation of duties is lacking, consider whether someone can use the expense cycle to steal funds. How? By making payments to fictitious vendors, for example. Or intentionally paying a vendor twice--and then stealing the second check. (See the section titled Auditing for Fraud below.)

Risks of Material Misstatement for Payables and Expenses

In smaller engagements, I usually assess control risk at high for each assertion. When I assess control risk at less than high, I have to test controls to support the lower risk assessment. Therefore, assessing risks at high is usually more efficient (than testing controls).

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

My response to higher risk assessments is to perform certain substantive procedures: namely, a search for unrecorded liabilities and detailed expense analyses. The particular expense accounts that I examine are often the result of my preliminary planning analytics

Search for Unrecorded Liabilities

How does one perform a search for unrecorded liabilities? Use these steps:

  1. Obtain a complete check register for the period subsequent to your audit period
  2. Pick a dollar threshold ($10,000) for the examination of subsequent payments
  3. Examine the subsequent payments (above the threshold) and related invoices to determine if the payables are suitably included or excluded from the period-end accounts payable detail
  4. Inquire about any unrecorded invoices

As the RMM for completeness increases, vouch payments at a lower dollar threshold.

How should you perform a detailed analysis of expense accounts? First, compare your expenses to budget—if the entity has one—or to prior year balances. If you note any significant variances (that can’t be explained), then obtain a detail of those particular expense accounts and investigate the cause.

Theft can occur in numerous ways—such as fictitious vendors or duplicate payments. If control weaknesses are present, consider performing fraud-related procedures. When fraud-related control weaknesses exist, assess the RMM for the occurrence assertion at high. Why? There is a risk that the expense (the occurrence) is fraudulent. 

So, how should you respond to such risks?

Auditing for Fraud

Auditing accounts payable

An example of a fraud-related test is one for duplicate payments. How?

  • Obtain a check register in Excel
  • Sort by the vendor
  • Scan the check register for payments made to the same vendor for the same amount
  • Inquire about payments made to the same vendor for the same amount

In a duplicate payment fraud, the thief intentionally pays an invoice twice. He steals the second check and converts it to cash.

This is just one example of expense fraud. There are dozens of such schemes. 

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

Substantive Procedures for Accounts Payable and Expenses

My customary audit tests are as follows:

  1. Vouch subsequent payments to invoices using the steps listed above (in Search for Unrecorded Liabilities)
  2. Compare expenses to budget and examine any unexplained variances
  3. When control weaknesses are present, design and perform fraud detection procedures

If there are going concern issues, you may need to examine the aged payables listing. Why? Management can fraudulently shorten invoice due dates. Doing so makes the company appear more current. For example, suppose the business has three unpaid invoices totaling $1.3 million that were due over ninety days ago. The company changes the due dates in the accounts payable system, causing the invoices to appear as though they were due just thirty days ago. Now the aged payables listing looks better than it would have. 

Typical Payable and Expense Work Papers

My accounts payable and expense work papers usually include the following:

  • An understanding of internal controls as they relate to accounts payable and expenses
  • Risk assessment of accounts payable and expenses at the assertion level
  • Documentation of any accounts payable and expense control deficiencies
  • Accounts payable and expense audit program
  • An aged accounts payable detail at period-end
  • A search for unrecorded liabilities work paper
  • Budget to actual expense reports and, if unexpected variances are noted, a detailed analysis of those accounts 
  • Fraud-related expense work papers (if significant control weaknesses are present)

So, now you learned about auditing accounts payable. My next post addresses auditing payroll.

In some entities such as governments, payroll makes up over 50% of total expenses. Consequently, knowing how to audit payroll expenses is of great importance. My next post is titled The Why and How of Auditing Payroll. So, stay tuned.

See my prior posts in The Why and How of Auditing.

Get Your Copy of the Why and How of Auditing

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Get your copy of the Why and How of Auditing.

ASU 2018-08
Feb 02

ASU 2018-08: Conditional Contribution Recognition

By Charles Hall | Accounting and Auditing

In June of 2018, FASB issued ASU 2018-08: Clarifying the Scope and the Accounting Guidance for Contributions Received and Contributions Made.

Today I provide an overview of how this standard affects nonprofit revenue recognition. 

ASU 2018-08

ASU 2018-08: Nonprofit Contribution Recognition

The purpose of the standard is to provide guidance in regard to recognizing contributions in nonprofit organizations. This standard is conceptually consistent with Topic 606, Revenue from Contracts with Customers, which requires revenue to be recognized when performance obligations are satisfied. ASU 2018-08 requires contribution revenue recognition when conditions are met (see below).

Once ASU 2018-08 becomes effective (years ending December 31, 2019 for many nonprofits), nonprofits will recognize revenues in one of three ways:

  1. Exchange transaction
  2. Conditional Contribution
  3. Unconditional Contribution

The financial statement presentation of the revenue can be affected by the nature of the transaction. For example, there might be a conditional contribution and a donor restriction for the same monies. So contribution revenue will not be recognized until the barriers are satisfied (see below), but revenue will appear in with donor restriction or without donor restriction on the statement of activities, depending on the specifics of the transaction. 

1. Exchange transaction

If a nonprofit is paid based on commensurate value, then there is an exchange transaction. The nonprofit recognizes revenue as it provides the service or goods. Apply Topic 606, Revenue from Contracts With Customers, for these transactions. An example of an exchange transaction is a nonprofit is paid market rate for painting a local store.

ASU 2018-08 makes it plain that benefits received by the public as a result of the assets transferred is not equivalent to commensurate value received by the resource provider.

2. Conditional Contribution

A conditional contribution is one where: 

  • a barrier is present and
  • a right of return or right of release for the contributor exists

Barriers

The following are indicators of a barrier:

  • Recipient must achieve a measurable, performance-related outcome (e.g., providing a specific level of service, creating an identified number of units of output, holding a specific event)
  • A stipulation limits the recipient’s discretion on the conduct of the activity (e.g., specific guidelines about incurring qualifying expenses)
  • A stipulation is related to the primary purpose of the agreement (e.g., must report on funded research)

Recognize revenue when the barrier is overcome.

An example of meeting a measurable outcome would be if the donor requires the serving of meals to 1,000 homeless persons. Another example of the first indicator above is a matching requirement.

An example of limited discretion would be a requirement to hire specific individuals to conduct an activity.

ASU 2018-08

Stipulation Related to Grant's Primary Purpose

An example of a stipulation related to the primary purpose of the agreement is a grant that requires the filing of an annual report of funded research. If the grantor requires repayment of the amount received should the report not be filed, then the requirement is a barrier. 

Judgment is necessary to determine whether a requirement is a barrier. For example, filing routine reports to a resource provider showing progress on a funded activity may be seen as routine and not a barrier. Goals or budgets where no penalty is assessed if the organization fails to achieve them are not considered barriers.

Effect of Budgets

Are budgets an indicator of limited discretion? A line-item budget for a grant is often seen as a guardrail rather than a barrier. A June 2019 FASB Q&A states “Thus, stipulations other than adherence to a budget (for example, the need to incur qualifying expenses) would normally need to be present for a barrier to entitlement to exist.” The Q&A goes on to say, “The unique facts and circumstances of each grant agreement must be analyzed within the context of the indicators to conclude whether a barrier to entitlement exists.”

Recognition of Contribution

Per ASU 2018-08 “Conditional contributions received are accounted for as a liability or are unrecognized initially, that is, until the barriers to entitlement are overcome, at which point the transaction is recognized as unconditional and classified as either net assets with restrictions or net assets without restrictions.”

3. Unconditional Contribution

If there are no barriers or if barriers have been overcome, the receipt is unconditional. There might still be a purpose or time restriction, resulting in the funds being classified as “With Donor Restrictions” until the restriction is satisfied. Recognize the revenue either as:

  • Net Assets with Donor Restriction
  • Net Assets without Donor Restriction

Effective Date 

A public company or a not-for-profit organization that has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market would apply the new standard for transactions in which the entity serves as a resource recipient to annual reporting periods beginning after June 15, 2018, including interim periods within that annual period. Other organizations would apply the standard to annual reporting periods beginning after December 15, 2018, and interim periods within annual periods beginning after December 15, 2019.

A public company or a not-for-profit organization that has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the counter market would apply the new standard for transactions in which the entity serves as a resource provider to annual reporting periods beginning after December 15, 2018, including interim periods within that annual period. Other organizations would apply the standard to annual reporting periods beginning after December 15, 2019, and interim periods within annual periods beginning after December 15, 2020.

Applicability

Per ASU 2018-08,Accounting for contributions is an issue primarily for not-for-profit (NFP) entities because contributions are a significant source of revenue for many of those entities. However, the amendments in this Update apply to all entities, including business entities, that receive or make contributions of cash and other assets, including promises to give within the scope of Subtopic 958-605 and contributions made within the scope of Subtopic 720-25, Other Expenses—Contributions Made.”

Audit workpapers
Jan 21

10 Steps to Better Audit Workpapers

By Charles Hall | Accounting and Auditing , Preparation, Compilation & Review

In this post, I provide ten steps to better audit workpapers. 

Have you ever been insulted by a work paper review note?

Your tickmarks look like something my six-year old created. 

Rather than providing guidance, the comment feels like an assault.

Or maybe as a reviewer you stare at a workpaper and you’re thinking, “what the heck is this?” Your stomach tightens and you say out loud, “I can’t understand this.”

There are ways to create greater audit workpaper clarity.

Audit workpapers

10 Steps to Better Audit Workpapers

Here are ten steps to make your workpapers sparkle.

  1. Timely review. The longer the in-charge waits to review work papers, the harder it is for the staff person to remember what they did and, if needed, to make corrections. Also, consider that the staff person may be reassigned to another job. Therefore, he may not be available to clear the review notes.
  2. Communicate the purpose.

a.  An unclear work paper is like a stone wall. It blocks communication.

b.  State the purpose; for example:

Purpose of Work Paper – To search for unrecorded liabilities as of December 31, 2018. Payments greater than $30,000 made from January 1, 2019, through March 5, 2019, were examined for potential inclusion in accounts payable.

Or:

Purpose of Work Paper – To provide a detail of accounts receivable that agrees with the trial balance; all amounts greater than $20,000 agreed to subsequent receipt.

If the person creating the work paper can’t state the purpose, then maybe there is none. It’s possible that the staff person is trying to copy prior year work that (also) had no purpose.

c.  All work papers should satisfy a part of the audit program (plan). No corresponding audit program step? Then the audit program should be updated to include the step—or maybe the work paper isn’t needed at all.

3.  The preparer should sign off on each workpaper  (so it’s clear who created it).

4. Audit program steps should be signed off as the work is performed (not at the end of the audit–just before review). The audit program should drive the audit process—not the prior year workpapers.

5.  Define tickmarks.

6.  Reference work papers. (If you are paperless, use electronic links.)

7.  Communicate the reason for each journal entry.

The following explanation would not be appropriate:

To adjust to actual.

A better explanation:

To reverse client-prepared journal entry 63 that was made to accrue the September 10, 2018, Carter Hardware invoice for $10,233.

8.   When in doubt, leave it out.

Far too many documents are placed in the audit file simply because the client provided them. Moreover, once the work paper makes its way into the file, auditors get “remove-a-phobia“–that dreaded sense that if the auditor removes the work paper, he may need it later.

If you place those unneeded documents in your audit file and do nothing with them, they may create potential legal issues. I can hear the attorney saying, “Mr. Hall, here is an invoice from your audit file that reflects fraud.”

Again, does the work paper have a purpose?

My suggestion for those in limbo: Place them in a “file 13” stack until you are completely done. Then–once done–destroy them. I place these documents in a recycle bin at the bottom of my file.

9.  Complete forms. Blanks should not appear in completed forms (use N/A where necessary).

10. Always be respectful in providing feedback to staff. It’s too easy to get frustrated and say or write things we shouldn’t. For instance, your audit team is more receptive to:

Consider providing additional detail for your tickmark: For instance–Agreed invoice to cleared check payee and dollar amount.

This goes over better than:

You failed to define your tickmark–again?

Last Remarks

What other ways do you make your audit workpapers sparkle? Comment below.

The AICPA provides a sample workpaper template that you may find helpful. 

You may also be interested in a related post: How to Review Financial Statements.

Also, see Audit Documentation: Peer Review Finding

SSARS 25
Jan 21

SSARS 25: Materiality and Adverse Conclusions

By Charles Hall | Accounting and Auditing , Preparation, Compilation & Review

The AICPA has issued SSARS 25. It is titled Materiality in a Review of Financial Statements and Adverse Conclusions. Below I tell you how this standard affects your future review engagements.

Materiality in Review Engagements

Until SSARS 25, there was no requirement for you to document materiality in review engagements. Some firms, like my own, decided to do so any way. Others have not. Now, there's no choice. SSARS 25 explicitly requires that we determine and use materiality.

Makes sense. The accountant's conclusion says we are not aware of any material modifications that should be made. The conclusion paragraph follows:

Accountant's Conclusion
Based on our review, we are not aware of any material modifications that should be made to the accompanying financial statements in order for them to be in accordance with accounting principles generally accepted in the United States of America. 

It would be difficult to plan or conclude a review engagement without knowing what materiality is. SSARS 25 requires that we design and perform analytical procedures and inquiries to address all material items in the financial statements. This includes disclosures.

New Inquiry Requirements

SSARS 25 adds new inquiries of management including:

  • Material commitments, contractual obligations, or contingencies
  • Material nonmonetary transactions
  • Significant changes in the business activities or operations
  • Significant changes to the terms of contracts that materially affect the financial statements
  • Significant journal entries
  • Status of any uncorrected misstatements from the previous review engagement
  • How management determined that significant estimates are reasonable
  • Management's assessment of the entity's ability to continue as a going concern, and whether there are conditions that cast doubt about the entity's ability to continue as a going concern

Related Party Transactions

Additionally, SSARS 25 requires that the accountant remain alert for related party transactions that were not disclosed by management. The accountant should inquire of management about transactions outside the normal course of business. You want to know if related party transactions are being used to make the financial statements look better than they really are. 

Next, you will see that the standard now permits adverse conclusions.

Adverse Conclusions in Review Engagements

In the past, adverse conclusions in a review engagement were not allowed. SSARS 25 changes this. If the financial statements are materially and pervasively misstated, you can issue an adverse conclusion.

SSARS 25 provides an illustrative accountant's review report with an adverse conclusion. (See illustration 7 on pages 85 and 86 of SSARS 25.) That example states the financial statements are not in accordance with accounting principles generally accepted in the United States of America.

Here's the adverse review report conclusion:

Adverse Conclusion
Based on my (our) review, due to the significance of the matter described in the Basis for Adverse Conclusion paragraph, the financial statements are not in accordance with accounting principles generally accepted in the United States of America.

One more thing, SSARS 25 requires a statement in the review report regarding independence.

SSARS 25

Independence in Review Reports

Independence is still required to perform a review engagement. What is different, however, is the accountant must include a statement in the review report saying he or she is independent. That phrase, to be included in the Accountant's Responsibility section of the report, reads as follows:

We are required to be independent of ABC Company and to meet our other ethical responsibilities, in accordance with the relevant ethical requirements related to our review.

See examples of the independence wording in the illustrative reports in SSARS 25. Those reports start on page 75 of the standard.

So when is SSARS 25 effective?

SSARS 25 Effective Date 

The effective date for SSARS 25 is for periods ending on or after December 15, 2021. Early implementation is permitted.

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