Category Archives for "Accounting and Auditing"

Funded Depreciation: Becoming More Profitable

By Charles Hall | Accounting and Auditing , Local Governments

From time to time, I have clients ask me “What is funded depreciation?” And more importantly, they ask, “How can this technique make my organization more profitable and less stressful?”

Here’s a simple explanation.

Funded depreciation is the setting aside of cash in amounts equal to an organization’s annual depreciation. The purpose: to fund future purchases of capital assets with cash.

Funded Depreciation

Suppose you buy a $10,000 whiz-bang gizmo—a piece of equipment—that you expect to use for ten years, and at the end of the ten years you expect it to have no value. Your annual depreciation is $1,000.

In this example, a $1,000 depreciation expense is recognized annually on your income statement (depreciation decreases net income) even though no cash outlay occurs. The balance sheet includes the cost of the whiz-bang gizmo, but at the end of ten years, the equipment has a $0 book value, being fully depreciated.

The smart manager will annually set aside $1,000 in a safe investment—such as a certificate of deposit or money market account—for the future replacement of the whiz-bang gizmo.

If the company does not annually invest the $1,000, it has a few options at the end of the ten-year period:

• Borrow the full amount for the replacement cost
• Seek outside funding (e.g., grants)
• Use other funds from within the organization
• Lease the equipment
• Ask U2 to do a special benefits concert—just kidding

Obviously, if you borrow money to replace the equipment, you will have to pay interest—another cash outlay. Suppose the rate is 10%. Now the organization must pay out $1,100 each year. So, if the organization funds the depreciation (invests $1,000 annually), it earns interest. But if the entity chooses not to fund depreciation, it pays interest.

Businesses that fund depreciation are always making money from interest (granted not much these days) rather than paying for it.

Another advantage to funding depreciation: you know you will have the money to purchase the capital asset. You’re not concerned with whether a creditor will lend you the money for the acquisition. You’re financially stronger.

Why Doesn’t Every Entity Fund Depreciation?

So why doesn’t everyone fund depreciation?

• Some don’t understand the concept
• Some had rather spend the cash flows for the ten years (e.g., owners taking too much in distributions)
• Some need the money just to run the organization
• In governments, elected officials desire to keep tax rates low while they are in office
• In growing businesses, the owners may need the money to fund the growth of the company
• Most importantly, it may require two cash payments 

Concerning the last point, if the business had to borrow money to purchase the initial capital asset, then it must make debt service payments (cash outlay 1). If the company also funds depreciation for that same asset (making investments equal to the annual depreciation), another cash flow occurs (cash outlay 2). Nevertheless, if the business can ever get into a position where it pays cash for new equipment, it will be better off. Then only one cash outlay (investment funding) occurs, and the company is making–not paying–interest.

What if the organization cannot–due to cash flow constraints–fund depreciation for all new equipment purchases? Consider doing so for just one or two pieces of equipment–over time, the entity may be able to move into a fully funded position.

Who Should Fund Depreciation?

So, who should fund depreciation?

Organizations with sufficient cash flow and discipline. It’s the smart thing to do.

Imagine a world with no debt, a world where you don’t have to wonder how you will pay for equipment. Dreaming? Maybe, but funded depreciation is worth your consideration.

See my article Auditing Plant, Property, and Equipment. 

Audit Planning: Develop Your Audit Plan and Strategy

By Charles Hall | Auditing

This article teaches you how to develop your audit plan and strategy. Once you complete your risk assessment, it’s time to build these critical pieces of your audit engagement. 

Effectiveness and efficiently are both possible with a good audit plan. Below I explain how to do this. Additionally, we’ll also take a look at three common mistakes made in planning. See if you make any of these. 

To be in compliance with audit standards, we need to develop:

• Our audit strategy
• Our audit plan

Developing Your Audit Strategy

What’s in the audit strategy? AU-C 300, Planning an Audit, states that the audit strategy should include the following:

• The characteristics of the engagement (these define its scope)
• The reporting objectives (these affect the timing of the audit and the nature of the reports to be provided)
• The significant factors (these determine what the audit team will do)
• The results of preliminary engagement activities (these inform the auditor’s actions)
• Whether knowledge gained on other engagements is relevant (these potentially provide additional insight)

Think of the audit strategy as the big picture.

We are documenting:

• The scope (the boundaries of the work)
• The objectives (what the deliverables are) 
• The significant factors (e.g., is this a new or complex entity?)
• The risk assessment (what are the risk areas?)
• The planned resources (e.g., the engagement team) 

Much can be achieved with the right strategy—even walking on the moon.

Strategy for Walking on the Moon

When NASA planned to put a man on the moon, a strategy was created. It could have read as follows:

We will put a man on the moon. The significant factors of our mission include mathematical computations, gravitational pull, thrust, and mechanics. The risks include threats to our astronauts’ lives, so we need to provide sufficient food, air, sound communications, and a safe vessel. The deliverable will be the placement of one man on the moon and the safe return of our three astronauts. The engagement team will include three astronauts, launch personnel at Kennedy Space Center, and mission-control employees in Houston, Texas. 

A sound strategy led to Neil Armstrong’s historic walk on July 20, 1969.

Our audit strategy—in a more pedestrian pursuit—is a summary of objectives, resources, and risk. It’s the big picture. Our strategy leads to the successful issuance of our audit opinion (not quite as exciting as walking on the moon, but still important).

What’s in an Audit Strategy?

The audit strategy doesn’t have to be complicated or long, especially for smaller entities—it can be a short memo. What are we after? A summary of risks, needed resources, and objectives.

My firm uses an internally-developed strategy form—mainly, to ensure consistency. The form contains structure, such as references to risk assessment work and blank boxes in certain areas—such as partner directions—so it is flexible. As a result, the form has structure and flexibility.

Here are the main areas we cover:

• Deliverables and deadlines
• A time budget
• The audit team
• Key client contacts
• New accounting standards affecting the audit
• Problems encountered in the prior year 
• Anticipated challenges in the current year 
• Partner directions regarding key risk areas
• References to work papers addressing risk

Who Creates the Audit Strategy?

Who should create the strategy? The in-charge can create it with the assistance of the engagement partner, or the partner can do so. 

Audit Strategy as the Central Document

If you want to see one document that summarizes the entire audit, this is it. As you can see, the strategy is general in nature, but you also need a detailed plan to satisfy the demands of the strategy—this is the audit plan (commonly referred to as the audit program). NASA had a mission statement for Apollo 11, but—I’m sure—written guidelines directed the step-by-step execution of the project. 

Audit Plan (or Audit Program)

Now we create the detailed planning steps—the audit program. Think of the audit program as the final stage of audit planning. What have we done to get to this stage of the audit? 

1. Performed risk assessment procedures
2. Developed our audit strategy

Now it’s time to create the audit plan.

The audit plan is the linkage between planning and further audit procedures. What are “further audit procedures”? They are the tactical steps to address risk including substantive procedures and test of controls. The audit program links back to the identified risks and points forward to the substantive procedures and test of controls. Substantive procedures include tests of details and substantive analytical procedures.

Creating the Audit Program

How—in a practical sense—do we create the audit programs? Most auditors tailor the prior year audit programs. That works—as long as we revise them to address the current year risks. Audit programs are not—at least, they should not be—static documents. Even so, the current year audit program can be the same as last year—as long as the risks are the same.

Sufficient Audit Steps

How do we know if we have adequate audit program steps? Look at your risks of material misstatement (RMM)—which, hopefully, are assessed at the assertion level (e.g., completeness). Audit steps should address all high and moderate RMMs. 

Integrating Risk Assessment with the Audit Program

How else can we integrate our documentation? Put the relevant assertions next to each audit step—this makes the connections between the RMMs (at the assertion level) and the audit steps clear.

AU-C 330 says the auditor is required to apply substantive procedures to all relevant assertions related to each material class of transactions, account balance, and disclosure. So, the audit program should reflect steps for all material areas.

Creating Efficiency in the Audit Plan

Once you complete your risk assessment work, you want to ask, “Which is the more efficient route? Testing controls or performing substantive procedures.” Then go with your instincts. 

Generally, I assess control risk at high. While we can’t default to a high control, we can—once the risk assessment work is complete—decide to assess control risk at high as an efficiency measure. Why? If we assess control risk at below high, we must test the controls as a basis for the lower risk assessment. The testing of controls can—sometimes—take longer than substantive procedures. 

For example, is it better to test the controls related to fixed asset additions or is it more efficient to vouch the invoices for significant additions? Usually, the vouching of the invoices will get you to your desired destination quicker than testing controls. Generally—at least in my opinion—this line of reasoning is less true for more complex organizations. Larger organizations process more transactions and tend to have better controls. So it can be better to test controls for larger entities.

There you have it—the creation of the audit strategy and the audit plan. Your strategy includes the risks, needed resources, and objectives. And your audit program contains the tactical steps to address risks. You are set to go. 

I find that auditors usually understand the above, but still make one of the following three audit planning mistakes. 

Three Mistakes in Audit Planning

Auditors make three common planning mistakes: (1) not tailoring audit programs and (2) allowing prior year work papers to drive the audit process, and (3) using a balance sheet audit approach. Let’s see how these happen.

1. Not Tailoring Audit Programs

Where do most audit programs come from? They are purchased from forms providers, usually international publishing companies. These purchased programs are useful, but they can become a crutch, leading to canned audit approaches that are not responsive to risks. 

If we use unrevised audit programs and if our audit approach is always the same, what good is risk assessment? Another way to say this is, If audit programs never change, why perform walkthroughs, preliminary analytics, and other risk assessment procedures? 

Canned audit programs are one reason auditors give lip-service to risk assessment. In the auditor’s mind, he may be thinking, I already know what I’m going to do, so why waste time with risk assessment? This cookie-cutter approach is dangerous, but quite common. And why is it dangerous? Because it can lead to an intentional blindness toward internal controls and significant risks. And deficiencies in risk assessment lead to deficiencies in audit procedures. The result: material misstatements are not identified and an unmodified audit opinion is rendered. In other words, audit failure occurs.

Audit programs can be tailored: steps can be added, changed, or deleted. These steps can be amended based on the risk of material misstatement. But some auditors don’t change their audit plan. 

And not tailoring audit programs can lead to several problems such as:

• Audit team members signing off on steps not performed 
• Team members typing Not Applicable (N/A) next to several audit steps 
• Auditors performing unnecessary procedures 
• Auditors not performing necessary procedures 

In addition to not tailoring audit programs, some auditors hit autopilot and use their prior year work papers as their current year plan. 

2. Prior Year Work Papers as the Audit Plan

Audit documentation should develop sequentially:

1. Risk assessment
2. Audit programs
3. Audit work papers 

But poor auditors tend to follow the prior year work papers and complete the audit program as an afterthought. Worse yet, the risk assessment work is completed at the end of the engagement, if at all. The tail wags the dog. This same-as-last-year approach leads to incongruities in risks of material misstatement and the procedures performed. In effect, the prior year work papers become the current year audit program. 

Another common audit planning mistake is the use of a balance sheet audit approach. 

3. Balance Sheet Audit Approach

Many auditors use a fully substantive approach, meaning they don’t test controls for effectiveness. Moreover, some auditors test balance sheet accounts and little else. But this approach can lead to problems.

I have heard auditors say: If I audit all of the balance sheet accounts, then the only thing that can be wrong is the composition of revenues and expenses. But is this true?

The accounting equation says:

Totals assets = Total liabilities plus Total equity

Another way to say this is:

Total equity = Total assets minus Total liabilities

If we disregard stock purchases and sales, equity is usually the accumulation of retained earnings. And retained earnings comes from the earnings or losses on the income statement. In other words, retained earnings comes from revenues and expenses. So the net income or loss (revenues minus expenses) has to fit into the accounting equation (equity equals assets minus liabilities).

Therefore, if we audit all assets and liability accounts, doesn’t it make sense that the only thing that can be wrong is the composition of revenues and expenses? Mathematically I see why someone might say this, but a flaw lurks in the construct. 

Audit Failure Example

I once saw an audit firm sued for several million dollars. The CPAs audited the company for several years, issuing an unqualified opinion each year, but a theft was occurring all along.

So what were the audit firm’s mistakes? They relied too heavily upon a balance sheet audit approach, and they did not gain an understanding of the company’s key internal controls. 

The auditors used substantive procedures such as:

• Testing bank reconciliations
• Sending receivable confirmations and vouching subsequent collections
• Computing annual depreciation and agreeing it to the general ledger
• Vouching additions to plant, property, and equipment
• Performing a search for unrecorded liabilities in payables
• Confirming debt

The balance sheet accounts reconciled to the general ledger, and no problems were noted in the audit of the balance sheet accounts. But millions were missing. 

So what flaw lies in a balance sheet audit approach? Millions can go missing while the balance sheet accounts reconcile to the general ledger. Consequently, auditing the balance sheet accounts alone may not detect theft. Therefore, gaining an understanding of the internal controls and developing appropriate responses is critical to identifying material misstatements, especially when fraud is possible. 

So as we plan our substantive procedures, we need to avoid the flawed balance sheet approach. Yes, substantive procedures for the balance sheet accounts are important, but fraud detection procedures are necessary when control weaknesses are present. A test of details is necessary when a significant risk (such as a fraud risk) is present. 

In Summary

Develop an audit strategy and plan once you complete your risk assessments procedures. Then link the risks of material misstatement to your further audit procedures. Doing so will help ensure that your audit is successful. In other words, that no material misstatements are present when you issue an unmodified opinion. 

Moreover, don’t make these three audit planning mistakes: (1) not tailoring audit programs and (2) allowing prior year work papers to drive the audit process, and (3) using a balance sheet audit approach.

See my audit series The Why and How of Auditing to learn even more about the full audit process, including how to audit transaction cycles such as cash, receivables, payables, and debt. 

Special Purpose Reporting Frameworks

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

In this article, I provide information about various special purpose reporting frameworks (e.g., cash basis, modified-cash basis, and income tax basis) and how you can use them to create financial statements for your clients. 

Suppose you’ve been contacted by your client to prepare their financial statements and issue a compilation report. At first, you think, I’ll create the financials in accordance with GAAP, but then you remember there are special purpose reporting frameworks. Maybe the cash basis or income tax basis is a better option.

Continue reading

Audit Assertions in Financial Statement Audits

By Charles Hall | Auditing

Audit and Work Paper Mistakes: A List of 40

By Charles Hall | Auditing

Today, I offer you a list of forty audit and work paper mistakes.

The list is based on my observations from over over thirty-five years of audit reviews (and not on any type of formal study).

You will, however, shake your head in agreement as you read these. I know you’ve seen them as well. The list is not comprehensive. So, you can add others in the comments section of this post.

Here’s the list.

1. No preparer sign-off on a work paper
2. No evidence of work paper reviews
3. Placing unnecessary documents in the file (the work paper provides no evidential matter for the audit)
4. Signing off on unperformed audit program steps
5. No references to supporting documentation in the audit program
6. Using canned audit programs that aren’t based on risk assessments for the particular entity
7. Not documenting expectations for planning analytics
8. Inadequate explanations for variances in planning analytics (“revenue went up because sales increased”)
9. Planning analytics with obvious risk of material misstatement indicators, but no change in the audit plan to address the risk (sometimes referred to as linkage)
10. Not documenting who inquiries were made of
11. Not documenting when inquiries were made
12. Significant deficiencies or material weaknesses that are not communicated in written form
13. Verbally communicating control deficiencies (those not significant deficiencies or material weaknesses) without documenting the conversation
14. Performing needed substantive tests with no related audit program steps (i.e., the audit program was not amended to include the necessary procedures)
15. Assessing control risk below high without testing controls
16. Assessing the risk of material misstatement at low without a basis (reason) for doing so
17. Documenting significant risks (e.g., allowance for uncollectible receivable estimates in healthcare entities) but no high inherent risks (when inherent risk are separately documented)
18. Not documenting the predecessor auditor communication in a first-year engagement
19. Not documenting the qualifications and objectivity of a specialist
20. Not documenting all nonattest services provided
21. Not documenting independence
22. Not documenting the continuance decision before an audit is started
23. Performing walkthroughs at the end of an engagement rather than the beginning
24. Not performing walkthroughs or any other risk assessment procedures
25. Not performing risk assessment procedures for all significant transaction areas (e.g., risk assessment procedures performed for billing and collections but not for payroll which was significant)
26. Not retaining the support for opinion wording in the file (especially for modifications)
27. Specific items tested are not identified (e.g., “tested 25 disbursements, comparing amounts in the check register to cleared checks” — we don’t know which particular payments were tested)
28. Making general statements that can’t be re-performed based on the information provided (e.g., “inquired of three employees about potential fraud” — we don’t know who was interviewed or what was asked or their responses)
29. Retrospective reviews of estimates are not performed (as a risk assessment procedure)
30. Going concern indicators are present but no documentation regarding substantial doubt
31. IT controls are not documented
32. The representation letter is dated prior to final file reviews by the engagement partner or a quality control partner
33. Consultations with external or internal experts are not documented
34. No purpose or conclusion statement on key work papers

35. Tickmarks are not defined (at all)

36. Inadequately defining tickmarks (e.g., ## Tested) — we don’t know what was done

37. No group audit documentation though a subsidiary is included in the consolidated financial statements

38. No elements of unpredictability were performed

39. Not inquiring of those charged with governance about fraud

40. Not locking the file down within 60 days 

That’s my list of audit and workpaper mistakes. What would you add?

Even if you do all of these, have you documented them properly? See my article If It’s Not Documented, It’s Not Done.