The Western District of North Carolina U.S. Attorney’s Office issued a press release on June 17, 2013, detailing how James Shepherd, an investment company owner, defrauded over 100 investors of approximately $6 million. How? By misusing funds and tricking his company’s external auditors with fake bank confirmation responses.
Hiding Theft with Fake Bank Confirmation Responses
The press release states, “Documents indicate that Shepherd built a $2 million residence in Vass, North Carolina, and used investor money to make mortgage payments on the residence.” The U.S. Attorney’s Office said, “For seven years Shepherd used his investment fund as his personal piggy bank and repeatedly lied to his investors who trusted him with their savings.” The release goes on to say the fraud was concealed as “Shepherd sent to investors certified financial statements…accompanied by an Independent Auditor’s Report.” The fraudulent December 31, 2012, financial statement reflected a $6,041,850 cash balance when in reality the fund had less than $100,000. So, how was Shepherd able to get an independent auditor’s report based on fraudulent numbers?
The auditor sent bank confirmations to a P.O. Box address provided by Shepherd. Additionally, the confirmations were sent to the attention of a “Charles Fisher,” a fictitious bank employee.
And who controlled the P.O. Box? Mr. Shepherd.
According to the U.S. Attorney’s Office, Shepherd would receive the bank confirmations, “forge the name Fisher on a fake bank letter” and “send forged bank statements with fake balances” to the auditor. The responses came in the form of both letters and faxes.
So, how were the forged bank statements created? The press release stated that “Shepherd generated the fraudulent bank statements using a version of Adobe Acrobat that enabled him to type false numbers over true bank statements.”
Given the false bank confirmations, how was Mr. Shepherd ever caught? In March 2013 the auditors “insisted on verifying the cash balance of funds’ bank account electronically through the audit confirmation website www.confirmation.com.” Shepherd then refused to give the accountant authority to utilize the site to verify the cash balance.After that, the auditor notified the National Futures Association that his audit opinion could no longer be relied upon.
Given this cautionary tale, how can auditors combat the threat of false bank contact information?
Designing Confirmations
A while back, my friend James Ulvog brought to my attention the following clarified auditing section about confirmations.
AU-C Section 505.A7 states:
Determining that requests are properly addressed includes verifying the accuracy of the addresses, including testing the validity of some or all of the addresses on the confirmation requests before they are sent out, regardless of the confirmation method used. When a confirmation request is sent by e-mail, the auditor’s determination that the request is being properly directed to the appropriate confirming party may include performing procedures to test the validity of some or all of the e-mail addresses supplied by management.
Auditors often confirm bank accounts using:
Letters
Emails
Regardless of how an account is confirmed, auditors need to verify the contact information provided by the auditee–at least for some of the confirmations.
Bottom line
Audit standards require that steps be taken to ensure that confirmations are sent to the appropriate persons.
Using Confirmation.com reduces risk related to faulty confirmations. If you don’t use Confirmation.com, then consider checking street addresses by Googling them, or you might call the confirming party–especially for high-risk accounts.
The procedures used to verify mailing addresses, fax numbers, and email addresses should be documented in the auditor’s work papers.
Postscript
On February 11, 2015, Mr. Shepherd was sentenced to 84 months in prison and three years of supervised release. Shepherd pleaded guilty to one count of securities fraud in June 2013.
Do you know how to assess inherent risk? Knowing when this risk is low is a key to efficient audits. In this article, I tell you how to assess inherent risk--and how lower risk assessments (potentially) decrease the amount of work you perform.
While audit standards don't require a separate assessment on inherent risk (IR) and control risk (CR), it's wise to do so. Why? So you know what drives the risk of material misstatement (RMM).
Many auditors assess control risk at high (after performing their risk assessment procedures). Why? So they don't have to test controls.
If control risk is high, then inherent risk is the only factor that can lower your risk of material misstatement. For example, a high control risk and a low inherent risk results in a moderate risk of material misstatement. Why is this important? Lower RMMs provide the basis for less substantive work.
The Audit Risk Model
Before we delve deeper into inherent risk assessment, let's do a quick review of the audit risk model. Auditing standards (AU-C 200.14) define audit risk as “The risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. Audit risk is a function of the risks of material misstatement and detection risk.”
Audit risk is defined as follows:
Audit Risk = IR X CR X Detection Risk
Inherent risk and control risk live within the entity to be audited.
Detection risk lies with the auditor.
A material misstatement may develop within the company because the transaction is risky or complex. Then, controls may not be sufficient to detect and correct the misstatement.
If the auditor fails to detect the material misstatement, audit failure occurs. The auditor issues an unmodified opinion when a material misstatement is present.
If the RMM is high, more substantive work is needed. Why? To reduce detection risk.
But if the RMM is low to moderate, less substantive work is needed.
Inherent Risk Definition
What is inherent risk? The susceptibility of an assertion about a class of transaction, account balance, or disclosure to a misstatement that could be material, either individually or when aggregated with other misstatements, before consideration of any related controls.
Examples
The risk for cash is greater than that of a building. Cash is easily stolen. Buildings are not.
The risk of a hedge transaction is greater than that of a trade receivable. Hedges can be complicated to compute. Trade receivables are not.
Post-retirement liabilities are inherently risky. Why? It's a complex accounting area. The numbers usually come from an actuary. There are estimates in the form of assumptions.
Inherent Risk Factors
Consider factors such as the following in assessing risk:
Susceptibility to theft or fraudulent reporting
Complex accounting or calculations
Accounting personnel’s knowledge and experience
Need for judgment
Difficulty in creating disclosures
Size and volume of accounts balance or transactions
Susceptibility to obsolescence
Prior year period adjustments
Inherent risk is not an average of the above factors. Just one risk factor can make an account balance or transaction cycle or disclosure high risk.
Inherent Risk at Less Than High
When inherent risk is less than high, you can perform fewer or less rigorous substantive procedures.
An example of a low inherent risk is the existence assertion for payables. If experienced payables personnel accrue payables, then the existence assertion might be assessed at low. (The directional risk of payables is an understatement, not an overstatement.) The lower risk assessment for existence allows the auditor to perform little if any procedures in relation to this assertion.
Conversely, the completeness assertion for accounts payable is commonly a high inherent risk. Businesses can inflate their profits by accruing fewer payables. Fraudulent reporting of period-end payables is possible. Therefore, the risk of completeness for payables is often high. That's why auditors perform a search for unrecorded liabilities.
Base your risk assessment on factors such as those listed above. If inherent risk is legitimately low, then great. You can perform less substantive work. But if the assertion is high risk, then it should be assessed accordingly--even if that means more work. (The AICPA has included questions in peer review checklists regarding the basis for lower risk assessments. Their concern (I think) is that auditors might manipulate this risk in order to perform less work. I've heard no one from the AICPA say this. But I can see how they might be concerned about this possibility.)
Control Risk
So, what is the relationship between inherent risk and control risk?
Companies develop internal controls to manage areas that are inherently risky.
A business might create internal controls to lessen the risk that payables are understated. Examples of such controls include:
The CFO reviews the payables detail at period-end, inquiring about the completeness of the list
A payables supervisor reviews all invoices entered into the payables system
The payables supervisor inquires of all payables clerks about any unprocessed invoices at period-end
A budget to actual report is provided to department heads for review
Inherent risk exists independent of internal controls.
Control risk exists when the design or operation of a control does not remove the risk of misstatement.
Audit Risk Assessment Book
My new book, Audit Risk Assessment Made Easy, is now available on Amazon. If you struggle with internal control walkthroughs, preliminary analytics, understanding the entity and its environment, risk assessment and linkage, then this book is for you. Click the book cover to see it now on Amazon.
This video provides an overview of the four opinions:
Unmodified Opinion
If there are no material misstatements, then you will issue an unmodified opinion. The unmodified opinion says the financial statements are presented fairly.
Example SAS 134 Unmodified Opinion
A sample unmodified audit opinion follows:
[Date]
INDEPENDENT AUDITOR’S REPORT
[Appropriate Addressee]
[Entity Name]
Opinion
We have audited the financial statements of [Entity Name], which comprise the balance sheets as of December 31, 2020 and 2019, and the related statements of income, changes in stockholders’ equity, and cash flows for the years then ended, and the related notes to the financial statements.
In our opinion, the accompanying financial statements present fairly, in all material respects, the financial position of [Entity Name] as of December 31, 2020 and 2019, and the results of its operations and its cash flows for the year then ended in accordance with accounting principles generally accepted in the United States of America.
Basis for Opinion
We conducted our audits in accordance with auditing standards generally accepted in the United States of America (GAAS). Our responsibilities under those standards are further described in the Auditor’s Responsibilities for the Audit of the Financial Statements section of our report. We are required to be independent of [Entity Name] and to meet our other ethical responsibilities, in accordance with the relevant ethical requirements relating to our audit. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion.
Responsibilities of Management for the Financial Statements
Management is responsible for the preparation and fair presentation of the financial statements in accordance with accounting principles generally accepted in the United States of America, and for the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error.
In preparing the financial statements, management is required to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about [Entity Name]’s ability to continue as a going concern for one year after the date that the financial statements are available to be issued.
Auditor’s Responsibilities for the Audit of the Financial Statements
Our objectives are to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, and to issue an auditor’s report that includes our opinion. Reasonable assurance is a high level of assurance but is not absolute assurance and therefore is not a guarantee that an audit conducted in accordance with GAAS will always detect a material misstatement when it exists. The risk of not detecting a material misstatement resulting from fraud is higher than for one resulting from error, as fraud may involve collusion, forgery, intentional omissions, misrepresentations, or the override of internal control. Misstatements are considered material if there is a substantial likelihood that, individually or in the aggregate, they would influence the judgment made by a reasonable user based on the financial statements.
In performing an audit in accordance with GAAS, we:
Exercise professional judgment and maintain professional skepticism throughout the audit.
Identify and assess the risks of material misstatement of the financial statements, whether due to fraud or error, and design and perform audit procedures responsive to those risks. Such procedures include examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements.
Obtain an understanding of internal control relevant to the audit in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of [Entity Name]’s internal control. Accordingly, no such opinion is expressed.
Evaluate the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluate the overall presentation of the financial statements.
Conclude whether, in our judgment, there are conditions or events, considered in the aggregate, that raise substantial doubt about [Entity Name]’s ability to continue as a going concern for a reasonable period of time.
We are required to communicate with those charged with governance regarding, among other matters, the planned scope and timing of the audit, significant audit findings, and certain internal control-related matters that we identified during the audit.
Firm Signature
Modified Opinions
If material misstatements are present, then a modified audit opinion is necessary. Modifications can also occur when you are unable to obtain sufficient appropriate audit evidence; for instance, when a scope limitation is present.
Definitions
AU-C 705 defines a modified opinion as a (1) qualified opinion, (2) an adverse opinion, or (3) a disclaimer of opinion.
Another key definition in AU-C 705 is that of pervasiveness. This term is used in the context of misstatements; so if a material misstatements are present, you’ll want to know if they are pervasive. Two factors–material misstatements and pervasiveness–affect the type of opinion to be issued. Additionally, the ability or inability to obtain sufficient appropriate audit evidence affects the type of opinion to be issued. A misstatement (or possible misstatement) is pervasive if:
It’s not confined to specific accounts or items of the financial statement, or
If confined, the amount represents a substantial portion of the financial statements, or
If in relation to disclosures, the information is fundamental to the users’ understanding of the financial statements
For example, if material misstatements are present for inventory, receivables, and debt, they are pervasive. Or if, in another example, inventory makes up 60% of total assets and a material misstatement is present in that area, then it’s pervasive. Lastly, if key disclosures are not appropriately communicated or if they are omitted, then that is pervasive.
Now, let’s look at the three modified opinions.
1. Qualified Opinion
Suppose your audit reveals inventories are materially misstated, the client does not record your proposed audit adjustment, and there are no other material misstatements. If this is your situation (a material misstatement exists that is not pervasive), then audit standards allow for the issuance of a qualified opinion.
Here is sample qualified opinion language (this is not the full opinion):
Qualified Opinion
We have audited the financial statements of ABC Company, which comprise the balance sheets as of December 31, 20X1 and 20X0, and the related statements of income, changes in stockholders’ equity, and cash flows for the years then ended, and the related notes to the financial statements.
In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion section of our report, the accompanying financial statements present fairly, in all material respects, the financial position of ABC Company as of December 31, 20X1 and 20X0, and the results of its operations and its cash flows for the years then ended in accordance with accounting principles generally accepted in the United States of America.
Basis for Qualified Opinion
The Company has property with impaired value. The impairment occurred in 20X9. Accounting principles generally accepted in the United States of America require that impaired assets be written down to their fair market value. The Company continues to reflect the property at cost. If the property was stated at fair value upon impairment, total assets and stockholder’s equity would have been reduced by $X,XXX,XXX as of December 31, 20X1 and 20X0, respectively.
2. Adverse Opinion
Now let’s suppose that you are auditing a consolidated entity, and your client is not willingto include a material subsidiary and which, if included, would have a pervasive impact on the statements.
Here is sample adverse opinion language (this is not the full opinion):
Adverse Opinion
We have audited the consolidated financial statements of ABC Company and its subsidiaries, which comprise the consolidated balance sheet as of December 31, 20X1, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for the year then ended, and the related notes to the financial statements.
In our opinion, because of the significance of the matter discussed in the Basis for Adverse Opinion section of our report, the accompanying consolidated financial statements do not present fairly the financial position of ABC Company and its subsidiaries as of December 31, 20X1, or the results of their operations or their cash flows for the year then ended in accordance with accounting principles generally accepted in the United States of America.
Basis for Adverse Opinion
As described in Note X, The Golfing Company has not consolidated the financial statements of its subsidiary Easy-Go Company that it acquired during 20X1. This investment is accounted for on a cost basis by The Golfing Company. Under accounting principles generally accepted in the United States of America, the subsidiary should have been consolidated. Had Easy-Go Company been consolidated, many elements in the accompanying consolidated financial statements would have been materially affected. The effects on the consolidated financial statements of the failure to consolidate have not been determined.
3. Disclaimer of Opinion
Finally, let’s suppose you are performing an audit in which insufficient audit information is provided with regard to receivables and inventories (both of which are material) and that the misstatements have a pervasive impact on the financial statements as a whole.
Here is sample disclaimer of opinion language (this is not the full opinion):
Disclaimer of Opinion
We were engaged to audit the financial statements of ABC Company, which comprise the balance sheet as of December 31, 20X1, and the related statements of income, changes in stockholders’ equity, and cash flows for the year then ended, and the related notes to the financial statements.
We do not express an opinionon the accompanying financial statements of ABC Company. Because of the significance of the matters described in the Basis for Disclaimer of Opinion section of our report, we have not been able to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion on these financial statements.
Basis for Disclaimer of Opinion
The Company’s accounting system was hacked during the year by an unknown party, resulting in a series of changes in accounting entries. Additionally, the Company was unable to restore the accounting system. As a result of these matters, we were unable to determine the adjustments that were necessary to correct the balance sheet, statement of income, changes in stockholder’s equity, and cash flow statement as of and for the year ended December 31, 20X1.
Effective Date of SAS 134
The new SAS 134 opinions are required for periods ending on or after December 15, 2021.
Resolving Conflict with Clients
If, as described above, you have a client that is unwilling to post a material audit adjustment, consider creating a draft of the opinion and providing it to them. This is not a threat, just a way to clearly communicate the effect of not posting the adjustment.
Before doing anything, allow the client to fully explain their position. A modified opinion may not be necessary once you understand the facts. But if after the discussion, the you are still convinced there is a material misstatement, a modified opinion may be necessary.
In some cases, you may want to consider withdrawing from the engagement. Consult with your legal counsel before doing so.
Audit Opinion Research
Deciding on the opinion is often the most important decision you will make in an audit. So, do your research, and, if needed, consult with others to gain assurance about your decisions. AU-C 705: Modifications to the Opinion in the Independent Auditor’s Report provides several sample opinions; so refer to those as you create any modified opinions including qualified, adverse, or disclaimer. See AU-C 700: Forming an Opinion and Reporting on Financial Statements for information about unmodified opinions.
Peer reviewers are saying, “If it’s not documented, it’s not done.” Why? Because standards requiresufficient audit documentation in AU-C 230. And if it’s not documented, the peer reviewer can’t give credit. Work papers are your vehicle of communication.
But what does sufficient documentation mean? What should be in our work papers? How much is necessary? This article answers these questions.
Insufficient Audit Documentation
Insufficient audit documentation has been and continues to be a hot-button peer review issue. And it’s not going away.
But auditors ask, “What is sufficient documentation?” That’s the problem, isn’t it? The answer is not black and white. We know good documentation when we see it–and poor as well. It’s the middle that is fuzzy. Too often audit files are poor-to-midland. But why?
First, many times it boils down to profit. Auditors can make more money by doing less work. So, let’s go ahead and state the obvious: Quality documentation takes more time and may lessen profit. But what’s the other choice? Poor work.
Second, the auditor may not understand what the audit requirements are. So, in this case, it’s not motive (make more money), it’s a lack of understanding.
Thirdly, another contributing factor is that firms often bid for work–and low price usually carries the day. Then, when it’s time to do the work, there’s not enough budget (time)–and quality suffers. Corners are cut. Planning is disregarded. Confirmations, walkthroughs, fraud inquiries are omitted. And yes, it’s easier–at least in the short run.
But we all know that qualityis the foundation of every good CPA firm. And work papers tell the story–the real story–about a firm’s character. How would you rate your work paper quality? Is it excellent, average, poor? If you put your last audit file on a website and everyone could see it, would you be proud? Or does it need improvement?
Sufficient Audit Documentation According to AU-C 230
Let’s see what constitutes sufficient documentation.
AU-C 230Audit Documentation defines how auditors are to create audit evidence. It says that an experienced auditor with no connection to the audit should understand:
Nature, timing, and extent of procedures performed
Results and evidence obtained
Significant findings, issues, and professional judgments
While most auditors are familiar with this requirement, the difficulty lies in how to accomplish this. What does it look like? Here are some pointers for complying with AU-C 230.
Experienced Auditor’s Understanding
Here’s the key: When an experienced auditor reviews the documentation, does she understand the work?
Any good communicator makes it her job to speak or write in an understandable way. The communicator assumes responsibility for clear messages. In creating work papers, we are the communicators. The responsibility for transmitting messages lies with us (the auditors creating work papers).
A Fog in the Work Papers
So what creates fogginess in work papers? We forget we have an audience.Others will review the audit documentation to understand what was done. As we prepare work papers, we need to think about those who will see our work. All too often, the person creating a work paper understands what he is doing, but the reviewer doesn’t. Why? The message is not clear.
Just because I know why I am doing something does not mean that someone else will. So how can we create clarity?
Creating Clarity
Work papers should include the following:
A purpose statement (what is the reason for the work paper?)
The source of the information (who provided it? where did they obtain it and how?)
An identification of who prepared and reviewed the work paper
The audit evidence (what was done)
A conclusion (does the audit evidence support the purpose of the work paper?)
When I make these suggestions, some auditors push back saying, “We’ve already documented some of this information in the audit program.” That may be true, but I am telling you–after reviewing thousands of audit files–the message (what is being done and why) can get lost in the audit program. The reviewer often has a difficult time tieing the work back to the audit program and understanding its purpose and whether the documentation provides sufficient audit evidence.
Remember, the work paper preparer is responsible for clear communication.
And here’s another thing to consider: You (the work paper preparer) might spend six hours on one document, so you are keenly aware of what you did. The reviewer, on the other hand, might spend five minutes–and she is trying (as quickly as she can) to understand your work.
Help Your Reviewers
To help your reviewers:
Tell them what you are doing (purpose statement)
Do it (document the test work)
Then, tell them how it went (the conclusion)
Now let’s move from proper to improper documentation.
Examples of Poor Work Paper Documentation
So, what does insufficient audit documentation look like? In other words, what are some of the signs that we are not complying with AU-C 230?
Here are examples of poor audit work paper documentation:
Signing off on audit steps with no supporting work papers (and no explanation on the audit program)
Placing a document in a file without explaining why (what is its purpose?)
Not signing off on audit steps
Failing to reference audit steps to supporting work papers
Listing a series of numbers on an Excel spreadsheet without explaining their source (where did they come from? who provided them?)
Not signing off on work papers as a preparer
Not signing off on work papers as the reviewer
Failing to place excerpts of key documents in the file (e.g., debt agreement)
Performing fraud inquiries but not documenting who was interviewed (their name) and when (the date)
Not documenting the selection of a sample (why and how and the sample size)
Failing to explain the basis for low inherent risk assessments
A failure to document the current year walkthroughs for significant transaction cycles (the file contains a generic description of controls with no evidence of a current year review)
Not documenting entity-level controls (e.g., tone at the top, management’s risk assessment procedures)
A failure to document risk assessments
Low control risk assessments without a test of controls
A lack of linkage from the risk assessment to the audit plan
This list is not comprehensive, but it provides examples to consider. This list is based on my past experiences. Probably the worst offense (at least in my mind) is signing off on an audit program with no support.
Strangely, however, poor work papers are not the result of insufficient documentation, but too much documentation.
Too Much Audit Documentation
Many CPAs say to me, “I feel like I do too much,” meaning they believe they are auditing more than is necessary. To which I often respond, “I agree.”
Files received from clients that don’t support the audit opinion
Unnecessary work performed on extraneous documents
For whatever reason, clients usually provide more information than we request. And then–for some other reason–we retain those documents, even if not needed.
If auditors add purpose statements to each work paper, then they will discover that some work papers are unnecessary. In writing the purpose statement, we might realize it has none. Which is nice–now, we can eliminate it.
One healthy exercise is topretend we’ve never audited the company and that we have no prior year audit files. Then, with a blank page, we plan the audit. Once done, we compare the new plan to prior year files. If there’s any fat, start cutting.
The key to eliminating unnecessary work lies in performing the following steps (in the order presented):
Too often, we roll the prior year file forward and rock on. If the prior year file has extraneous audit procedures, we repeat them. This creates waste year after year after year.
Before I close this article, here is one good work paper suggestion from my friend Jim Bennett of Bennett & Associates: transaction area maps.
Transaction Area Maps
Include transaction area maps in your file. A summary creates organization and makes it easier to find your work papers. It also provides a birds-eye view of what you have done. Here’s an example:
ACCOUNTS RECEIVABLE WORKPAPER MAP
4-02 Audit Program
4-10 Risk Assessment Analyticals
ACCOUNTS RECEIVABLE AGING
4-20 Customer aging report
4-21 AR break-out of intercompany balances
4-23 AR aging tie in to TB
4-24 Review of AR aging
ACCOUNTS RECEIVABLE CONFIRMATIONS
4-50 Planning worksheet – substantive procedures
4-51 AR confirmation reconciliation
4-52 AR confirmation replies
4-60 Allowance for doubtful accounts
4-70 Intercompany balances and sales to significant customers
4-80 Sales analytics
4-90 Sales cut-off testing
4-95 Revenue recognition 606 support and disclosures
Summary
In summary, audit documentation continues to be a significant peer review problem. We can enhance the quality of our work papers by remembering we are not just auditing. We are communicating. It is our responsibility to provide a clear message. We need to do so to comply with AU-C 230, Audit Documentation.
Today we look at one of most misunderstood parts of auditing: audit risk assessment.
Are auditors leaving money on the table by avoiding risk assessment? Can inadequate risk assessment lead to peer review findings? This article shows you how to make more money and create higher quality audit documentation. Below you’ll see how to use risk assessment procedures to identify risks of material misstatement. You’ll also learn about the risk of material misstatement formula and how you can use it to plan your engagements.
Audit Risk Assessment as a Friend
Audit risk assessment canbe our best friend, particularly if we desire efficiency, effectiveness, and profit—and who doesn’t?
This step, when properly performed, tells us what to do—and what can be omitted. In other words, risk assessment creates efficiency.
So, why do some auditors (intentionally) avoid audit risk assessment? Here are two reasons:
We don’t understand it
We're creatures of habit
Too often auditors continue doing the same as last year (commonly referred to as SALY)--no matter what. It’s more comfortable than using risk assessment.
But what if SALY is faulty or inefficient?
Maybe it’s better to assess risk annually and to plan our work accordingly (based on current conditions).
Are We Working Backwards?
The old maxim “Plan your work, work your plan” is true in audits. Audits—according to standards—should flow as follows:
Determine the risks of material misstatements (plan our work)
Issue an opinion (the result of planning and working)
Auditors sometimes go directly to step 3. and use the prior year audit programs to satisfy step 2. Later, before the opinion is issued, the documentation for step 1. is created “because we have to.”
In other words, we work backwards.
So, is there a better way?
A Better Way to Audit
During the initial planning phase of an audit, an auditor should do the following:
While we may not complete these steps in this order, we do need to perform our risk assessment first (1.-4.) and then assess risk.
Okay, so what procedures should we use?
Audit Risk Assessment Procedures
AU-C 315.06 states:
The risk assessment procedures should include the following:
Inquiries of management, appropriate individuals within the internal audit function (if such function exists), others within the entity who, in the auditor's professional judgment, may have information that is likely to assist in identifying risks of material misstatement due to fraud or error
Analytical procedures
Observation and inspection
I like to think of risk assessment procedures as detective tools used to sift through information and identify risk.
Just as a good detective uses fingerprints, lab results, and photographs to paint a picture, we are doing the same.
First, we need to understand the entity and its environment.
Understand the Entity and Its Environment
The audit standards require that we understand the entity and its environment.
I like to start by asking management this question: "If you had a magic wand that you could wave over the business and fix one problem, what would it be?"
The answer tells me a great deal about the entity's risk.
I want to know what the owners and management think and feel. Every business leader worries about something. And understanding fear illuminates risk.
Think of risks as threats to objectives. Your client's fears tell you what the objectives are--and the threats.
To understand the entity and its related threats, ask questions such as:
How is the industry faring?
Are there any new competitive pressures or opportunities?
Have key vendor relationships changed?
Can the company obtain necessary knowledge or products?
Are there pricing pressures?
How strong is the company’s cash flow?
Has the company met its debt obligations?
Is the company increasing in market share?
Who are your key personnel and why are they important?
What is the company’s strategy?
Does the company have any related party transactions?
As with all risks, we respond based on severity. The higher the risk, the greater the response.
Audit standards require that we respond to risks at these levels:
Financial statement level
Transaction level
Responses to risk at the financial statement level are general, such as appointing more experienced staff for complex engagements.
Responses to risk at the transaction level are more specific such as a search for unrecorded liabilities.
But before we determine responses, we must first understand the entity's controls.
Understand Transaction Level Controls
We must do more than just understand transaction flows (e.g., receipts are deposited in a particular bank account). We need to understand the related controls (e.g., Who enters the receipt in the general ledger? Who reviews receipting activity?).
So, as we perform walkthroughs or other risk assessment procedures, we gain an understanding of the transaction cycle, but—more importantly—we gain an understanding of controls. Without appropriate controls, the risk of material misstatement increases.
AU-C 315.14 requires that auditors evaluate the design of their client's controls and to determine whether they have been implemented. However, AICPA Peer Review Program statistics indicate that many auditors do not meet this requirement. In fact, noncompliance in this area is nearly twice as high as any other requirement of AU-C 315 - Understanding the Entity and Its Environment and Assessing the Risk of Material Misstatement.
Some auditors excuse themselves from this audit requirement saying, "the entity has no controls."
All entities have some level of controls. For example, signatures on checks are restricted to certain person. Additionally, someone usually reviews the financial statements. And we could go on.
The AICPA has developed a practice aid that you'll find handy in identifying internal controls in small entities.
The use of walkthroughs is probably the best way to understand internal controls.
Sample Walkthrough Questions
As you perform your walkthroughs, ask questions such as:
Who signs checks?
Who has access to checks (or electronic payment ability)?
Who approves payments?
Who initiates purchases?
Who can open and close bank accounts?
Who posts payments?
What software is used? Does it provide an adequate audit trail? Is the data protected? Are passwords used?
Who receives and opens bank statements? Does anyone have online access? Are cleared checks reviewed for appropriateness?
Who reconciles the bank statement? How quickly? Does a second person review the bank reconciliation?
Who creates expense reports and who reviews them?
Who bills clients? In what form (paper or electronic)?
Who opens the mail?
Who receipts monies?
Are there electronic payments?
Who receives cash onsite and where?
Who has credit cards? What are the spending limits?
Who makes deposits (and how)?
Who keys the receipts into the software?
What revenue reports are created and reviewed? Who reviews them?
Who creates the monthly financial statements? Who receives them?
Are there any outside parties that receive financial statements? Who are they?
Understanding the company’s controls illuminates risk. The company’s goal is to create financial statements without material misstatement. And a lack of controls threatens this objective.
So, as we perform walkthroughs, we ask the payables clerk (for example) certain questions. And—as we do—we are also making observations about the segregation of duties. Also, we are inspecting certain documents such as purchase orders.
This combination of inquiries, observations, and inspections allows us to understand where the risk of material misstatement is highest.
In a AICPA study regarding risk assessment deficiencies, 40% of the identified violations related to a failure to gain an understanding of internal controls.
40%
failure to gain understanding of internal controls
Another significant risk identification tool is the use of planning analytics.
Preliminary Analytical Procedures
Use planning analytics to shine the light on risks. How? I like to use:
Multiple-year comparisons of key numbers (at least three years, if possible)
Key ratios
In creating preliminary analytics, use management’s metrics. If certain numbers are important to the company, they should be to us (the auditors) as well—there’s a reason the board or the owners are reviewing particular numbers so closely. (When you read the minutes, ask for a sample monthly financial report; then you’ll know what is most important to management and those charged with governance.)
You may wonder if you can create planning analytics for first-year businesses. Yes, you can. Compare monthly or quarterly numbers. Or you might compute and compare ratios (e.g., gross profit margin) with industry benchmarks. (For more information about, see my preliminary analytics post.)
Sometimes, unexplained variations in the numbers are fraud signals.
Identify Fraud Risks
In every audit, inquire about the existence of theft. In performing walkthroughs, look for control weaknesses that might allow fraud to occur. Ask if any theft has occurred. If yes, how?
Also, we should plan procedures related to:
Management override of controls, and
The intentional overstatement of revenues
My next post—in The Why and How of Auditing series—addresses fraud, so this is all I will say about theft, for now. Sometimes the greater risk is not fraud but errors.
Same Old Errors
Have you ever noticed that some clients make the same mistakes—every year? (Johnny--the controller--has worked there for the last twenty years, and he makes the same mistakes every year. Sound familiar?) In the risk assessment process, we are looking for the risk of material misstatement whether by intention (fraud) or by error (accident).
One way to identify potential misstatements due to error is to maintain a summary of the larger audit entries you’ve made over the last three years. If your client tends to make the same mistakes, you’ll know where to look.
Now it’s time to pull the above together.
Creating the Risk Picture
Once all of the risk assessment procedures are completed, we synthesize the disparate pieces of information into a composite image.
What are we bringing together? Here are examples:
Control weaknesses
Unexpected variances in significant numbers
Entity risk characteristics (e.g., level of competition)
Large related-party transactions
Occurrences of theft
Armed with this risk picture, we can now create our audit strategy and audit plan (also called an audit program). Focus these plans on the higher risk areas.
How can we determine where risk is highest? Use the risk of material misstatement (RMM) formula.
Assess the Risk of Material Misstatement
Understanding the risk of material misstatement formula is key to identifying high-risk areas.
What is the risk of material misstatement formula?
Put simply, it is:
Risk of Material Misstatement = Inherent Risk X Control Risk
Using the RMM formula, we are assessing risk at the assertion level. While audit standards don’t require a separate assessment of inherent risk and control risk, consider doing so anyway. I think it provides a better representation of your risk of material misstatement.
Here's a short video about assessing inherent risk.
And another video regarding control risk assessment.
My new book titled Audit Risk Assessment Made Easy is now available on Amazon. I’ve been working on this for over a year and a half. I think you’ll find it to be a valuable resource in understanding, documenting, planning, and performing risk assessment procedures.
