Category Archives for "Auditing"

SAS 134
Sep 08

SAS 134 Unmodified and Modified Audit Opinions

By Charles Hall | Auditing

In this post, you’ll gain an understanding of unmodified and modified audit opinions using the guidance from AU-C Section 700, Forming an Opinion and Reporting on Financial Statements and AU-C 705, Modifications to the Opinion in the Independent Auditor’s Report. SAS 134 (and other SASs) amended these sections resulting in new audit opinions for periods ending after December 15, 2021. 

There are four potential audit opinions:

  1. Unmodified
  2. Qualified
  3. Disclaimer
  4. Adverse

Video Overview of Audit Opinions

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. 

Modified Opinion

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.

modified 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 willing to include a material subsidiary and which, if included, would have a pervasive impact on the statements.

Adverse opinion

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.

disclaimer of opinion

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 opinion on 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. 

If you need to add an emphasis of matter or other matter paragraph for issues such as a lack of consistency, see my article.  

audit documentation
Aug 15

Audit Documentation: Peer Review Finding

By Charles Hall | Auditing

Peer reviewers are saying, “If it’s not documented, it’s not done.” Why? Because standards require sufficient 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.

audit documentation

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 quality is 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 230 Audit 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:

  1. Tell them what you are doing (purpose statement)
  2. Do it (document the test work)
  3. 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
  • Key bank accounts and debt are not confirmed
  • Not documenting the reason for not sending receivable confirmations
  • A lack of retrospective reviews
  • 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
  • No independence documentation though nonattest services are provided

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.”

In looking at audit files, I see:

  • The clutter of unnecessary work papers
  • 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 to pretend 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):

  1. Perform risk assessment
  2. Plan your audit based on the identified risks
  3. Perform the audit procedures

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

Additional Guidance

The AICPA also provides some excellent guidance regarding work paper documentation. Download their work paper template; it’s very helpful. 

Also, see my article titled 10 Ways to Make Your Work Papers Sparkle.

audit risk assessment
Aug 14

Audit Risk Assessment: The Why and the How

By Charles Hall | Auditing

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. 

risk assessment

Audit Risk Assessment as a Friend

Audit risk assessment can be 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:

  1. We don’t understand it
  2. 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:

  1. Determine the risks of material misstatements (plan our work)
  2. Develop a plan to address those risks (plan our work)
  3. Perform substantive procedures (work our plan) and tests controls for effectiveness (if planned)
  4. 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:

  1. Understand the entity and its environment
  2. Understand entity-level controls
  3. Understand the transaction level controls
  4. Use preliminary analytical procedures to identify risk
  5. Perform fraud risk analysis
  6. Assess risk

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.

Risk assessment

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 audit 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

Need help with risk assessment walkthroughs?

See my article Audit Walkthroughs: The What, Why, How, and When.

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

Synthesis of risks

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.

Once you have completed the risk assessment process, control risk can be assessed at high--simply as an efficiency decision. See my article Assessing Audit Control Risk at High and Saving Time

The Input and Output

The inputs in audit planning include all of the above audit risk assessment procedures.

The outputs (sometimes called linkage) of the audit risk assessment process are:

  • Audit strategy
  • Audit plan (audit programs)
Linking risk assessment to audit planning

We tailor the strategy and plan based on the risks..

In a nutshell, we identify risks and respond to them.

(In a future post in this series, I will provide a full article concerning the creation of audit strategy and plans.)

Next in the Audit Series

In my next post, we’ll take a look at Auditing for Fraud: The Why and How

The Auditing Standards Board has issued an exposure draft for a new risk assessment standard. Final issuance of the new standard is expected in August or September of 2021. 

Audit Risk Assessment Made Easy - My New Book

My new book titled Audit Risk Assessment Made Easy will soon be available on Amazon. I’ve been working on this for over a year and I think you’ll find it to be a valuable resource in understanding, documenting, planning, and performing risk assessment procedures. Look for it in September 2021. 


auditing for fraud
Aug 08

Auditing for Fraud: The Why and How

By Charles Hall | Auditing , Fraud

Auditing for fraud is important, but some auditors ignore this duty. Even so, fraud risk is often present. 

So what is an auditor’s responsibility for detecting fraud? Today, I answer that question in light of generally accepted auditing standards in the United States. We’ll look specifically at AU-C 240, Consideration of Fraud in a Financial Statement Audit.

Here’s an overview of this article:

  • Auditor’s responsibility for detecting fraud
  • Turning a blind eye to fraud
  • Signs of auditor disregard for fraud
  • Incentives for fraud
  • Discovering fraud opportunities
  • Inquiries required by audit standards
  • The accounting story and big bad wolves
  • Documenting control weaknesses
  • Brainstorming and planning your response to fraud risk 

Auditor’s Responsibility for Detecting Fraud – AU-C 240

I still hear auditors say, “We are not responsible for detecting fraud.” But are we not? The detection of material misstatements whether caused by error or fraud is the heart and soul of an audit. So writing off our responsibility for fraud is not an option. We must plan to look for material fraud.

Audits will not, however, detect every material misstatement—even if the audit is properly planned and conducted. Audits are designed to provide reasonable assurance, not perfect assurance. Some material frauds will not be detected. Why? First, an auditor’s time is limited. He can’t audit forever. Second, complex systems make it extremely difficult to discover fraud. Third, the number of potential fraud schemes (there are thousands) makes it challenging to consider all possibilities. And, finally, some frauds are so well hidden that auditors won’t detect them.

Even so, auditors should not turn a blind eye to fraud.

Turning a Blind Eye to Fraud

Why do auditors not detect fraud?

Think of these reasons as an attitude—a poor one—regarding fraud. This disposition manifests itself in the audit file with signs of disregard for fraud.

Signs of Auditor Disregard for Fraud

A disregard for fraud appears in the following ways:

  • Asking just one or two questions about fraud
  • Limiting our inquiries to as few people as possible (maybe even just one)
  • Discounting the potential effects of fraud (after known theft occurs)
  • Not performing walkthroughs
  • We don’t conduct brainstorming sessions and window-dress related documentation
  • Our files reflect no responses to brainstorming and risk assessment procedures
  • Our files contain vague responses to the brainstorming and risk assessment (e.g., “no means for fraud to occur; see standard audit program” or “company employees are ethical; extended procedures are not needed”)
  • The audit program doesn’t change though control weaknesses are noted

In effect, auditors—at least some—dismiss the possibility of fraud, relying on a balance sheet approach.

So how can we understand fraud risks and respond to them? First, let’s look at fraud incentives.

Incentives for Fraud

The reasons for theft vary by each organization, depending on the dynamics of the business and people who work there. Fraudsters can enrich themselves indirectly (by cooking the books) or directly (by stealing).

Fraud comes in two flavors:

  1. Cooking the books (intentionally altering numbers)
  2. Theft

Two forms of fraud: Auditor's Responsibility for Fraud

Cooking the Books

Start your fraud risk assessment process by asking, “Are there any incentives to manipulate the financial statement numbers.” For example, does the company provide bonuses or promote employees based on profit or other metrics? If yes, an employee can indirectly steal by playing with the numbers. Think about it. The chief financial officer can inflate profits with just one journal entry—not hard to do. While false financial statements is a threat, the more common fraud is theft.

Theft

If employees don’t receive compensation for reaching specific financial targets, they may enrich themselves directly through theft. But employees can only steal if the opportunity is present. And where does opportunity come from? Weak internal controls. So, it’s imperative that auditors understand the accounting system and—more importantly—related controls. 

Discovering Fraud Opportunities

My go-to procedure in gaining an understanding of the accounting system and controls is walkthroughs.  Since accounting systems are varied, and there are no “forms” (practice aids) that capture all processes, walkthroughs can be challenging. So, we may have to “roll up our sleeves,” and “get in the trenches.” 

For most small businesses, performing a walkthrough is not that hard. Pick a transaction cycle; start at the beginning and follow the transaction to the end. Ask questions and note who does what. Inspect the related documents. As you do, ask yourself two questions:

  1. What can go wrong?
  2. Will existing control weakness allow material misstatements?

In more complex companies, break the transaction cycle into pieces. You know the old question, “How do you eat an elephant?” And the answer, “One bite at a time.” So, the process for understanding a smaller company works for a larger one. You just break it down and allow more time.

Discovering fraud opportunities requires the use of risk assessment procedures such as observations of controls, inspections of documents and inquiries. Of the three, the more commonly used is inquiries.

Inquiries Required by Audit Standards

Audit Standards (AU-C 240) state that we should inquire of management regarding:

  • Management’s assessment of the risk that the financial statements may be materially misstated due to fraud, including the nature, extent, and frequency of such assessments
  • Management’s process for identifying, responding to, and monitoring the risks of fraud in the entity, including any specific risks of fraud that management has identified or that have been brought to its attention, or classes of transactions, account balances, or disclosures for which a risk of fraud is likely to exist
  • Management’s communication, if any, to those charged with governance regarding its processes for identifying and responding to the risks of fraud in the entity
  • Management’s communication, if any, to employees regarding its views on business practices and ethical behavior
  • The auditor should make inquiries of management, and others within the entity as appropriate, to determine whether they know of any actual, suspected, or alleged fraud affecting the entity
  • For those entities that have an internal audit function, the auditor should make inquiries of appropriate individuals within the internal audit function to obtain their views about the risks of fraud; determine whether they have knowledge of any actual, suspected, or alleged fraud affecting the entity; whether they have performed any procedures to identify or detect fraud during the year; and whether management has satisfactorily responded to any findings resulting from these procedures

Notice that AU-C 240 requires the auditor to ask management about its procedures for identifying and responding to the risk of fraud. If management has no method of detecting fraud, might this be an indicator of a control weakness? Yes. What are the roles of management and outside auditors regarding fraud?

  • Management develops control systems to lessen the risk of fraud. 
  • Auditors review the accounting system to see if fraud-prevention procedures are designed and operating appropriately.

So, the company creates the accounting system, and the auditor gains an understanding of the same. As auditors gain an understanding of the accounting system and controls, we put together the pieces of a story.

The Accounting Story and Big Bad Wolves

Think of the accounting system as a story. Our job is to understand the narrative of that story. As we describe the accounting system in our work papers, we may find missing pieces. Controls may be inadequate. When they are, we ask more questions to make the story complete.

The purpose of writing the storyline is to identify any “big, bad wolves.”

The Auditor's Responsibility for Fraud - The Big Bad Wolves

The threats in our childhood stories were easy to recognize. The wolves were hard to miss. Not so in walkthroughs. It is only in connecting the dots—the workflow and controls—that the wolves materialize.

So, how long should the story be? That depends on the size of the organization. Scale your documentation. If the transaction cycle is simple, the documentation should be simple. If the cycle is complex, provide more details. By focusing on control weaknesses that allow material misstatements, you’ll avoid distracting details.

But what if control weaknesses are noted?

Documenting Control Weaknesses

I summarize the internal control strengths and weaknesses within the description of the system and controls and highlight the wording “Control weakness.” For example:

Control weakness: The accounts payable clerk (Judy Jones) can add new vendors and can print checks with digital signatures. In effect, she can create a new vendor and have a check sent to that provider without anyone else’s involvement.

Highlighting weaknesses makes them more prominent. Then I can use the identified fraud opportunities to brainstorm about how theft might occur and to develop my responses to the threats.

Brainstorming and Planning Your Responses 

Now, you are ready to brainstorm about how fraud might occur and to plan your audit responses.

The risk assessment procedures provide the fodder for the brainstorming session. 

Armed with knowledge about the company, the industry, fraud incentives, and the control weaknesses, we are ready to be creative. 

In what way are we to be creative? Think like a thief. By thinking like a fraudster, we unearth theft schemes. Why? So we can audit those possibilities. This is the reason for risk assessment procedures in the first place.

What we discover in risk assessment informs the audit plan. Now we are ready to perform our fraud risk assessment. With the information gained in from the risk assessment procedures, we know where the risks are. If, for example, there is a risk that fictitious vendors are present, we might assess the risk of material misstatement at high for the expense occurrence assertion. (Our risks of material misstatement should be assessed at the assertion level.) Then we plan our response which might be testing new vendors added to determine if they are legitimate. So the fraud risk assessment occurs after we perform our risk assessment procedures. This tells us where the risks of material misstatement are. 

The Auditor’s Responsibility for Detecting Fraud – AU-C 240

In conclusion, I started this post saying I’d answer the question, “What is an auditor’s responsibility for detecting fraud?”

Hopefully, you now better understand fraud procedures. But to understand the purpose of them, look at a standard audit opinion:

The procedures selected depend on the auditor’s judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity’s preparation and fair presentation of the consolidated financial statements 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 the entity’s internal control. Accordingly, we express no such opinion.

The purpose of fraud risk assessments is not to opine on internal control systems or to discover every fraud. It is to assist the auditor in determining where material misstatements—due to fraud—might occur.

Additionally, even well-performed audits will not detect all material fraud. As we saw above, some frauds are extremely difficult to detect. Audits are designed to provide reasonable assurance, not perfect assurance. The standard audit opinion states:

Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement.

In summary, the auditor should conduct the audit in a manner to detect material fraud. But it is possible that some material frauds will be missed, even when we perform the audit correctly.

The Why and How of Auditing: A Blog Series About Audit Basics

Check out my series of posts: The Why and How of Auditing?

You’ll see how to audit cash, receivables/revenues, payables/expenses, investments, and other transaction cycles. You’ll also see how to perform risk assessment procedures before you plan your further audit procedures. 

Also, see my book The Why and How of Auditing on Amazon.

test of controls
May 29

Test of Controls: When to Perform and How

By Charles Hall | Auditing

Most auditors don’t perform a test of controls? But should they? Below I explain when such a test is required. I also explain why some auditors choose to use this test even when not required. 

test of controls

Once risk assessment is complete, auditors have three further audit procedures they can use to respond to identified risks:

  1. Test of details 
  2. Substantive analytics
  3. Test of controls

This article focuses on the third option.

Below you will see:

  • The Right Response
  • Not Testing Controls (including video about the same)
  • The Decision Regarding Testing 
  • How to Test Controls
  • Required Tests
  • Which Controls to Test
  • Three-year Rotation of Testing
  • Interim or Period-End Testing

The Right Response 

Which responses to risks of material misstatement are best? That depends on what you discover in risk assessment.

If, for example, your client consistently fails to record payables, then assess control risk for completeness at high and perform a search for unrecorded liabilities (a substantive procedure).

By contrast, if the internal controls for receivables are strong, then assess control risk for the existence assertion at less than high, and test controls for effectiveness. (You do, however, have the option to perform substantive tests rather than test controls, even when controls are appropriate. More about this in a moment.)

Not Testing Controls

Many auditors assess control risk at high (after risk assessment is complete) and use a fully substantive approach. That is fine, especially in audits of smaller entities. Why? Because smaller entities tend to have weaker controls. As a result, controls may not be effective. Therefore, you may not be able to assess control risk at less than high. 

Control risk assessments of less than high must be supported with a test of controls to prove their effectiveness. But if controls are not effective, you must assess control risk at high. This is one reason why you might bypass testing controls: you know, either from prior experience or from current-year walkthroughs, that controls are not effective. If your test reveals ineffectiveness, you are back to square one: a control risk assessment of high. Then substantive procedures are your only option. In such a situation, the initial test was a waste of time. 

The Decision Regarding Testing 

But if controls are effective, why not test them? Doing so allows you to reduce your substantive procedures. There is one reason, however, why you might not test controls even though they appear appropriate: substantive tests may take less time.

Once risk assessment is complete, your responses—the further audit procedures—are based on efficiency and effectiveness. If control testing takes less time, then use this option. If substantive procedures takes less time, then perform a test of details or use substantive analytics. But, regardless of efficiency considerations, address all risks with appropriate responses.

How to Test Controls 

Suppose you’ve decided to test controls for effectiveness. But how? Let’s look at an example starting with risk assessment.

control test

Risk Assessment

Your approach to testing controls depends on risk. 

For example, suppose your billing and collections walkthrough reveals appropriate segregation of duties. You see that authorized personnel issue receipts for each payment received. Additionally, you determine that total daily cash inflows are reconciled by the collections supervisor to the online bank statement, and she signs off on a reconciliation sheet as evidence of this procedure. Lastly, you note that a person not involved in cash collections reconciles the monthly bank statement. In other words, controls are properly designed and in use. 

Furthermore, you believe completeness is a relevant assertion. Why? Theft of incoming cash is a concern since the business handles a high volume of customer checks. If checks are stolen, cash collections would not be complete. Consequently, the inherent risk for completeness is high. The fraud risk is a significant risk which requires a test of details in addition to the test of controls.

Test Supports Effectiveness

Now it’s time to test for effectiveness. 

Test the receipt controls on a sample basis. But before doing so, document the controls you desire to test and the sample size determinations. (See AICPA’s Audit Sampling standard, AU-C 530.)

The first control you are testing is the issuance of receipts by an authorized person and your sample size might be sixty. 

The second control you are testing is the daily reconciliation of cash to the bank statement. For example, you could agree total daily receipts to the bank statement for twenty-five days. As you do so, you review the daily sign-offs on the reconciliation sheets. Why? The collection supervisor’s sign-off is the evidence that the control was performed. 

The third control you are reviewing is the reconciliation of the bank account by a person not involved in the receipting process. So, you review the year-end bank reconciliation and confirm that the person that reconciled the bank statement was not involved in cash collections. 

Once the tests are performed, determine whether the controls are effective. If they are, assess control risk for the completeness assertion at less than high. Now you have support for that lower assessment. 

And what about substantive tests?

You need to perform a test of details since a significant risk (the fraud risk) is present. You might, for example, reconcile the daily total receipts to the general ledger for a month.

Test Doesn’t Support Effectiveness

If your tests do not support effectiveness, expand your sample size and examine additional receipts. Or skip the tests (if you believe the controls are not effective) and move to a fully substantive approach. Regardless, if controls are not effective, consider the need to communicate the control deficiency to management and those charged with governance. 

So, when should you test controls? First let’s look at required tests and then optional ones. 

Required Audit Tests of Controls

Here are two situations where you must test controls:

  • When there is a significant risk and you are placing reliance on controls related to that risk
  • When substantive procedures don’t properly address a risk of material misstatement

Let me explain.

Auditing standards allow a three-year rotation for control testing, as long as the area tested is not a significant risk. But if the auditor plans to rely on a test of controls related to a significant risk, operating effectiveness must be tested annually. 

Also a test of controls is necessary if substantive procedures don’t properly address a risk of material misstatement. For example, consider the controls related to reallocation of investments in a 401(k). The participant goes online and moves funds from one account to another. Other than the participant, there are no humans involved in the process. When processes are fully automated, substantive procedures may not provide sufficient audit evidence. If that is your situation, you must test of controls. Thankfully, a type 2 service organization control report is usually available in audits of 401(k)s. Such a report provides evidence that controls have already been tested by the service organization’s auditor. And you can place reliance upon those tests. In most cases, substantive procedures can properly address risks of material misstatement. So this test requirement is usually not relevant. 

Optional Audit Test of Controls

We just covered the two situations when testing is required. All other control testing is optional.

internal controls

Prior to making the decision about testing, consider the following:

  • Do you anticipate effectiveness? There’s no need to test an ineffective control. 
  • Does the control relate to an assertion for which you desire a lower control risk? 
  • Will it take less time to test the control than to perform a substantive procedure? Sometimes you may not know the answer to this question until you perform the test of controls. If the initial test does not prove effectiveness, then you have to expand your sample or just punt—in other words, use a fully substantive approach. 
  • Will you use the control testing in conjunction with a test of details or substantive analytics? How would effective controls reduce these substantive tests? In other words, how much substantive testing time would you save if the control is effective?
  • Is the control evidence physical or electronic? For example, are the entity’s receipts in a physical receipt book or in a computer? It’s usually easier to test electronic evidence.
  • How large will your sample size be? Some controls occur once a month. Others, thousands of times in the period. The larger the population, the larger the sample. And, of course, the larger the sample size, the more time it will take to perform the test. 
  • Can you test the population as a whole without sampling? Data analytics software—in some instances—can be used to test the entire population. For example, if a purchase order is required for all payments above $5,000, it might be easy to compare all payments above the threshold to purchase orders, assuming the purchase orders are electronic. 

Three-Year Rotation of Testing

As I said earlier, audit standards allow a three-year rotation for testing. For example, if you test accounts payable controls in 2020, then you can wait until 2023 to test them again. In 2021 and 2022, you need to ensure that these controls have not changed. You also want to determine that those controls have continuing relevance in the current audit. How? See if the controls continue to address a risk of material misstatement. And as you perform your annual walkthroughs, inquire about changes, observe the controls, and inspect documents. Why? You want to know that everything is working as it was in 2020, when the initial test was performed. And, yes, you do need to perform those walkthroughs annually, if that is how you corroborate your understanding of controls.

In short, testing for effectiveness can, in most cases, occur every three years. But walkthroughs are necessary each year. If you tested sixty transactions for an appropriate purchase order in 2020, then you can wait until 2023 to do so again. But review of the purchase order process each year in your annual walkthroughs. 

So should you test controls at interim or after year-end?

Interim or Period-End Testing

Some auditors test controls after the period-end (after year-end in most cases). Others at interim. Which is best?

It depends.

interim audit test

Perform interim tests if this fits better in your work schedule. Here’s an example: You perform an interim test on November 1, 2021. Later, say in February 2022, consider whether controls have changed during the last two months of the year. See if the same people are performing those controls. And consider performing additional tests for the November 1 to December 31 period. Once done, determine if the controls are effective. 

Testing on an interim date is not always the answer. For example, if management is inclined to manipulate earnings near year-end, then interim tests may not be appropriate

If you choose to test after period-end, then do so for the full period being audited. Your sample should be representative of that timeframe.

So should you ever test controls at a point in time and not over a period of time? Yes, sometimes. For example, test inventory count controls at year-end only. Why? Well those controls are only relevant to the year-end count, a point in time. Most controls, however, are in use throughout the period you are auditing. Therefore, you need to test those controls over that period of time (e.g., year).

Conclusion

As I said above, many auditors tend to rely fully on substantive responses to the risks of material misstatement. But, in some cases, that may not be the best or wisest approach. If controls are designed well and functioning, why not test them? Especially if it takes less time than substantive procedures.

Finally, take a look at my two related articles regarding responses to the risk of material misstatement: (1) Test of Details: Substantive Procedures and (2) Substantive Analytical Procedures: Power Up.

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