Category Archives for "Auditing"

test of controls
Dec 18

Test of Controls: When is It Required?

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.

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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.

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.

Auditing Payroll
Dec 13

Auditing Payroll: A Step by Step Guide

By Charles Hall | Auditing

Auditing payroll is a critical skill. Today I explain how.

While payroll is often seen as a low-risk area, considerable losses can occur here. So, knowing how to audit payroll is important.

Auditing Payroll

Auditing Payroll – An Overview

Payroll exceeds fifty percent of total expenses in many governments, nonprofits, and small businesses. Therefore, it is often a significant transaction area.

To assist you in understanding how to audit payroll, let me provide you with an overview of a typical payroll process.

First, understand that entities have payroll cycles (e.g., two weeks starting on Monday). Then, payments are made at the end of this period (e.g., the Tuesday after the two-week period). Also, understand that most organizations have salaried and hourly employees. Salaried personnel are paid a standard amount each payroll, and hourly employees earn their wages based on time.

Second, an authorized person (e.g., department head) hires a new employee at a specified rate (e.g., $80,000 per year).

Third, human resources assists the new-hire with the completion of payroll forms, including tax forms and elections to purchase additional benefits such as life insurance.

Fourth, a payroll department employee enters the approved wage in the accounting system. The employee’s bank account number is entered into the system (if direct deposit is used).

Fifth, employees clock in and out so that time can be recorded.

Sixth, once the payroll period is complete, a person (e.g., department supervisor) reviews and approves the recorded time.

Seventh, a second person (e.g., payroll supervisor) approves the overall payroll.

Eighth, the payroll department processes payments. Direct deposit payments are made (and everyone is happy).

In this article, we will cover the following:

  • Primary payroll assertions
  • Payroll walkthroughs
  • Payroll fraud
  • Payroll mistakes
  • Directional risk for payroll
  • Primary risks for payroll
  • Common payroll control deficiencies
  • Risk of material misstatement for payroll
  • Substantive procedures for payroll
  • Common payroll work papers

Primary Payroll Assertions

The primary relevant payroll assertions are:

  • Completeness
  • Cutoff
  • Occurrence

I believe—in general—completeness and cutoff (for accrued payroll liabilities) and occurrence (for payroll expenses) are the most important payroll assertions. When a company accrues payroll liabilities at period-end, it is asserting that they are complete and that they are recorded in the right period. Additionally, the company is saying that recorded payroll expenses are legitimate.

Additionally, payroll auditing requires an understanding of threats in light of these assertions. So how do I gain this knowledge? Payroll walkthroughs.

Payroll Walkthroughs

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Perform a walkthrough of payroll to see if there are any control weaknesses. How? Walk transactions from the beginning (the hiring of an employee) to the end (a payroll payment and posting). And ask questions such as the following:

  • Does the company have a separate payroll bank account?
  • How often is payroll processed? What time period does the payroll cover? On what day is payroll paid?
  • Who has the authority to hire and fire employees?
  • What paperwork is required for a new employee? For a terminated employee?
  • Is payroll budgeted?
  • Who monitors the budget to actual reports? How often?
  • Who controls payroll check stock? Where is it stored? Is it secure?
  • If the company uses direct deposit, who keys the bank account numbers into the payroll system? Who can change those numbers?
  • Do larger salary payments require multiple approvals?
  • Who approves overtime payments?
  • Who monitors compliance with payroll laws and regulations?
  • Who processes payroll and how?
  • Who signs checks or makes electronic payments? If physical checks are used, are they signed electronically (as checks are printed) or physically?
  • How are payroll tax payments made? How often? Who makes them?
  • Who creates the year-end payroll tax documents (e.g., W-2s) and how?
  • What controls ensure the recording of payroll in the appropriate period?
  • Are the following duties assigned to different persons:
    • Approval of each payroll,
    • Processing and recording payroll,
    • The reconciliation of related bank statements
    • Possession of processed payroll checks
    • Ability to enter or change employee bank account numbers
    • Ability to add employees to the payroll system or to remove them
  • Who can add or remove employees from the payroll system? What is the process for adding and removing employees from the payroll system?
  • Who can change the master pay rate file? Does the computer system provide an audit trail of those changes?
  • Who approves salary rates and how?
  • Who reconciles the payroll bank statements and how often?
  • Who approves bonuses?
  • What benefits (e.g., retirement accounts) does the company offer? Who pays for the benefits (e.g., employee) and how (e.g., payroll withholding)?
  • Who reconciles the payroll withholding accounts and how often?
  • Are any salaries capitalized rather than expensed? If yes, how and why?
  • Are surprise payroll audits performed? If yes, by whom?
  • Does the company outsource its payroll to a service organization? If yes, does the payroll company provide a service organization control (SOC) report? What are the service organization controls? What are the complementary controls (those performed by the employing company)?

Moreover, as we ask these questions, we need to inspect documents (e.g., payroll ledger) and make observations (e.g., who signs checks or makes electronic payments?).

If controls weaknesses exist, we create audit procedures to respond to them. For example, during the walkthrough, if we see that one person prints and signs checks, records payments, and reconciles the bank statement, then we will plan fraud-related substantive procedures.

As we perform payroll walkthroughs, we are asking, “What can go wrong—whether intentionally or by mistake?”

Payroll Fraud

When payroll fraud occurs, understatements or overstatements of payroll expense may exist.

If a company desires to inflate its profit, it can—using bookkeeping tricks—understate its expenses. As (reported) costs go down, profits go up.

On the other hand, overstatements of payroll can occur when theft is present. For example, if a payroll accountant pays himself twice, payroll expenses are higher than they should be.

Payroll Mistakes

Mistakes also lead to payroll misstatements. Payroll errors can occur when payroll personnel lack sufficient knowledge to carry out their duties. Additionally, misstatements occur when employees fail to perform internal control procedures such as reconciling bank statements.

Directional Risk for Payroll

auditing payroll

The directional risk for payroll is an understatement. So, audit for completeness (determining that all payroll is recorded). Nevertheless, when payroll theft occurs (e.g., duplicate payments), overstatements can occur.

Primary Risks for Payroll

The primary payroll risks include:

  1. Payroll is intentionally understated
  2. Inappropriate parties receive payments
  3. Employees receive duplicate payments

As you think about these risks, consider the control deficiencies that allow payroll misstatements.

Common Payroll Control Deficiencies

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

  • One person performs two or more of the following:
    • Approves payroll payments to employees,
    • Enters time or salary rates in the payroll system,
    • Issues payroll checks or makes direct deposit payments,
    • Adds or removes employees from the payroll system
    • Reconciles the payroll bank account
  • No one reviews and approves recorded time
  • No one reviews and approves payroll before processing
  • No one performs surprise audits of payroll
  • Appropriate procedures for adding and removing employees are not present
  • No one reviews the removal of terminated employees from payroll
  • No one compares payroll expenses to a budget

(Here are suggestions to make your payroll controls stronger.)

Another key to auditing payroll is understanding the risks of material misstatement.

Risk of Material Misstatement for Payroll

In auditing payroll, the assertions that concern me the most are completeness, occurrence, and cutoff. So my risk of material misstatement for these assertions is usually moderate to high.

My response to higher risk assessments is to perform certain substantive procedures: namely, a reconciliation of payroll in the general ledger to quarterly 941s. Why? The company has an incentive to accurately file 941s since the returns are subject to audit by governmental authorities. So, if the 941s are correct, the reconciliation provides support for recorded payroll.

Additionally, consider theft which can occur in numerous ways, such as duplicate payments or ghost employees.

In a duplicate payment fraud, the thief, usually a payroll department employee, pays himself twice.

Ghost employees exist when payroll personnel leave a terminated employee on the payroll. Why would someone in the payroll department intentionally leave a terminated employee in the payroll system? To steal the second payment. How? By changing the terminated employee’s direct deposit bank account number to his own. The result? He receives two payments (his own and that of the terminated employee).

Once your payroll risk assessment is complete, decide what substantive procedures to perform.

Substantive Procedures for Auditing Payroll

My customary tests for auditing payroll are as follows:

  1. Reconcile 941s to payroll
  2. Recompute accrued payroll liability (amount recorded at period-end)
  3. Review payroll withholding accounts for appropriateness and vouch subsequent payments for any significant amounts
  4. Compare payroll expenses (including benefits) to budget and examine any unexplained variances
  5. When control weaknesses are present, design and perform procedures to address the related risks
  6. Compare accrued vacation to prior periods and current payroll activity

In light of my risk assessment and substantive procedures, what payroll work papers do I normally include in my audit files?

Common Payroll Work Papers

My payroll work papers normally include the following:

  • An understanding of payroll-related internal controls
  • Risk assessment of payroll at the assertion level
  • Documentation of any payroll control deficiencies
  • Payroll audit program
  • Accrued salaries detail at period-end
  • A summary of any significant payroll withholding accounts with supporting information
  • A detail of vacation payable (if material) with comparisons to prior periods
  • Budget to actual payroll reports
  • A reconciliation of payroll in the general ledger to quarterly 941s
  • Fraud-related payroll work papers (when needed)

In Summary

In this article we looked at the keys to auditing payroll. Those keys include risk assessment procedures, determining relevant assertions, assessing risks, and developing substantive procedures. My go-to substantive procedure is to reconcile payroll to 941s. I also review payroll withholding accounts and recompute salary accruals. Comparisons of payroll expenses are useful. Finally, if merited, I perform fraud-related payroll procedures.

See my book on Amazon: The Why and How of Auditing.

Gift a bribe
Oct 30

When is a Gift a Bribe?

By Charles Hall | Auditing , Corruption

When is a gift a bribe?

Vendors often give sporting event tickets to clients. Or maybe they take them out for a nice dinner. Others might pay for a trip to Vegas.

So, at what point does a gift become a bribe? A friend of mine recently asked me this question. He said, "I give football tickets to clients. Is that a bribe?" I responded, "Maybe not, but if you give them season-long tickets, probably yes." (Such tickets cost several thousand dollars.) My friend followed with, "What if I go to every game with them?" My answer was, "That makes no difference." And doing so could be worse.

Cozy Vendor Relationships

20% of the 2022 fraud cases in the ACFE's recent study revealed "unusually close association with a vendor" as a red flag.

I've lost count of the fraud cases involving close vendor-client relationships. For example, the vendor and client might take annual family vacations together (think Aspen ski trip), with the former footing the bill.

I once spoke at a conference with vendors in the audience. One of them asked, "What can vendors give?" I responded, "I can't give you a list, but I would never give cash." He wanted a list of acceptable gifts. So, here's one: planes, trains, and automobiles. Yes, I'm trying to be funny, though I know of one vacation home gifted to a CEO. Why? So, a construction company could win a bid.

Some presents (like a vacation home) are obviously a bribe, but lower-cost ones are more difficult to define.

Gray Gift Decisions

You may wonder, "How can I know when a gift is okay?" There's no easy answer to this question. But consider these scenarios. A vendor offers one of the following to you:

-A sleeve of golf balls
-Takes you to play golf
-Pays for you to attend a PGA tournament at Pebble Beach and all expenses for a week-long trip (including your spouse and children)
-Pays your annual dues at your local country club (cost is $25,000 annually)

I'll take the sleeve of balls and play golf, but I'm uncomfortable with the other two.

Front Page Litmus Test

When there is a gray ethical decision, I always say, "Put it on the front page of the paper and see how you feel." If you're comfortable with it, you're probably okay. If not, then don't do it. Another step you might take is to ask an honest friend what they think, someone who has no vested interest. (If you're unwilling to ask your friend the question, your conscience is probably telling you, "This is not okay.")

Most vendors want to give gifts without crossing the line (they want to avoid going to jail). But the line is not usually defined, and naming particulars can be futile. After all, how many things could be on such a list? So, creating a list of proper (or improper) gifts may not work.

So, how do we know if a gift is a bribe?

Quid Pro Quo

In the context of bribery, the concept of "quid pro quo" plays a significant role. This Latin phrase means a direct exchange, where something is given with the expectation of receiving something in return. To determine if a gift can be considered a bribe, one key question is: Was the gift given with the expectation of receiving something in return?

It's easier to argue that a gift is not a bribe if it's small or of low value. In such cases, it may appear more like a token of appreciation than an inducement for a particular action. However, when a vendor gives an expensive gift, it becomes much more challenging to assert that there's no expectation of something in return. Expensive gifts raise red flags and make it more likely that the present is, in fact, a bribe.

So, your company should create a gift policy, defining what is acceptable and unacceptable.

Gift Policies

Gift policies should limit amounts to a specific dollar amount, such as $100 annually. As I said earlier, cash (at least, in my mind) is never an acceptable gift.

The gift policy might provide examples of proper activity with a vendor, such as playing golf together once or twice a year. It might also provide examples of improper actions, such as going on vacations with vendors.

You could list unacceptable gifts, but this is challenging. I would instead define inappropriate gifts in terms of dollars. Doing so is a blanket covering all types of activity.

Moreover, consider including actions the company might take if the employee violates the policy. You may want to say that violations could lead to the loss of their job. But, consult with your legal advisors about the written policy.

And remember to communicate the policy.

Communicate the Gift Policy

Give your written gift policy to new employees, and discuss the importance of transparency regarding vendor gifts. Additionally, remind existing employees of the policy. You might do so in annual training classes.

So, should companies require written disclosure of gifts received?

Gift Disclosure Forms

Companies might also require a signed disclosure form once a year where employees provide details of what they receive from vendors. (Here’s a sample disclosure form.) Additionally, provide such disclosures to your compliance department if you have one. If not, consider giving these to the company owner.

And who might you require to complete such a disclosure form? Anyone with the power to purchase, whether a person issuing a purchase order, a department head authorizing payments, or someone signing checks--anyone able to pay a vendor (or cause a vendor to be paid).

Again, consult with your legal advisors about your disclosure form and processes.

So, is bribery a significant threat to most businesses?

Bribery is Real

ACFE fraud surveys continue to reveal that bribery is one of the leading causes of fraud. 50% of the ACFE's 2022 fraud cases involved corruption (bribery is a form of corruption). Why is this so?

Because it's easy for employees to receive illegal payments (or gifts) without anyone's knowledge, but make no mistake: This activity adversely affects the employer. How? The vendors usually pass the bribe cost to the company through inflated prices or substandard goods. Strangely enough, the vendor often sees a bribe as a cost of doing business, albeit an illegal one.

monitoring and remediation
Oct 19

Understand Engagement Quality Reviews and Monitoring and Remediation

By Charles Hall | Auditing

The new quality management standards include (1) engagement quality reviews and (2) monitoring and remediation. So what are these, and how will they impact CPA firms? Will they require changes in how you operate? Will you need additional personnel? Can firms review their own work, or will you need external help?

In this post, I explain how engagement quality reviews (EQR) and monitoring are different and how they complement each other. We also look at the objectivity requirements for monitoring (which can be tricky, especially for small firms). 

SQMS No. 1, A Firm’s System of Quality Management, requires firms to create a monitoring and remediation process. That standard also requires an Engagement Quality Review for higher-risk engagements (as defined by the firm). SQMS No. 2, Engagement Quality Reviews, provides information about the reviewers’ appointments and responsibilities. 

So, how do EQRs relate to monitoring and remediation? 

To answer this question, let’s first look at a summary of these two functions. 

1. Engagement Quality Reviews

EQRs are at the engagement level. For example, a designated reviewer will review a completed audit file for compliance with standards and an appropriate audit report. The purpose of an EQR is to provide an objective evaluation of significant judgments and conclusions. The EQR will, if done appropriately, reduce the risk of noncompliance with professional standards and the risk of issuing improper reports. It is not, however, an evaluation of the entire engagement. 

Firms perform EQRs for selected (usually high-risk) engagements. SQMS No. 2 requires EQRs for two types of engagements:

  1. When laws or regulations require an EQR for an audit or other engagement (which is rare)
  2. When a firm determines that an EQR is an appropriate response to one or more quality risks (which is common)

The second engagement type is one most firms will encounter, especially if it audits more complex entities such as banks. Why? Because such entities have estimates with a high degree of estimation uncertainty, making it higher risk. Additionally, an entity with significant going concern uncertainties will usually need an EQR, another example of a higher risk engagement.

Next, we’ll look at EQR criteria. 

EQR Criteria

Firms must create EQR policies and procedures defining the engagements requiring such reviews. The firm’s EQR criteria (see SQMS No. 1, A145) might include the following:

  • Types of engagements (e.g., audits)
  • Types of reports (e.g., Single Audits)
  • Types of entities (e.g., employee benefit plans)
  • Engagements with a high level of complexity or judgment (e.g., banks)
  • Engagements with recurring internal or external inspection findings
  • Engagements involving regulatory filing information 
  • Entities in emerging industries (e.g., artificial intelligence)
  • Entities for which the firm has no prior experience
  • Entities with public accountability characteristics (e.g., benefit plans)
  • Governmental entities, if large or complex

So, consider these criteria as you define which engagements will require an EQR. Create a firm policy for this purpose. 

Now, let’s consider the monitoring and remediation requirements.

2. Monitoring and Remediation

Firms perform a monitoring and remediation process, a component of the engagement quality control system. Another component is the risk assessment process. The QM system also includes the following six components:

  • Governance and leadership
  • Relevant ethical requirements
  • Engagement performance
  • Acceptance and continuance
  • Information and communication
  • Resources  

As we saw in my previous QM post, firms create quality objectives, quality risks, and responses for these six components (as a part of their risk assessment process). Once those are in place, firms must monitor them–and remediate deficiencies when noted. 

Monitoring activities may include in-process engagements and should include the inspection of completed engagements. These reviews may include engagements not subject to an EQR, such as those with lower risk (e.g., a client with no estimates or complex accounting). 

In-Process Reviews (Optional)

So, why might a firm review a lower-risk job while it’s in process as a part of monitoring? To see if the QM system is working. For instance, the reviewer might look at risk assessment documentation if the previous inspection revealed problems in this area. Additionally, the firm may want to look at a particular engagement partner’s work if that person had prior deficiencies. 

Completed Engagement Reviews (Required)

Firms should also perform inspections of completed engagements. The firm should review at least one completed engagement for each engagement partner on a cyclical basis (e.g., once every three years). 

Remediation

If a firm notes deficiencies, it will remediate the issues by planning and performing corrective steps. For example, suppose Single Audit engagements reviewed in monitoring did not have appropriate major program determination documentation. In that case, the firm might require that a designated reviewer look at this part of each future Single Audit file. The purpose of the step is to cure the deficiency. 

So, what’s the difference between EQRs and monitoring?

Differences in EQRs and Monitoring 

Engagement risk triggers an EQR, but monitoring has a broader perspective, one focused on the QM system as a whole. 

Engagement Reviews

So, EQRs occur based on the firm’s policies and procedures that define higher-risk jobs. If a firm has only three audits that meet the firm’s EQR criteria (as we previously discussed), then only those are subject to an EQR. 

But even if a firm has no EQR engagements (which would be unusual), it still needs to monitor its QM system. And that may entail reviews of in-process jobs. 

Other Components Monitoring

Additionally, monitoring includes reviews of the QM responses to the six components listed above. (Remember, the firm establishes quality objectives, quality risks, and responses for each of the components.) 

For example, a firm could test its hiring practices for the resource component’s response to a related quality risk. Or a firm might see if peer review findings are being communicated to relevant firm members as a test of the information and communication component. Notice these monitoring examples do not focus on a particular engagement (as an EQR does). 

EQR Findings Affect Monitoring and Remediation

Firms should communicate EQR findings, if any, to firm members. Such findings might lead to remedial action. For example, if the EQRs discover a need for more documentation related to estimates, the firm might require a second partner review of specific estimates (e.g., a bank’s allowance for loan losses). Then, the firm might monitor the response to see if the second review takes place. 

Next, we will discuss the importance of objectivity. 

Maintaining Objectivity

Reviewers need to be objective, whether in an engagement quality review or when monitoring. 

SQMS No. 1 (paragraph 40) requires firms to create policies and procedures that address the objectivity of individuals performing monitoring activities. Objectivity is enhanced when someone monitoring does not review their prior work (such as (1) serving as a member of the engagement team or (2) as an engagement quality reviewer). 

Self Review Threat

A self-review threat exists if a monitoring person reviews their previous work. For example, if the quality management director serves as the EQR person in the audit of ABC Company and then checks that job in the monitoring process, she examines her own work. Such a situation can adversely affect her objectivity. It would be better for another person (someone not a part of the ABC Company audit engagement team or who did not serve as the engagement quality reviewer) to look at that engagement during monitoring. 

EQR in Stages

So, can the person performing the EQR do so at different engagement stages (e.g., beginning, middle, end) or only after the file is complete? You can do either. Consider doing that which lessens your risk the most. 

If the EQR person reviews the engagement at stages (e.g., beginning, middle, end), can they be objective? Yes, as long as they don’t make engagement decisions. For example, they can review and sign off on planning but can’t tell the engagement team how to plan the job. In another example, the EQR person can review risk assessment, but they can’t make those decisions.

Firms are not required to perform EQRs in stages, but they can. Alternatively, the firm might decide to do the EQRs once the engagement is finished. 

Safeguards

SQMS No. 1 states it does not preclude self-inspection. Nevertheless, it says self-review leads to a higher risk that noncompliance with policies and procedures may occur. It is best to remove self-inspection, but if this is not possible, the firm may provide safeguards (actions to reduce the self-review threat) such as the following:

  • Promote continuing professional education and provide training programs to ensure that personnel are current in accounting, auditing, and QM standards
  • Require the use of peer review or other inspection checklists in the monitoring work
  • Provide training about proper monitoring procedures
  • Perform the self-inspection after some time has passed since the completion of the engagement

Responses to Quality Risks

Additionally, the firm’s responses to certain quality risks (as developed in the risk assessment process) may be helpful, such as the following:

  • Develop strong client acceptance and continuance policies that require the firm to have the competence and time to perform the engagement
  • Create a consultation policy that requires the engagement team to consult with another person (e.g., external or internal CPA) when they encounter difficult accounting and auditing issues
  • Take corrective action to cure issues noted in internal monitoring, EQRs, peer review, or other outside reviews (e.g., DOL inspection)
  • Require the use of an outside service provider to perform EQRs when deficiencies were previously noted (e.g., in peer review) or the firm or its environment changes (e.g., the firm starts auditing a client in a new industry)
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Summary

So, engagement characteristics trigger EQRs, and firms need to perform monitoring and remediation, regardless of the EQRs. Furthermore, firms perform EQRs at the engagement level, but monitoring and remediation focuses on the QM system as a whole. 

As you prepare for the new QM standards, consider if you have the personnel to perform the EQRs and monitoring. You may need to hire new staff or contract with external CPAs. 

Finally, if there are objectivity threats from self-review, your firm may need safeguards such as using a peer review checklist in performing a cold engagement review. Strong quality risk responses are also helpful.

quality management
Oct 13

AICPA Quality Management: Why You Need to Start Now

By Charles Hall | Auditing

All firms performing any engagement in an accounting and auditing practice must comply with the new Quality Management (QM) standards, including SQMS No. 1 and SQMS No. 2.

Your quality management system must be designed and implemented by December 15, 2025.

Then, after your new QM process is in place for one year, your managing partner (or other persons with ultimate QM system responsibility) will conclude whether the QM system provides reasonable assurance that objectives are being achieved.

Start your work on this implementation as soon as you can, especially if you perform more complex engagements such as audits and attestations. 

In this article, I explain why quality management is essential, and then I summarize SQMS No. 1 (the firm’s system of QM) and SQMS No. 2 (engagement quality reviews).

I also provide this video (an interview with Jennifer O’Neal) that provides an overview of the QM standards and information about how to get started. 

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Why Quality Management?

The purpose of the QM Standards, issued by the American Institute of Certified Public Accountants (AICPA), is to assist accountants with compliance (with professional standards). The QM standards assist with the following:

  1. Compliance with professional standards and
  2. Issuance of appropriate engagement reports

And when firms comply with professional standards and issue correct reports, their peer review results should be good. 

An unstated benefit of the QM standards is risk management (avoiding loss through legal suits). These standards (when used appropriately) lessen the probability that a firm will be sued for deficient work. How? By helping firms identify QM system and engagement deficiencies. Thereafter, firms can create responses to improve their work.

My main point here is the QM standards help protect your accounting firm, lessening the potential for future harm (whether from peer review failures or legal loss).

QM Standards

The QM standards are made up of the following:

Standard Abbreviation Title
Statement of Quality Management Standards No. 1 SQMS No. 1 The Firm’s System of Quality Management
Statement of Quality Management Standards No. 2 SQMS No. 2 Engagement Quality Reviews
Statement of Quality Management Standards No. 3 SQMS No. 3 Amendments to QM Sections 10, A Firm’s System of Quality Management, and 20, Engagement Quality Reviews
Statement on Auditing Standards No. 146 SAS 146 Quality Management for an Engagement Conducted in Accordance With Generally Accepted Auditing Standards
Statement on Standards for Accounting and Review Services 26 SSARS 26 Quality Management for an Engagement Conducted in Accordance With Generally Accepted Auditing Standards

This article addresses SQMS No. 1 and SQMS No. 2.

SQMS No. 1 – The Firm’s System of QM

SQMS No. 1 addresses how a firm’s system of quality management operates and specifies eight components:

  1. Risk assessment process
  2. Governance and leadership
  3. Relevant ethical requirements
  4. Acceptance and continuance
  5. Engagement performance
  6. Resources
  7. Information and communication
  8. Monitoring and remediation process

(1) Risk assessment and (2) information and communication are new components; they were not included in the prior quality control standards. 

Risk assessment, as well as monitoring and remediation, are processes. So, you will not establish quality objectives, quality risks, and responses for these. 

Risk Assessment: Most Significant Change

The risk assessment component is the most significant change. Firms are required to do the following for the six components listed below:

  1. Establish quality objectives
  2. Identify and assess risks to achieving the quality objectives and
  3. Design and implement responses to address the quality risks

Here’s an example:

  1. A quality objective might be that consultation occurs when there are complex or contentious matters.
  2. The risk could be that firm personnel do not consult with persons in or outside the firm regarding complex or contentious issues.
  3. The risk response could be, for example, that the engagement partner is responsible for consultations and documentation.

SQMS No. 1 requires that firms establish quality objectives, quality risks, and responses (the risk assessment process) for the following components:

  1. Governance and leadership
  2. Relevant ethical requirements
  3. Acceptance and continuance
  4. Engagement performance
  5. Resources
  6. Information and communication

Monitoring and Remediation

After that, the firm will establish a monitoring and remediation process. In doing so, firms will consider the reasons for quality risk assessments, the designed responses, changes in the QM system, the results of previous monitoring, and other relevant information such as peer review information.

Holistic QM System

The QM standards are a holistic approach to ensure (1) that firms comply with professional standards and (2) issue appropriate reports. Develop your objectives, risks, and responses in light of these objectives. The eight components should dovetail. In other words, they should work together.

Additionally, the QM system is organic (or at least, it should be). As changes occur in your firm’s accounting and auditing engagements or how it operates, you will reassess your overall system to see if it needs changing.

No longer will we create static quality control documents that sit on the shelf. Real-time changes make sense: your responses (actions to lessen risk) should change as your risks change.

Scalable QM System

The QM system is also scalable. For smaller firms with fewer risks, the QM documentation will be less than that of more complex CPA firms.

Think of a firm that does compilation engagements and nothing else; this firm’s chance of noncompliance with professional standards and issuing incorrect reports is generally less than that of a firm performing audits or attestation services. So, the smaller firm’s QM system will be simpler.

The QM system is like an accordion, expanding for more risk and compressing for less risk.

So, who is responsible for the QM system?

Persons Responsible for QM System

SQMS No. 1 states that your firm will assign ultimate responsibility and accountability to your managing partner, CEO, or managing board. This person or board will evaluate the QM system at a point in time (at least annually) and conclude whether the QM system provides reasonable assurance that objectives are being met.

The conclusion will include one of the following:

  1. The QM system provides reasonable assurance that the system’s objectives are being achieved.
  2. Except for matters related to identified deficiencies, the QM system provides reasonable assurance that the system’s objectives are being achieved.
  3. The QM system does not provide reasonable assurance that the objectives of the QM system are being achieved.

If 2. or 3. is in play, the firm should take prompt and appropriate action and communicate to engagement teams and QM personnel as needed.

SQMS No. 1 also says that firms will assign operational responsibility for the QM system to someone such as a QM partner or director. The person with operational responsibility oversees:

  • Compliance with independence standards
  • Monitoring and remediation process

So, does this person have to perform all QM duties? No, the person with operational responsibility can delegate specific responsibilities to other firm members, such as independence monitoring. Even so, the person with operational responsibility is still responsible for the QM system operations (in this example, independence monitoring).

The standard creates accountability by defining who is responsible for what. In most firms, the managing partner has ultimate responsibility, and the quality control partner/director has operational responsibility. Also, SQMS No. 1 states that the firm should perform periodic performance evaluations of these persons.

QM System Documentation

The firm should document its QM system, including:

  • Person(s) with ultimate responsibility
  • Person(s) with operational responsibility
  • Quality objectives
  • Quality risks
  • Responses
  • How quality risks are addressed
  • Monitoring activities
  • Evaluation of findings
  • Evaluation of identified deficiencies (and their root causes)
  • Remedial actions
  • Communications about monitoring and remediation
  • Conclusions reached
  • Basis for conclusion

This documentation should be retained long enough for the firm and its peer reviewer to monitor the QM system (and to meet any legal and regulatory requirements).

For higher-risk engagements, firms may need an engagement quality review.

Engagements Subject to Engagement Quality Reviews

SQMS No. 1 requires that firms establish policies and procedures that address engagement quality reviews in accordance with SQMS No. 2. Engagement quality reviews are required for the following:

  • Audits or other engagements requiring an engagement quality review due to laws or regulations
  • Audits or other engagements as a response to quality risks as defined by the firm

Not all engagements are subject to an engagement quality review. Riskier engagements (as defined by the firm; see SQMS No. 1 criteria) are more likely to be subject to an engagement quality review.

Next, we look at SQMS No. 2, Engagement Quality Reviews.

SQMS No. 2 – Engagement Quality Reviews

An engagement quality review (EQR) is an objective evaluation of the engagement team’s significant judgments and conclusions. It is not an evaluation of the entire engagement. The review is done at the engagement level, and an engagement quality reviewer performs the EQR before the engagement report is released.

So, who can be an engagement quality reviewer (EQ reviewer)? An engagement quality reviewer can be a:

  • Partner
  • Another individual in the firm, or
  • Someone external to the firm

EQ Reviewer Requirements

The EQ reviewer should understand SQMS No. 2 and apply the requirements. The firm will also define the EQ reviewer qualifications in its policies and procedures, namely that this person must have the competence, capability, and time to perform the review and that the person will be objective.

EQR Policies and Procedures

EQR policies and procedures should address the following:

  • Require the EQ reviewer to take overall responsibility for the EQR
  • Require the EQ reviewer to take overall responsibility for the supervision of persons assisting with the EQR
  • The EQ reviewer (and anyone assisting this person) can’t be a member of the audit team
  • The EQ reviewer (and anyone assisting this person) must have sufficient competence, capabilities, and time to perform their duties
  • The EQ reviewer (and anyone assisting this person) must comply with relevant ethical requirements and laws and regulations
  • Circumstances in which the EQ reviewer’s discussion with the engagement team gives rise to an objectivity threat and actions to take when this happens
  • Circumstances in which the EQ reviewer’s eligibility is impaired, including how a replacement reviewer will be chosen
  • Performance of EQRs during the engagement
  • A prohibition from releasing an engagement report until the EQ reviewer notifies the engagement partner that the EQR is complete

SQMS No. 2 also provides EQR performance requirements.

EQR Performance

The EQR performance should include the following:

  • EQ reviewer talks with the engagement partner (and team, if needed) about significant matters and significant judgments
  • EQ reviewer reviews communications regarding the nature and circumstances of the engagement and the entity
  • EQ reviewer considers the firm’s monitoring and remediation process, including deficiencies relating to significant judgment areas
  • EQ reviewer reviews significant judgment documentation, including the basis for the judgment, and determines:
  • Whether the documents support the conclusion
  • Whether the conclusions are appropriate
  • EQ reviewer evaluates the basis for the engagement partner’s independence determination when applicable
  • EQ reviewer should evaluate whether an appropriate consultation took place for difficult or contentious matters
  • EQ reviewer should determine whether the engagement partner was sufficiently involved when the engagement is subject to generally accepted auditing standards (if not, the engagement partner may not have a sufficient basis for determining that significant judgments and conclusions are appropriate)
  • EQ reviewer should review the financial statements and reports for audits and review engagements
  • EQ reviewer should review the engagement report and the subject matter information (when applicable) for engagements other than audits and review engagements
  • EQ reviewers should notify the engagement partner when they have concerns about significant judgments and conclusions
  • EQ reviewer should notify the engagement partner when the engagement review is complete

SQMS No. 2 includes documentation requirements. Let’s see what those are.

EQR Documentation

The EQR documentation should include:

  • Policies and procedures requiring the EQ reviewer to take responsibility
  • Evidence of the EQ review in the engagement file
  • Names of the EQ reviewers
  • Identification of the engagement reviewed
  • Whether the EQR complies with SQMS No. 2
  • Evidence that the engagement is complete
  • Notification that the reviewer has concerns about judgments and conclusions, if applicable
  • Notification from the EQ reviewer to the engagement partner that the review is complete

EQR Findings

It’s a good idea—though not required by standards—to capture EQR findings in a summary document (e.g., Excel or a database). Then, the firm can use this information in planning and performing its monitoring duties. 

EQR is Scalable

The EQR is scalable depending on the engagement, entity’s nature, and circumstances. Again, less risk will result in less work and documentation than riskier engagements. Fewer significant judgments will likely mean fewer EQR procedures.

Given the EQ reviewer’s involvement, can the engagement partner’s work be reduced? The short answer is no. 

EQR’s Effect on Engagement Partner Responsibilities

The EQR does not change the engagement partner’s responsibilities. For example, an engagement partner should review judgment areas such as complex estimates even though the EQ reviewer does the same.

How EQRs Relate to Monitoring and Remediation

You may be wondering how EQRs relate to monitoring and remediation. For instance, can the person performing an EQR also perform the monitoring on the same engagement? Find in this related article

Conclusion

In conclusion, the QM standards are no small change. As you can see from the above, you have a great deal of work before you. This is especially true if you perform riskier audits and attestation engagements. So, start working on this transition as soon as possible. That way, you’ll have everything in place by December 15, 2025.

You have this many days left:

The most challenging part of this change is the risk assessment process. You need to document your quality objectives, quality risks, and responses for the six components (those that are not processes, i.e., risk assessment and monitoring) listed above.

Finally, consider whom you will assign the QM system operational responsibility. This person must have the competence, capability, and time to comply with the standards. You may need to hire someone to fill this role or contract with someone outside your firm.

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