Category Archives for "Auditing"

Jul 17

Government Auditing Standards 2018 Revision (Hot Off the Press)

By Charles Hall | Auditing , Local Governments

Government Auditing Standards 2018 Revision

The Government Accountability Office just issued the new Yellow Book titled Government Auditing Standards 2018 Revision.

Government Auditing Standards 2018 Revision

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An electronic version of the 2018 Yellow Book can be accessed on GAO’s Yellow Book web page at http://www.gao.gov/yellowbook.

Major Changes

The introduction to the new Yellow Book summarizes the significant changes as follows:

This revision contains major changes from, and supersedes, the 2011 revision. These changes, summarized below, reinforce the principles of transparency and accountability and strengthen the framework for high quality government audits.

  • All chapters are presented in a revised format that differentiates requirements and application guidance related to those requirements.
  • Supplemental guidance from the appendix of the 2011 revision is either removed or incorporated into the individual chapters.
  • The independence standard is expanded to state that preparing financial statements from a client-provided trial balance or underlying accounting records generally creates significant threats to auditors’ independence, and auditors should document the threats and safeguards applied to eliminate and reduce threats to an acceptable level or decline to perform the service.
  • The peer review standard is modified to require that audit organizations comply with their respective affiliated organization’s peer review requirements and GAGAS peer review requirements. Additional requirements are provided for audit organizations not affiliated with recognized organizations.
  • The standards include a definition for waste.
  • The performance audit standards are updated with specific considerations for when internal control is significant to the audit objectives.

Effective with the implementation dates for the 2018 revision of Government Auditing Standards, GAO is also retiring Government Auditing Standards: Guidance on GAGAS Requirements for Continuing Professional Education (GAO-05-568G, April 2005) and Government Auditing Standards: Guidance for Understanding the New Peer Review Ratings (D06602, January 2014).

Effective Dates

The 2018 revision of Government Auditing Standards is effective for financial audits, attestation engagements, and reviews of financial statements for periods ending on or after June 30, 2020, and for performance audits beginning on or after July 1, 2019.

Early implementation is not permitted.

The 2018 revision of Government Auditing Standards supersedes the 2011 revision (GAO-12-331G, December 2011), the 2005 Government Auditing Standards: Guidance on GAGAS Requirements for Continuing Professional Education (GAO-05-568G, April 2005), and the 2014 Government Auditing Standards: Guidance for Understanding the New Peer Review Ratings (D06602, January 2014). 

Client Acceptance and Continuance
Jul 17

Client Acceptance and Continuance: The Why and How

By Charles Hall | Auditing

Client acceptance and continuance may be the most critical step in an audit, but it’s one that gets little attention. A prospective client calls saying, “Can you audit my company?” and we respond, “sure.” While new business can be a good thing, relationships need appropriate vetting. Not doing so can lead to significant (and sometimes disastrous) consequences.

New Relationships

My daughter recently met a young man on Instagram. Not unusual these days. But now the relationship is entering into its third month. They talk every day for two or three hours. So far, they have not been in the same room—and not even in the same city. Skype, yes. Physical presence, no. That’s happening at the end of this month. (He lives eight hours away.)

So what do Mom and Dad think about all of this? Well, it’s fine. My wife checked him out on Facebook (I know you’ve never done this). And my daughter has told us all about the “fella” and his family. We like what we’re hearing. He has similar beliefs. He has a job (Yay!), and he has graduated from college. His family background is like ours.

Why do we want to know all the details about the young man? Because relationships impact people—my daughter, the young man, his family members, and yes, my wife and I. We want everyone to be happy.

Client Acceptance 

And that’s what good relationships create. Happiness. The same is true with clients. As Steven Covey said, “think win, win.” When the customer wins, and your CPA firm wins, everyone is happy. Mutual needs are met.

Careless CPAs accept business with only one consideration: Can I get paid? 

While getting paid is important, other factors are also critical.

Here are a few things to consider:

  1. Are they ethical?
  2. Are you independent?
  3. Do you have the technical ability to serve them?
  4. Do you the capacity to serve them?

Are They Ethical?

I want my daughter to marry a guy with beliefs that correspond with who she is. Is he honest? Would he steal? Is he transparent? Who are his associates? What do others think of him? 

We ask similar questions about accepting a new client. Audit standards require us to consider whether the prospective client has integrity. If the company is not morally straight, then there’s no need to move forward. 

Are You Independent?

The time to determine your firm’s independence is the beginning—not at the conclusion of the audit.

Consider what happens—during a peer review—when a firm is not independent, and it has issued an audit opinion. The original audit report will be recalled, and I’ll bet the company asks for and receives a full refund of your audit fee. Now, the company needs to be re-audited.  (Oh, and there’s that impact on the peer review report.)

Pay attention to requested nonattest services—such as preparation of financial statements. If the client has no one with sufficient skill, knowledge, and experience to accept responsibility for such services, you may not be independent. See the AICPA’s Plain English Guide to Independence for more information. 

Do You Have the Technical Ability to Serve Them?

If you can pick up a client in an industry in which you have no experience, should you? Possibly, but it depends on whether you can appropriately understand the client and their industry before you conduct the engagement. Some new customers may not be complicated. In those cases, CPE may get you into position to provide the audit. 

But what if the potential engagement involves a highly sophisticated industry and related accounting standards for which you are ill-equipped? It may be better to let the engagement go and refer it to an audit firm that has the requisite knowledge. Or maybe you can partner with the other firm. 

Do You Have the Capacity to Serve Them?

A prospective client calls saying, “Can you audit my company? We have a December 31 year-end, and we need the audit report by March 31.” After some discussion, I think the fee will be around $75,000. But my staff is already working sixty hours a week during this time of the year. Should I take the engagement? 

My answer would be no unless I can create the capacity. How? I can hire additional personnel or maybe I can contract with another firm to assist. If I can’t build additional capacity, then I may let the opportunity pass. 

Far too many firms accept work without sufficient capacity. When this happens, corners are cut, and staff members and partners suffer. Stuffingeven morework into a stressful time of the year is not (always) a wise thing. We lose staff. And if the engagement is deficient, peer review results may take a hit.

When you don’t have the capacity to accept new good clients, consider whether you should discontinue service to existing bad customers.

The Continuance Decision

Quality controls standards call for CPAs to not only develop acceptance procedures, but we are to create continuance protocols as well.

I previously said CPAs often don’t give proper attention to acceptance procedures. So, how about continuance decisions? Even worse. 

Continuance Decision

Picture from AdobeStock.com

Each year, we should ask, “If this was a new client opportunity, would I accept them?” If the answer is no, then why do we continue serving them? 

Here are a few questions to ponder:

  • Has the client paid their prior year fees? 
  • Am I still independent (consider the new Hosting Services interpretation)?
  • Does the client demand more from me than the fee merits?
  • Do I enjoy working with this client?
  • Is the client’s financial condition creating additional risks for my firm?
  • Is the client acting ethically?

Each year, well before the audit starts, ask these questions.

And then consider, is the bottom 10% of my book of business keeping me from accepting better clients? My experience has been that when I have the capacity, new business appears. When capacity is lacking, I don’t. The decision to hold on to bad clients is a decision to close the door to better clients. Don’t be afraid to let go.

Risk Assessment Starts Now

When should we start thinking about risk assessment? Now.

Whether you are going through the initial acceptance procedures or you are making your continuance decision, start thinking about risk assessment now. Assuming you accept the client, you’ll be a step ahead as you begin to develop your audit plan. Ask questions such as:

  • How is your cash flow?
  • Do you have any debt with covenants?
  • Who receives the financial statements?
  • Has the company experienced any fraud losses?
  • How experienced is management?
  • Why are you changing auditors?

Keep these notes for future reference and audit planning. 

Next Post in this Series

The above is the first post in The Why and How of Auditing. My next post will be Audit Risk Assessment: The Why and How. Subscribe to my blog (see below) to make sure you don’t miss anything.

Review Quiz

Jul 10

The Why and How of Auditing: A Blog Series about Basics

By Charles Hall | Auditing

Do you struggle with what needs to be done in an audit–and what does not? Do you perform audit procedures (because they are in a standard audit program) but you’re not sure why? Do you want to be more efficient? You are not alone.

While audit forms—like risk assessment, audit planning, and audit program—are necessary, they can make us feel like a blind man being led by the hand. If you’re like me, you want to see, to know where you’re going and why. To gain sight, we need to go back to the basics. 

Each year, Vince Lombardi (the revered coach of the Green Bay Packers) held a pigskin up and said, “This is a football.” And he did so with the best players in the world. He knew that winning is all about basics: blocking, tackling, passing, running. Understanding fundamentals brings clarity and power. And that’s what I’m after in The Why and How of Auditing. I’ll strip away the technical mumbo-jumbo and make auditing accessible, even for beginners. Moreover, experienced auditors will profit as you revisit what matters (and what does not).

The Why and How of Auditing

Here’s an overview of the upcoming posts:

Moving from Wasteful to Efficient Auditing

In the cartoons I read as a kid, Lucy would say to Charlie Brown, “I will hold the ball, and you kick,” but as Charlie Brown would lean into his launch, she would pull away. And you remember the result: Charlie Brown, lying on his backside. 

Some audit procedures (like the invitation to kick) are tempting. They call us (like a familiar friend), but they are a waste of time–even if we have done these steps for years. In the end, they leave us staring at the sky. So, we need to know what is best and what is necessary. Then, we can avoid waste.

This series provides you with what you need to know—without excess baggage. By design, the series is simple. Why? To provide clarity. I want you to understand the basics of auditing. 

When you’re done, you’ll understand auditing, possibly in a way you never have. Then you’ll work with greater confidence and effectiveness. So, let’s begin.

going concern
Jun 20

Going Concern: How to Understand the Accounting and Auditing Standards

By Charles Hall | Accounting , Auditing

Are you preparing financial statements and wondering whether you need to include going concern disclosures? Or maybe you’re the auditor, and you’re wondering if a going concern paragraph should be added to the audit opinion. You’ve heard there are new requirements for both management and auditors, but you’re not sure what they are.

This article summarizes (in one place) the new going concern accounting and auditing standards.

going concern

Going Concern Standards

For many years the going concern standards were housed in the audit standards–thus, the need for FASB to issue accounting guidance (ASU 2014-15). It makes sense that FASB created going concern disclosure guidance. After all, disclosures are an accounting issue. 

Accounting Standard

ASU 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern, provides guidance in preparing financial statements. This standard was effective for years ending after December 15, 2016.

GASB Statement 56, Codification of Accounting and Financial Reporting Guidance Contained in the AICPA Statements on Auditing Standards, is the relevant going concern standard for governments. GASB 56 was issued in March 2009. (GASB 56 requires financial statement preparers to evaluate whether there is substantial doubt about a governmental entity’s ability to continue as a going concern for 12 months beyond the date of the financial statements. As you will see below, this timeframe is different from the one called for under ASU 2014-15. This post focuses on ASU 2014-15 and SAS 132.)

Meanwhile, the Auditing Standards Board issued their own going concern standard in February 2017: SAS 132.

Auditing Standard

Auditors will use SAS 132, The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern, to make going concern decisions. This SAS is effective for audits of financial statements for periods ending on or after December 15, 2017. SAS 132 amends SAS 126The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern.

So, let’s take a look at how to apply ASU 2014-15 and SAS 132.

Two Stages of Going Concern Decisions

In the past, the going concern decisions were made by auditors in a single step. Now, it is helpful to think of going concern decisions in two stages:

  1. Management decisions concerning the preparation of financial statements 
  2. Auditor decisions concerning the audit of the financial statements

First, we’ll consider management’s decisions.

Stage 1. Management Decisions

 

ASU 2014-15 provides guidance concerning management’s determination of whether there is substantial doubt regarding the entity’s ability to continue as a going concern.

Going Concern

What is Substantial Doubt?

So, how does FASB define substantial doubt? 

Substantial doubt about the entity’s ability to continue as a going concern is considered to exist when aggregate conditions and events indicate that it is probable that the entity will be unable to meet obligations when due within one year of the date that the financial statements are issued or are available to be issued.

What is Probable?

So, how does management determine if “it is probable that the entity will be unable to meet obligations when due within one year”?

Probable means likely to occur

If for example, a company expects to miss a debt service payment in the coming year, then substantial doubt exists. This initial assessment is made without regard to management’s plans to alleviate going concern conditions. 

ASC 205-40-50-4 says:

The evaluation initially shall not take into consideration the potential mitigating effect of management’s plans that have not been fully implemented as of the date that the financial statements are issued (for example, plans to raise capital, borrow money, restructure debt, or dispose of an asset that have been approved but that have not been fully implemented as of the date that the financial statements are issued).

But what factors should management consider?

Factors to Consider

Management should consider the following factors when assessing going concern:

  • The reporting entity’s current financial condition, including the availability of liquid funds and access to credit
  • Obligations of the reporting entity due or new obligations anticipated within one year (regardless of whether they have been recognized in the financial statements)
  • The funds necessary to maintain operations considering the reporting entity’s current financial condition, obligations, and other expected cash flows
  • Other conditions or events that may affect the entity’s ability to meet its obligations

Moreover, management is to consider these factors for one year. But from what date?

Timeframe

The financial statement preparer (i.e., management or a party contracted by management) should assess going concern in light of one year from the date “the financial statements are issued or are available to be issued.”

So, if December 31, 2017, financial statements (for a nonpublic company) are available to be issued on March 15, 2017, the preparer looks forward one year from March 15, 2017. Then, the preparer asks, “Is it probable that the company will be unable to meet its obligations through March 15, 2018?” If yes, substantial doubt is present and disclosures are necessary. If no, then substantial doubt does not exist. As you would expect, the answer to this question determines whether going concern disclosures are to be made and what should be included.

Substantial Doubt Answer Determines Disclosures

If substantial doubt does not exist, then going concern disclosures are not necessary.

If substantial doubt exists, then the company needs to decide if management’s plans alleviate the going concern issue. This decision determines the disclosures to be made. The required disclosures are based upon whether:

  1. Management’s plans alleviate the going concern issue
  2. Management’s plans do not alleviate the going concern issue

1. What if Management’s Plans Alleviate the Going Concern Issue?

If conditions or events raise substantial doubt about an entity’s ability to continue as a going concern, but the substantial doubt is alleviated as a result of consideration of management’s plans, the entity should disclose information that enables users of the financial statements to understand all of the following (or refer to similar information disclosed elsewhere in the footnotes):

  1. Principal conditions or events that raised substantial doubt about the entity’s ability to continue as a going concern (before consideration of management’s plans)
  2. Management’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations
  3. Management’s plans that alleviated substantial doubt about the entity’s ability to continue as a going concern

Management’s plans should be considered only if is it probable that they will be effectively implemented. Also, it must be probable that management’s plans will be effective in alleviating substantial doubt.

So, if management’s plans are expected to work, does the company have to explicitly state that management’s plans will alleviate substantial doubt? No. 

When management’s plans alleviate substantial doubt, companies need not use the words going concern or substantial doubt in the disclosures. And as Sears discovered, it may not be wise to do so (their shares dropped 16% after using the term substantial doubt even though management had plans to alleviate the risk). Rather than using the term substantial doubt, consider describing conditions (e.g., cash flows are not sufficient to meet obligations) and management plans to alleviate substantial doubt.

Sample Note – Substantial Doubt Alleviated

An example note follows:

Note 2 – Company Conditions

The Company had losses of $4,525,123 in the year ending March 31, 2017. As of March 31, 2017, its accumulated deficit is $11,325,354. 

Management believes the Company’s present cash flows will not enable it to meet its obligations for twelve months from the date these financial statements are available to be issued. However, management is working to obtain new long-term financing. It is probable that management will obtain new sources of financing that will enable the Company to meet its obligations for the twelve-month period from the date the financial statements are available to be issued.

Notice this example does not use the words substantial doubt.

2. What if Management’s Plans Do Not Alleviate the Going Concern Issue?

If conditions or events raise substantial doubt about an entity’s ability to continue as a going concern, and substantial doubt is not alleviated after consideration of management’s plans, an entity should include a statement in the notes indicating that there is substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are available to be issued (or issued when applicable). Additionally, the entity should disclose information that enables users of the financial statements to understand all of the following:

  1. Principal conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern
  2. Management’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations
  3. Management’s plans that are intended to mitigate the conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern

Sample Disclosure – Substantial Doubt Not Alleviated

An example disclosure follows:

Note 2 – Going Concern
 
The financial statements have been prepared on a going concern basis which assumes the Company will be able to realize its assets and discharge its liabilities in the normal course of business for the foreseeable future.  The Company had losses of $1,232,555 in the current year. The Company has incurred accumulated losses of $2,891,727 as of March 31, 2017. Cash flows used in operations totaled $555,897 for the year ended March 31, 2017.
 
Management believes these conditions raise substantial doubt about the Company’s ability to continue as a going concern within the next twelve months from the date these financial statements are available to be issued. The ability to continue as a going concern is dependent upon profitable future operations, positive cash flows, and additional financing.
 
Management intends to finance operating costs over the next twelve months with existing cash on hand and loans from its directors. Management is also working to secure new bank financing. The Company’s ability to obtain the new financing is not known at this time.
 
Notice this note includes a statement that substantial doubt is present. Though management’s plans are disclosed, the probability of success is not provided.

ASU 2014-15 Summary

ASU 2014-15 focuses on management’s assessment regarding whether substantial doubt exists. If substantial doubt exists, then disclosures are required. Here’s a short video summarizing 2014-15:

Thus far, we’ve addressed the stage 1. management decisions. As you can see management’s considerations focus on disclosures. By contrast, auditors focus on the audit opinion. Now, let’s look at what auditors must do.

Stage 2. Auditor Decisions

 

SAS 132 provides guidance concerning the auditor’s consideration of an entity’s ability to continue as a going concern.

Going Concern

Objectives of the Auditor

SAS 132, paragraph 10, states the objectives of the auditor are as follows:

  • Obtain sufficient appropriate audit evidence regarding, and to conclude on, the appropriateness of management’s use of the going concern basis of accounting, when relevant, in the preparation of the financial statements
  • Conclude, based on the audit evidence obtained, whether substantial doubt about an entity’s ability to continue as a going concern for a reasonable period of time exists
  • Evaluate the possible financial statement effects, including the adequacy of disclosure regarding the entity’s ability to continue as a going concern for a reasonable period of time
  • Report in accordance with this SAS

These objectives can be summarized as follows:

  1. Conclude about whether the going concern basis of accounting is appropriate
  2. Determine whether substantial doubt is present
  3. Determine whether the going concern disclosures are adequate
  4. Issue an appropriate opinion 

In light of these objectives, certain audit procedures are necessary.

Risk Assessment Procedures

In the risk assessment phase of an audit, the auditor should consider whether conditions or events raise substantial doubt. In doing so, the auditor should examine any preliminary management evaluation of going concern. If such an evaluation was performed, the auditor should review it with management. If no evaluation has occurred, then the auditor should discuss with management the appropriateness of using the going concern basis of accounting (the liquidation basis of accounting is required by ASC 205-30 when the entity’s liquidation is imminent) and whether there are conditions or events that raise substantial doubt. 

The auditor is to consider conditions and events that raise substantial doubt about an entity’s ability to continue as a going concern for a reasonable period of time. What is a reasonable period of time? It is the period of time required by the applicable financial reporting framework or, if no such requirement exists, within one year after the date that the financial statements are issued (or within one year after the date that the financial statements are available to be issued, when applicable). The governmental accounting standards require an evaluation period of “12 months beyond the date of the financial statements.”

Auditors should consider negative financial trends or factors such as:

  • Working capital deficiencies
  • Negative cash flows from operating activities
  • Default on loans
  • A denial of trade credit from suppliers
  • Need to restructure debt
  • Need to dispose of assets
  • Work stoppages or other labor problems
  • Need to significantly revise operations
  • Legal problems
  • Loss of key customers or suppliers
  • Uninsured catastrophes
  • The need for new capital

The risk assessment procedures are a part of planning an audit. You may obtain new information as you perform the engagement.

Remaining Alert Throughout the Audit

The auditor should remain alert throughout the audit for conditions or events that raise substantial doubt. So, after the initial review of going concern issues in the planning stage, the auditor considers the impact of new information gained during the subsequent stages of the engagement.

Audit Procedures When Substantial Doubt is Present

If events or conditions do give rise to substantial doubt, then the audit procedures should include the following (SAS 132, paragraph 16.):

  1. Requesting management to make an evaluation when management has not yet performed an evaluation
  2. Evaluating management’s plans in relation to its going concern evaluation, with regard to whether it is probable that: 
    1. management’s plans can be effectively implemented and 
    2. the plans would mitigate the relevant conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time
  3. When the entity has prepared a cash flow forecast, and analysis of the forecast is a significant factor in evaluating management’s plans: 
    1. evaluating the reliability of the underlying data generated to prepare the forecast and 
    2. determining whether there is adequate support for the assumptions underlying the forecast, which includes considering contradictory audit evidence
  4. Considering whether any additional facts or information have become available since the date on which management made its evaluation

Sometimes management’s plans to alleviate substantial doubt include financial support by third parties or owner-managers (usually referred to as supporting parties). 

Financial Support by Supporting Parties

When financial support is necessary to mitigate substantial doubt, the auditor should obtain audit evidence about the following:

  1. The intent of such supporting parties to provide the necessary financial support, including written evidence of such intent, and
  2. The ability of such supporting parties to provide the necessary financial support

If the evidence in a. is not obtained, then “management’s plans are insufficient to alleviate the determination that substantial doubt exists.”

Intent of Supporting Parties

The intent of supporting parties may be evidenced by either of the following:

  1. Obtaining from management written evidence of a commitment from the supporting party to provide or maintain the necessary financial support (sometimes called a “support letter”)
  2. Confirming directly with the supporting parties (confirmation may be needed if management only has oral evidence of such financial support)

If the auditor receives a support letter, he can still request a written confirmation from the supporting parties. For instance, the auditor may desire to check the validity of the support letter.

If the support comes from an owner-manager, then the written evidence can be a support letter or a written representation.

Support Letter

An example of a third party support letter (when the applicable reporting framework is FASB ASC) is as follows:

(Supporting party name) will, and has the ability to, fully support the operating, investing, and financing activities of (entity name) through at least one year and a day beyond [insert date] (the date the financial statements are issued or available for issuance, when applicable). 

You can specify a date in the support letter that is later than the expected date. That way if there is a delay, you may be able to avoid updating the letter.

The auditor should not only consider the intent of the supporting parties but the ability as well.

Ability of Supporting Parties

The ability of supporting parties to provide support can be evidenced by information such as:

  • Proof of past funding by the supporting party
  • Audited financial statements of the supporting party
  • Bank statements and valuations of assets held by a supporting party

After examining the intent and ability of supporting parties regarding the one-year period, you might identify potential going concern problems that will occur more than one year out.

Conditions and Events After the Reasonable Period of Time

So, should an auditor inquire about conditions and events that may affect the entity’s ability to continue as a going concern beyond management’s period of evaluation (i.e., one year from the date the financial statements are available to be issued or issued, as applicable)? Yes.

Suppose an entity knows it will be unable to meet its November 15, 2018, debt balloon payment. The financial statements are available to be issued on June 15, 2017, so the reasonable period goes through June 15, 2018. But management knows it can’t make the balloon payment, and the bank has already advised that the loan will not be renewed. SAS 132 requires the auditor to inquire of management concerning their knowledge of such conditions or events. 

Why? Only to determine if any potential (additional) disclosures are needed. FASB only requires the evaluation for the year following the date the financial statements are issued (or available to be issued, as applicable). Events following this one year period have no bearing on the current year going concern decisions. Nevertheless, additional disclosures may be merited.

Thus far, the requirements to evaluate the use of the going concern basis of accounting and whether substantial doubt is present have been explained. Now, let’s see what the requirements are for:

  • Written representations from management
  • Communications with those charged with governance
  • Documentation

Written Representations When Substantial Doubt Exists

When substantial doubt exists, the auditor should request the following written representations from management:

  1. A description of management’s plans that are intended to mitigate substantial doubt and the probability that those plans can be effectively implemented
  2. That the financial statements disclose all the matters relevant to the entity’s ability to continue as a going concern including conditions and events and management’s plans

Communications with Those Charged with Governance

Remember that you may need to add additional language to your communication with those charged with governance.

When conditions and events raise substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time, the auditor should communicate the following (unless those charged with governance manage the entity):

  1. Whether the conditions or events, considered in the aggregate, that raise substantial doubt about an entity’s ability to continue as a going concern for a reasonable period of time constitute substantial doubt
  2. The auditor’s consideration of management’s plans
  3. Whether management’s use of the going concern basis of accounting, when relevant, is appropriate in the preparation of the financial statements
  4. The adequacy of related disclosures in the financial statements
  5. The implications for the auditor’s report

Documentation Requirements

When substantial doubt exists before consideration of management’s plans, the auditor should document the following (SAS 132, paragraph 32.):

  1. The conditions or events that led the auditor to believe that there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time.
  2. The elements of management’s plans that the auditor considered to be particularly significant to overcoming the conditions or events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern, if applicable.
  3. The audit procedures performed to evaluate the significant elements of management’s plans and evidence obtained, if applicable.
  4. The auditor’s conclusion regarding whether substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time remains or is alleviated. If substantial doubt remains, the auditor should also document the possible effects of the conditions or events on the financial statements and the adequacy of the related disclosures. If substantial doubt is alleviated, the auditor should also document the auditor’s conclusion regarding the need for, and, if applicable, the adequacy of, disclosure of the principal conditions or events that initially caused the auditor to believe there was substantial doubt and management’s plans that alleviated the substantial doubt.
  5. The auditor’s conclusion with respect to the effects on the auditor’s report.

Opinion – Emphasis of Matter Regarding Going Concern

If the auditor concludes that there is substantial doubt concerning the company’s ability to continue as a going concern, an emphasis of a matter paragraph should be added to the opinion.

An example of a going concern paragraph is as follows:

The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the financial statements, the Company has suffered recurring losses from operations, has a net capital deficiency, and has stated that substantial doubt exists about the company’s ability to continue as a going concern. Management’s evaluation of the events and conditions and management’s plans regarding these matters are also described in Note 2. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. Our opinion is not modified with respect to this matter.

The auditor should not use conditional language regarding the existence of substantial doubt about the entity’s ability to continue as a going concern. 

Opinion – Inadequate Going Concern Disclosures

Paragraph 26. of SAS 132 states that an auditor should issue a qualified opinion or an adverse opinion, as appropriate, when going concern disclosures are not adequate.

SAS 132 Summary 

Now, let’s circle back to where we started and review the objectives of SAS 132.

The objectives are as follows:

  • Conclude about whether the going concern basis of accounting is appropriate
  • Determine whether substantial doubt is present
  • Determine whether the going concern disclosures are adequate
  • Issue an appropriate opinion 

Conclusion

As you can see ASU 2014-15 and SAS 132 are complex. So, make sure you are using the most recent updates to your disclosure checklists and audit forms and programs.

Finally, keep in mind that going concern is also relevant to compilation and review engagements.

Audit Planning Analytics
May 01

Audit Planning Analytics: What You Need to Know

By Charles Hall | Auditing

You can identify risks of material misstatement with audit planning analytics. 

Audit Planning Analytics

Audit Planning Analytics

The auditing standards provide four risk assessment procedures: 

  1. Inquiry
  2. Observation
  3. Inspection
  4. Analytical procedures

I previously provided you with information about the first three risk assessment procedures. Today, I provide you with the fourth, analytical procedures.

While analytical procedures should occur at the beginning and the end of an audit, this post focuses on planning analytics.

Below I provide the quickest and best way to develop audit planning analytics

What are Analytics?

If you're not an auditor, you may be wondering, "what are analytics?" Think of analytics as the use of numbers to determine reasonableness. For example, if a company's cash balance at December 31, 2017, was $100 million, is it reasonable for the account to be $5 million at December 31, 2018? Comparisons such as this one assist auditors in their search for errors and fraud.

Overview of this Post

We'll cover the following:

  • The purpose of planning analytics
  • When to create planning analytics (at what stage of the audit)
  • Developing expectations 
  • The best types of planning analytics
  • How to document planning analytics
  • Developing conclusions 
  • Linkage to the audit plan

Purpose of Planning Analytics

The purpose of planning analytics is to identify risks of material misstatement. Your goal as an auditor is to render an opinion regarding the fairness of the financial statements. So, like a good sleuth, you are surveying the accounting landscape to see if material misstatements exist.

A detective investigates a crime scene using various tools: fingerprints, forensic tests, interviews, timelines. Auditors have their own tools: inquiry, observation, inspection, analytical procedures. Sherlock Holmes looks for the culprit. The auditor (and I know this isn't as sexy) looks for material misstatements. 

The detective and the auditor are both looking for the same thing: evidence. And the deft use of tools can lead to success. A key instrument (procedure) available to auditors is planning analytics. 

When to Create Planning Analytics

Create your preliminary analytics after gaining an understanding of the entity. Why? Context determines reasonableness of numbers. And without context (your understanding of the entity), changes in numbers from one year to the next may not look like a red flag--though maybe they should.

Therefore, learn about the entity first. Are there competitive pressures?  What are the company's objectives? Are there cash flow issues? What is the normal profit margin percentage? Does the organization have debt? Context creates meaning.

Additionally, create your comparisons of numbers prior to creating your risk assessments. After all, the purpose of the analytical comparisons is to identify risk.

But before creating your planning analytics, you first need to know what to expect.

Developing Expectations 

Knowing what to expect provides a basis for understanding the changes in numbers from year to year. 

Expectations can include:

  • Increases in numbers
  • Decrease in numbers
  • Stable numbers (no significant change)

In other words, you can have reasons to believe payroll (for example) will increase or decrease. Or you might anticipate that salaries will remain similar to last year.

Examples of Expectations Not Met

Do you expect sales to decrease 5% based on decreases in the last two years? If yes, then an increase of 15% is a flashing light.

Or maybe you expect sales to remain about the same as last year? Then a 19% increase might be an indication of financial statement fraud.

But where does an auditor obtain expectations?

Sources of Expectations

Expectations of changes can come from (for example):

  • Past changes in numbers 
  • Discussions with management about current year operations
  • Reading the company minutes
  • Staffing reductions
  • Non-financial statistics (e.g., decrease the number of widgets sold)
  • A major construction project

While you'll seldom know about all potential changes (and that's not the goal), information--such as that above--will help you intuit whether change (or a lack of change) in an account balance is a risk indicator.

Now, let's discuss the best types of planning analytics. 

The Best Types of Planning Analytics

Auditing standards don't specify what types of planning analytics to use. But some, in my opinion, are better than others. Here's my suggested approach (for most engagements). 

Audit Planning Analytics

First, create your planning analytics at the financial statement reporting level. Why? Well, that's what the financial statement reader sees. So, why not use this level (if you can)? (There is one exception in regard to revenues. See Analytics for Fraudulent Revenue Recognition below.)

The purpose of planning analytics is to ferret out unexpected change. Using more granular information (e.g., trial balance) muddies the water. Why? There's too much information. You might have three hundred accounts in the trial balance and only fifty at the financial statement level. Chasing down trial-balance-level changes can be a waste of time. At least, that's the way I look at it.

Second, add any key industry ratios tracked by management and those charged with governance. Often, you include these numbers in your exit conference with the board (maybe in a slide presentation). If those ratios are important at the end of an audit, then they're probably important in the beginning.

Examples of key industry ratios include:

  • Inventory turnover
  • Return on equity
  • Days cash on hand
  • Gross profit 
  • Debt/Equity 

Okay, so we know what analytics to create, but how should we document them?

Analytics for Fraudulent Revenue Recognition

AU-C 240.22 says, "the auditor should evaluate whether unusual or unexpected relationships that have been identified indicate risks of material misstatement due to fraud. To the extent not already included, the analytical procedures, and evaluation thereof, should include procedures relating to revenue accounts." 

The auditing standards suggest a more detailed form of analytics for revenues. AU-C 240.A25 offers the following:

  • a comparison of sales volume, as determined from recorded revenue amounts, with production capacity. An excess of sales volume over production capacity may be indicative of recording fictitious sales.
  • a trend analysis of revenues by month and sales returns by month, during and shortly after the reporting period. This may indicate the existence of undisclosed side agreements with customers involving the return of goods, which, if known, would preclude revenue recognition.
  • a trend analysis of sales by month compared with units shipped. This may identify a material misstatement of recorded revenues.

In light of these suggested procedures, it may be prudent to create revenue analytics at a more granular level than that shown in the financial statements.

How to Document Planning Analytics

Here are my suggestions for documenting your planning analytics.

  1. Document overall expectations.
  2. Include comparisons of prior-year/current-year numbers at the financial statement level. (You might also include multiple prior year comparisons if you have that information.)
  3. Document key industry ratio comparisons.
  4. Summarize your conclusions. Are there indicators of increased risks of material misstatement? Is yes, say so. If no, say so.

Once you create your conclusions, place any identified risks on your summary risk assessment work paper (where you assess risk at the transaction level--e.g., inventory).

Use Filtered Analytical Reports with Caution (if at all)

Some auditors use filtered trial balance reports for their analytics. For instance, all accounts with changes of greater than $30,000. There is a danger in using such thresholds. 

What if  you expect a change in sales of 20% (approximately $200,000) but your filters include:

  •  all accounts with changes greater than $50,000, and 
  • all accounts with changes of more than 15%

If sales remain constant, then this risk of material misstatement (you expected change of 20%, but it did not happen) fails to appear in the filtered report. The filters remove the sales account because the change was minimal. Now, the risk may go undetected.

Developing Conclusions

I am a believer in documenting conclusions on key work papers. So, how do I develop those conclusions? And what does a conclusion look like on a planning analytics work paper?

First, develop your conclusions. How? Scan the comparisons of prior year/current year numbers and ratios. We use our expectations to make judgments concerning the appropriateness of changes and of numbers that remain stable. Remember this is a judgment, so, there's no formula for this. 

No Risk Identified

Now, you'll document your conclusions. But what if there are no unexpected changes? You expected the numbers to move in the manner they did. Then no identified risk is present. Your conclusion will read, (for example):

Conclusion: I reviewed the changes in the accounts and noted no unexpected changes. Based on the planning analytics, no risks of material misstatement were noted.

Risk Identified

Alternatively, you might see unexpected changes. You thought certain numbers would remain constant, but they moved significantly. Or you expected material changes to occur, but they did not. Again, document your conclusion. For example:

Conclusion: I expected payroll to remain constant since the company's workforce stayed at approximately 425 people. Payroll expenses increased, however, by 15% (almost $3.8 million). I am placing this risk of material misstatement on the summary risk assessment work paper at 0360 and will create audit steps to address the risk.

Now, it's time to place the identified risks (if there are any) on your summary risk assessment form.

Linkage to the Audit Plan

I summarize all risks of material misstatements on my summary risk assessment form. These risks might come from walkthroughs, planning analytics or other risk assessment procedures. Regardless, I want all of the identified risks--those discovered in the risk assessment process--in one place.

The final step in the audit risk assessment process is to link your identified risks to your audit program. 

Overview of Risk Assessment and Linkage

Now, I tailor my audit program to address the risks. Tailoring the audit program to respond to identified risks is known as linkage.

Audit standards call for the following risk assessment process:

  • Risk assessment procedures (e.g., planning analytics)
  • Identification of the risks of material misstatement
  • Creation of audit steps to respond to the identified risks (linkage)

Summary of Planning Analytics Considerations

So, now you know how to use planning analytics to search for risks of material misstatement--and how this powerful tool impacts your audit plan.

Let's summarize what we've covered:

  1. Planning analytics are created for the purpose of identifying risks of material misstatement
  2. Develop your expectations before creating your planning analytics (learn about the entity's operations and objectives; review past changes in numbers for context--assuming you've performed the audit in prior years)
  3. Create analytics at the financial statement level, if possible
  4. Use key industry ratios 
  5. Conclude about whether risks of material misstatement are present
  6. Link your identified risks of material misstatement to your audit program

If you have thoughts or questions about this post, please let me know below in the comments box. Thanks for reading.

First-Year Businesses and Planning Analytics

You may be wondering, "but what if I my client is new?" New entities don't have prior numbers. So, how can you create planning analytics? 

First Option

One option is to compute expected numbers using non-financial information. Then compare the calculated numbers to the general ledger to search for unexpected variances.

Second Option

A second option is to calculate ratios common to the entity’s industry and compare the results to industry benchmarks.

While industry analytics can be computed, I’m not sure how useful they are for a new company. An infant company often does not generate numbers comparable to more mature entities. But we’ll keep this choice in our quiver--just in case.

Third Option

A more useful option is the third: comparing intraperiod numbers. 

Discuss the expected monthly or quarterly revenue trends with the client before you examine the accounting records. The warehouse foreman might say, “We shipped almost nothing the first six months. Then things caught fire. My head was spinning the last half of the year.” Does the general ledger reflect this story? Did revenues and costs of goods sold significantly increase in the latter half of the year?

Fourth Option

The last option we’ve listed is a review of the budgetary comparisons. Some entities, such as governments, lend themselves to this alternative. Others, not so–those that don’t adopt budgets.

Summary

So, yes, it is possible to create useful risk assessment analytics–even for a first-year company.

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