Apr 27

How to Write Clear Financial Statement Disclosures

By Charles Hall | Accounting and Auditing

Creating clear financial statement disclosures is not always easy. Creating (unintentional) confusion? Well, that’s another matter.

Clear Financial Statement Disclosures

Let’s pretend that Olympic judges rate your most recent disclosures, flashing scores to a worldwide audience. What do you see? Tens everywhere—or something else?

Balance sheets tend to be clear. Why? The accounting equation. Assets always equal liabilities plus equity. But there is no disclosure equation (darn it), and without such, we flounder in our communication.

CPAs tend to be linear thinkers. We enjoy Pascal more than Hemingway, numbers more than words, debits and credits more than paragraphs. Our brains are wired that way.

But accounting is more than just numbers. It is the communication of financial statements and disclosures. In the name of clear disclosures, I offer these suggestions.

Consider Your Readers

Who will read the financial statements? Owners, lenders, and possibly vendors. Owners—especially those of smaller businesses—may need simpler language. Some CPAs write notes as if CPAs (alone) will read them. While accounting is technical, we need—as much as possible—to simplify.

Use Short Paragraphs

Lengthy paragraphs choke the reader. Breaking long paragraphs into shorter ones makes the print accessible.

Less is more in many instances. When we try to say too much, we sometimes say…too much. Additionally, short sentences are helpful.

Use Short Sentences

CPAs may have invented the run-on sentence. As I read one of those beauties, I feel as though I can’t breathe. And by the end, I’m gasping. Breaking long sentences into shorter ones makes the reader more comfortable. And she will thank you.

Use Shorter Words

CPAs don’t receive merit badges for long, complicated words. Our goal is to communicate, not to impress. For example, split is better than bifurcate.

Attorneys are not our model. I sometimes see notes that are regurgitations of legal agreements, copied word for word—and you can feel the stiltedness. Do your reader a favor and translate the legalese into digestible—and might I say more enjoyable—language.

Use Tables

Long sentences with several numbers can be confusing. Tables are easier to understand.

Write Your Own Note

Too many CPAs copy disclosures from the Internet without understanding the language. Make sure the language is appropriate for your company.

Put Disclosures in the Right Buckets

Think of each disclosure header as a bucket. For example, if the notes include a related party note, then that’s where the related party information goes. If the debt note includes a related party disclosure (and this may be necessary), place a reference in the related party note to the debt disclosure. You don’t want your reader to think all of the related party disclosures are in one place (the related party note) when they are not. The same issue arises with subsequent event notes.

Have a Second Person Review the Notes

When writing, we sometimes think we are clear when we are not. Have a second person review the note for proper punctuation, spelling, structure, and clarity. If you don’t have a second person available, perform a cold review the next day—you will almost always see necessary revisions. I find that reading out loud helps me to assess clarity.

I also use Grammarly to edit documents. The software provides grammar feedback as you write. If you don’t have a second person to review your financials, I recommend it.

Use a Current Disclosure Checklist

Vetting your notes with a disclosure checklist may be the most tedious and necessary step. FASB and GASB continue to issue new statements at a rapid rate, so using a checklist is necessary to ensure completeness.

Winning Gold

I hope these suggestions help you win gold–10s everywhere. I think I hear the national anthem.

Apr 26

Inherent Risk: How to Save Time by Properly Assessing

By Charles Hall | Auditing , Risk Assessment

Do you know how to assess inherent risk? Knowing when inherent risk is low is a key to efficient audits. In this article, I tell you how to assess inherent risk--and how lower risk assessments (potentially) decrease the amount of work you perform.

While audit standards don't require a separate assessment on inherent risk (IR) and control risk (CR), it's wise to do so. Why? So you know what drives the risk of material misstatement (RMM).

Many auditors assess control risk at high (after performing their risk assessment procedures). Why? So they don't have to test controls.

If control risk is high, then inherent risk is the only factor that can lower your risk of material misstatement. For example, a high control risk and a low inherent risk results in a moderate risk of material misstatement. Why is this important? Lower RMMs provide the basis for less substantive work.

The Audit Risk Model

Before we delve deeper into inherent risk assessment, let's do a quick review of the audit risk model. Auditing standards (AU-C 200.14) define audit risk as “The risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. Audit risk is a function of the risks of material misstatement and detection risk.”

Audit risk is defined as follows:

Audit Risk = IR X CR X Detection Risk

Inherent risk and control risk live within the entity to be audited.

Detection risk lies with the auditor.

A material misstatement may develop within the company because the transaction is risky or complex. Then, controls may not be sufficient to detect and correct the misstatement.

If the auditor fails to detect the material misstatement, audit failure occurs. The auditor issues an unmodified opinion when a material misstatement is present.

Risk of Material Misstatement

As we plan an audit, we assess the risk of material misstatement. It is defined as follows:

RMM = IR X CR

Auditors assess the risk of material misstatement at the assertion level so they can determine the level of substantive work. Substantive work is the response to risk.

If the RMM is high, more substantive work is needed. Why? To reduce detection risk.

But if the RMM is low to moderate, less substantive work is needed.

Inherent Risk

What is inherent risk? The susceptibility of an assertion about a class of transaction, account balance, or disclosure to a misstatement that could be material, either individually or when aggregated with other misstatements, before consideration of any related controls.

Examples

The inherent risk of cash is greater than that of a building. Cash is easily stolen. Buildings are not.

The inherent risk of a hedge transaction is greater than that of a trade receivable. Hedges can be complicated to compute. Trade receivables are not.

Post-retirement liabilities are inherently risky. Why? It's a complex accounting area. The numbers usually come from an actuary. There are estimates in the form of assumptions.

Inherent Risk Factors

Consider factors such as the following in assessing inherent risk:

Susceptibility to theft or fraudulent reporting
Complex accounting or calculations
Accounting personnel’s knowledge and experience
Need for judgment
Difficulty in creating disclosures
Size and volume of accounts balance or transactions
Susceptibility to obsolescence
Prior year period adjustments

Inherent risk is not an average of the above factors. Just one risk factor can make an account balance or transaction cycle or disclosure high risk.

Inherent Risk at Less Than High

When inherent risk is less than high, you can perform fewer or less rigorous substantive procedures.

An example of a low inherent risk is the existence assertion for payables. If experienced payables personnel accrue payables, then the existence assertion might be assessed at low. (The directional risk of payables is an understatement, not an overstatement.) The lower risk assessment for existence allows the auditor to perform little if any procedures in relation to this assertion.

Conversely, the completeness assertion for accounts payable is commonly a high inherent risk. Businesses can inflate their profits by accruing fewer payables. Fraudulent reporting of period-end payables is possible. Therefore, the inherent risk of completeness for payables is often high. That's why auditors perform a search for unrecorded liabilities.

Base your risk assessment on factors such as those listed above. If inherent risk is legitimately low, then great. You can perform less substantive work. But if the assertion is high risk, then it should be assessed accordingly--even if that means more work. (The AICPA has included questions in peer review checklists regarding the basis for lower risk assessments. Their concern (I think) is that auditors might manipulate inherent risk in order to perform less work. I've heard no one from the AICPA say this. But I can see how they might be concerned about this possibility.)

Control Risk

So, what is the relationship between inherent risk and control risk?

Companies develop internal controls to manage areas that are inherently risky.

A business might create internal controls to lessen the risk that payables are understated. Examples of such controls include:

The CFO reviews the payables detail at period-end, inquiring about the completeness of the list
A payables supervisor reviews all invoices entered into the payables system
The payables supervisor inquires of all payables clerks about any unprocessed invoices at period-end
A budget to actual report is provided to department heads for review

Inherent risk exists independent of internal controls.

Control risk exists when the design or operation of a control does not remove the risk of misstatement.

Video Demonstration of the Effects of Inherent Risk

Mar 20

Auditing Investments: The Why and How Guide

By Charles Hall | Auditing

Want to know how to audit investments? You're in the right place.

Below I provide a comprehensive look at how you can audit investments effectively and efficiently.

The complexity of auditing investments varies. For entities with simple investment instruments, auditing is easy. Your main audit procedure might be to confirm balances. Complex investments, however, require additional work such as auditing values. As investment complexity increases, so will your need for stronger audit team members (those that understand unusual investments). Regardless, you need an audit methodology.

So, here we go.

How to Audit Investments

In this post, we will take a look at:

Primary investment assertions
Investment walkthroughs
Directional risk for investments
Primary risks for investments
Common investment control deficiencies
Risk of material misstatement for investments
Substantive procedures for investments
Common investment work papers

Primary Investments Assertions

First, let’s look at assertions.

Primary relevant investment assertions include:

Existence
Accuracy
Valuation
Cutoff

The audit client is asserting that the investment balances exist, that they are accurate and properly valued, and that only investment activity within the period is recorded.

While investment balances in the financial statements are important, disclosures are also vital, especially when the entity owns complex instruments.

Investment Walkthroughs

Second, perform your risk assessment work in light of the relevant assertions.

As you perform walkthroughs of investments, you normally look for ways that investments might be overstated (though investments can be understated as well). You are asking, “What can go wrong?” whether intentionally or by mistake. You want to know if:

The controls were appropriately designed, and
The controls were implemented (in use)

Walkthrough Questions

In performing investment walkthroughs, ask questions such as:

What types of investments are owned?
Are there any unusual investments? If yes, how are they valued?
Is a specialist used to determine investment values?
Who determines the classification of investments (e.g., trading, available for sale, held to maturity) and how
Do the persons accounting for investment activity have sufficient knowledge to do so?
Are timely investment reconciliations performed by competent personnel?
Are all investment accounts reconciled (from the investment statements to the general ledger)?
Who reconciles the investment accounts and when?
Are the reconciliations reviewed by a second person?
Are all investment accounts on the general ledger?
How does the entity ensure that all investment activity is included in the general ledger (appropriate cutoff)?
Who has the ability to transfer investment funds and what are the related controls?
Is there appropriate segregation of duties for:
- Persons that record investments,
- Persons that buy and sell investments, and
- Persons that reconcile the investment statements
What investment accounts were opened in the period?
What investment accounts were closed in the period?
Who has the authority to open or close investment accounts?
Are there any investment restrictions (externally or internally)?
What persons are authorized to buy and sell investments?
Does the entity have a written investment policy?
Does the company use an investment advisor? If yes, how often does management interact with the advisor? How are investment fees determined?
Are there any investment impairments?
Who is responsible for investment disclosures and do they have sufficient knowledge to carry out this duty?
Are there any cost or equity-method investments?

As we ask questions, we also inspect documents (e.g., investment statements) and make observations (e.g., who reconciles the investment statements to the general ledger?).

If control weaknesses exist, we create audit procedures to address them. For example, if during the walkthrough we note that there are improperly classified investments, then will plan audit procedures to address that risk.

Directional Risk for Investments

Third, consider the directional risk of investments.

The directional risk for investments is that they are overstated. So, in performing your audit procedures, perform procedures to ensure that balances are properly stated.

Primary Risks for Investments

Fourth, think about the risks related to investments.

Primary risks include:

Investments are stolen
Investments are intentionally overstated to cover up theft
Investments accounts are intentionally omitted from the general ledger
Investments are misstated due to errors in the investment reconciliations
Investments are improperly valued due to their complexity and management’s lack of accounting knowledge
Investments are misstated due to improper cutoff
Investment disclosures are not accurate or complete

Common Investment Control Deficiencies

Fifth, think about control deficiencies noted during your walkthroughs and other risk assessment work.

It is common to have the following investment control deficiencies:

One person buys and sells investments, records those transactions, and reconciles the investment activity
The person overseeing investment accounting does not possess sufficient knowledge or skill to properly perform the duty
Investment reconciliations are not performed timely or improperly
The company does not employ sufficient assistance in valuing complex assets such as hedges or alternative investments

Risk of Material Misstatement for Investments

Sixth, now its time to assess your risks.

In my smaller audit engagements, I usually assess control risk at high for each assertion. (You may, however, assess control risk at less than high, provided your walkthrough reveals that controls are appropriately designed and that they were implemented. If control risk is assessed at below high, you must test controls for effectiveness to support the lower risk assessment.)

When control risk is assessed at high, inherent risk becomes the driver of the risk of material misstatement (control risk X inherent risk = risk of material misstatement). For example, if control risk is high and inherent risk is moderate, then my RMM is moderate.

Important Assertions

The assertions that concern me the most are existence, accuracy, valuation, and cutoff.

The assertions that concern me the most are existence, accuracy, valuation, and cutoff. So my RMM for these assertions is usually moderate to high.

My response to higher risk assessments is to perform certain substantive procedures: namely, confirming investments, testing investment reconciliations, testing values, and vetting investment disclosures.

Substantive Procedures for Investments

And finally, it’s time to determine your substantive procedures in light of your identified risks.

My customary audit tests include:

Confirming investment balances agreeing them to the general ledger
Inspecting period-end activity for proper cutoff
Using an investment specialist to value complex instruments (if any)
Vetting investment disclosures with a current disclosure checklist

I don’t normally test controls related to investments. If controls are tested and you determine they are effective, then some of the substantive procedures may not be necessary.

Common Investment Work Papers

My investments work papers normally include the following:

An understanding of investment-related internal controls
Risk assessment of investments at the assertion level
Documentation of any control deficiencies
Investment audit program
Investment reconciliations
Investment confirmations
Valuations performed by specialists
Documentation of the specialist’s experience, competence, and objectivity
Disclosure checklist

Auditing Investments - A Simple Summary

The primary relevant investment assertions include existence, accuracy, valuation, and cutoff
Perform a walkthrough of investments by making inquiries, inspecting documents, and making observations
The directional risk for investments is an overstatement
Primary risks for investments include:
- Investments are stolen
- Investments are intentionally overstated to cover up theft
- Investments accounts are intentionally omitted from the general ledger
- Investments are misstated due to errors in the investment reconciliations
- Investments are improperly valued due to their complexity and management’s lack of accounting knowledge
- Investments are misstated due to improper cutoff
- Investments disclosures are not accurate or complete
The substantive procedures for investments should be responsive to the identified risks; common procedures include:
- Confirming investments
- Inspecting period-end activity for proper cutoff
- Using an investment specialist to value complex instruments
- Vetting investment disclosures with a current disclosure checklist

Now you know how to audit investments.

Next, we’ll see how to audit plant, property and equipment.

This post is a part of my series The Why and How of Auditing. Check my other posts.

Mar 17

The Efficient CPA: 10 Super Easy Ways to Increase Your Productivity

By Charles Hall | Accounting and Auditing , Technology

Are you missing out on opportunities to be even more efficient as a CPA?

Here are ten super easy ways to increase your productivity.

1. Control f

First, I see too many CPAs hen-pecking around, trying to find information in their electronic piles. Many times the quickest route to finding information is Control f (Command f on a Mac). Hold your control key down and type f. This action will usually generate a find dialog box–-then key in your search words. Control f works in Excel, Word, PowerPoint, and Adobe Acrobat.

2. OCR Long Documents

Computers can’t read all electronic documents (that is, not all documents are electronically searchable). Sometimes you need to convert the document using OCR. OCR stands for optical character recognition. So how can you make an electronic document readable and searchable?

Scan documents into Adobe Acrobat and use the OCR feature to convert bitmap images into searchable documents. Then use Control f to locate words. When should you OCR a document? Typically when it’s several pages long. Do so when you don’t want to read the entire document to find a particular word or phrase.

For example, suppose your client gives you a one-hundred-page bond document, and you need to locate the loan covenants. Rather than reading the entire document, convert it to searchable text (using Adobe Acrobat) and use Control f to locate each instance of the word covenant.

3. Dispatching Paper Quickly

A clean work surface enables you to think clearly.

So make filing decisions quickly–as soon as a paper or electronic document is received. Keep your desk (and computer desktop) clean.

If you can dispatch a document in less than two minutes, do so immediately. For documents that take more than two minutes to file, electronically scan them. Then place the document in an action folder on your computer’s desktop. (If you don’t have time to scan the document at the moment, create a To Be Scanned pile in a paper tray.)

You’re thinking, “But I’ll forget about the document if it’s not physically on my desk.” Allay this fear by adding a task in Outlook to remind you of the scanned document (you can even add the document to a task). I create tasks with reminders. So, for example, the reminder pops up at 10:00 a.m. on Tuesday; attached is the relevant document. That way I don’t forget.

For more information about scanning, see my post How to Build an Accountant’s Scanning System. I also recommend David Allen’s book Getting Things Done which provides a complete system for making filing decisions.

4. Close Your Door

An open door says what? Come in.

A cracked door says what? Knock and come in.

A closed door says what? Don’t enter, especially without knocking.

I close my door for about an hour at a time. Additionally, I turn off all electronic devices and notifications. Doing so allows me to focus on the task at hand.

5. Use a Livescribe Pen

Do you remember everything someone says in a meeting? I sure don’t. Livescribe allows me to take notes and simultaneously record the conversation. Then I can hear any part of the discussion. For example, if–in a meeting–I write the words “intangible amortization,” I can (later) touch the tip of my pen to that phrase (in my Livescribe notebook) and hear what was said at that moment. The recording plays back through my Livescribe pen. That way, I don’t have to call and ask, “What did you say about intangible amortization?”

If you have an iPad, a cheaper alternative to Livescribe is Notability.

6. Take Breaks and Naps

Another idea is to take breaks and naps.

Counterintuitive? Yes, but it works.

Breaks

I come from the old school of “don’t lift your head or someone will see how lazy you are.” I’m not sure where this thinking comes from, but you will be more efficient–not less–when you take periodic breaks. I recommend a break at least once every two hours.

Naps

Naps? You may be thinking, “Are you kidding?”

Research shows you will be more productive if you take a nap during the day. It doesn’t have to be long, maybe ten or fifteen minutes after lunch. You’ll feel fresher and think more clearly. According to Dr. Sandra Mednick, author of Take a Nap, Change Your Life, napping can restore the sensitivity of sight, hearing, and taste. Napping also improves creativity.

Michael Hyatt recently listed several famous nappers:

Leonardo da Vinci took multiple naps a day and slept less at night.
The French Emperor Napoleon was not shy about taking naps. He indulged daily.
Though Thomas Edison was embarrassed about his napping habit, he also practiced his ritual daily.
Eleanor Roosevelt, the wife of President Franklin D. Roosevelt, used to boost her energy by napping before speaking engagements.
Gene Autry, “the Singing Cowboy,” routinely took naps in his dressing room between performances.
President John F. Kennedy ate his lunch in bed and then settled in for a nap—every day!
Oil industrialist and philanthropist John D. Rockefeller napped every afternoon in his office.
Winston Churchill’s afternoon nap was non-negotiable. He believed it helped him get twice as much done each day.
President Lyndon B. Johnson took a nap every afternoon at 3:30 p.m. to break his day up into “two shifts.”
Though criticized for it, President Ronald Reagan famously took naps as well.

For empirical evidence that naps help, check out the book Rest, Why You Get More Done When You Work Less.

Also, here are more ideas to create energy in your day.

7. Answer Emails and Phone Calls in Chunks

If you pause every time you get an email or a phone call, you will lose your concentration. Therefore, try not to move back and forth between activities. Do one thing at a time since multitasking is a lie.

Pick certain times of the day (e.g., once every three hours) to answer your accumulated emails or calls.

See my article Text, Email or Call: Which is Best?

8. Exercise

I run (by myself) or walk (with my wife) six days a week–usually in the morning before work. Exercising helps my attitude and clears my mind. Also, I feel stronger late in the day.

9. Lunch at 11:30 a.m. or 1:00 p.m.

Another idea: Go to lunch at 11:30 a.m. or 1:00 p.m. Why stand in line?

10. Take One Day Off a Week

Finally, I usually don’t work on Sundays (even in busy season). For me, it’s a day to worship, relax, see friends, and revive. I find the break gives me strength for the coming week.

Muddled minds destroy productivity.

Your Ideas?

These are my thoughts. Please share yours.

Mar 16

Emphasis-of-Matter and Other-Matter Paragraphs: What You Need to Know

By Charles Hall | Auditing

Do you know what you need to know about emphasis-of-matter and other-matter paragraphs? Sometimes auditors elect to or are required to add an extra paragraph after the opinion paragraph. You need to know why and when.

This post gives you the leg up on emphasis-of-matter (EOM) paragraphs and other-matter (OM) paragraphs.

Definitions

First, let’s first define the two terms.

AU-C 706.05 provides the following definitions:

Emphasis-of-matter paragraph. A paragraph included in the auditor's report that is required by GAAS, or is included at the auditor's discretion, and that refers to a matter appropriately presented or disclosed in the financial statements that, in the auditor's professional judgment, is of such importance that it is fundamental to users' understanding of the financial statements.

Other-matter paragraph. A paragraph included in the auditor's report that is required by GAAS, or is included at the auditor's discretion, and that refers to a matter other than those presented or disclosed in the financial statements that, in the auditor's professional judgment, is relevant to users' understanding of the audit, the auditor's responsibilities, or the auditor's report.

Notice that an EOM refers to “a matter appropriately presented or disclosed in the financial statements,” while an OM refers to “a matter other than those presented or disclosed in the financial statements.”

Now, let's take a look at sample EOM and OM paragraphs.

Sample EOM Paragraph

Here’s a sample EOM paragraph:

Emphasis of Matter

As discussed in Note X to the financial statements, the Company has elected to change its policy for determining cash equivalents in 20X 7. Our opinion is not modified with respect to that matter.

Sample OM Paragraph

Here is a sample OM paragraph:

Other Matter

In our report dated April 18, 20X5, we expressed a qualified opinion since the Company’s main office had a material unrecognized impairment loss. As noted in Note 12, the Company has now recognized the impairment in conformity with accounting principles generally accepted in the United States of America. Accordingly, our present opinion on the restated 20X4 financial statements, as presented herein, is different from that expressed in our previous report.

You also need to know the presentation requirements for EOM and OM paragraphs.

Presentation Requirements for an EOM

AU-C 706.06 and 706.07 provides guidance in reference to EOMs. The auditor should:

Refer only to information presented or disclosed in the financial statements
Include the EOM immediately after the opinion paragraph in the auditor’s report
Use the heading “Emphasis of Matter” or other appropriate heading
Include a clear reference to the matter being emphasized and to where relevant disclosures that describe the matter can be found
Indicate that the auditor’s opinion is not modified with respect to the matter emphasized

Presentation Requirements for an OM

AU-C 706.08 provides guidance in reference to OMs. The auditor should:

Include the OM immediately after the opinion paragraph and any EOM paragraph (or elsewhere in the auditor’s report if the content of the OM paragraph is relevant to the “Other Reporting Responsibilities” section – see AU-C 706.A6--.A11)
Use the heading “Other Matter” or other appropriate heading

AU-C Sections Requiring EOMs

Sometimes EOMs are required; here are examples:

AU-C 570.15-.16 The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern
AU-C 560-.16c Subsequent Events and Subsequently Discovered Facts
AU-C 708.08-.09 and .11-.13 Consistency of Financial Statements

See exhibit B of AU-C 706 for a complete listing of AU-C sections requiring EOM paragraphs.

An EOM is commonly required when a company has a change in an accounting principle (that has a material impact). AU-C 708 Consistency of Financial Statements paragraphs .07-.08 provides guidance on when the EOM is required.

The auditor also has an option to use an EOM to emphasize matters that are not required by audit standards. So, sometimes EOMs are included because they are required (e.g., going concern) and, other times, they are optional (e.g., to highlight a related party transaction).

AU-C Sections Requiring OMs

Sometimes OMs are required; here are examples:

AU-C 725.09 Supplementary Information in Relation to the Financial Statements
AU-C 800.20 Special Considerations—Audits of Financial Statements Prepared in Accordance With Special Purpose Frameworks

See exhibit C of AU-C 706 for a complete listing of AU-C sections requiring OM paragraphs.

Simple Summary

Use EOMs to OMs to highlight important matters
EOMs refer to matters presented or disclosed in the financial statements
OMs refer to a matter other than those presented or disclosed in the financial statements
EOMs and OMs are—in certain situations—required by audit standards
An EOM should immediately follow the opinion paragraph and should refer to the note that describes the issue; include the heading “Emphasis of a Matter” or other appropriate heading
An OM should immediately follow the opinion paragraph and any EOM (if one is included); include the heading “Other Matter” or other appropriate heading

Of course, creating your opinion is just a part of wrapping up your audits.

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