Auditing equity is usually one of the easiest parts of an audit. For some equity accounts, you agree the year-end balances to the prior year ending balance, and you’re done. For instance paid-in-capital seldom changes. Often, the only changes in equity are from current year profits and owner distributions. And testing those equity additions and reductions in equity takes only minutes.
Nevertheless, auditing equity can be challenging, especially for businesses that desire to attract investors. Such companies offer complicated equity instruments. Why? The desire to attract cash without giving away (too much) power. And this balancing act can lead to complex equity instruments.
Regardless of whether a company’s equity is easy to audit or not, below I show you how to focus on important equity issues.
This is a question I received this afternoon from another CPA firm, but I’ve bumped into this issue several times through the years. In this post I’ll give you tips to assist you in estimating the time it will take you to complete a new project.
Estimating New Project Time
Why is this hard? You don’t know how much time you’ll have in the engagement until you’ve done it—and you don’t have a crystal ball. Plus, you know you’ve bid on projects before and underestimated the time it would take (CPAs almost never overestimate); consequently, you took it on the chin. You don’t want that to happen again.
To state the obvious, the key is estimating the time it takes to complete the engagement and by what level of personnel.
So, how do you know? In short, you don’t, but here are some tips.
Time Estimate Tips
Ask what the present pricing is. This may be the most awkward part of initial conversation with a potential new client. Some CPAs don’t ask this question, but it’s one of the best gauges of the time it takes to do the work. If the client says, “We’re not providing that information,” then so be it. But you most certainly will not know if you don’t ask.
Another method is to do what builders do. Break the project into pieces and estimate the time for each part. So create a summary of each action necessary, and place an estimated time next to each part. Then compute the estimate price using your standard billing rates by personnel levels.
Finally, compare the project to similar projects in your firm. Similar projects are a great proxy for the estimated time.
Once you’ve documented the above, let someone else with experience review and give you feedback. Two eyes are usually better than one.
Also, consider when the project is needed. Is it a busy time of your year? If yes, then you may not want to lower your price (you may not want to bid on the project at all). If not, then maybe there’s some flexibility.
Is the project something you’ve never done before. Then consider the additional cost of getting into the new area: CPE, consultations with someone outside your firm, research materials, electronic workpapers.
Tendency to Under Estimate
The last thing I’ll say is you usually have a great deal more time in the first year of the engagement. I’d say, most of the time, you’ll have at least 50% more time than you estimated. Then, in subsequent years, the project should be more normal. Invariably, there are things you were not aware of in the bid stage.
Summary of Estimating New Project Time
Any way, there’s some ideas to consider in estimating new project time in a first-year engagement.
Remember to (1) ask what the client has previously paid (and back into the estimated hours using hourly rates), (2) estimate time for each part of the project, and (3) consider similar projects you’ve previously performed. Additionally, know that most people underestimate the hours it will take to complete a new project.
Did you know you can learn audit lessons from a brain tumor? Here’s my story.
One day while driving, I said to my wife, “Am I weaving?” I did not feel in control, and I was hearing clicking noises in my ears. My conditions worsened and the mystery grew over the next two years as I visited three doctors. They stuck, prodded, and probed me, but no solution.
Frustrating.
As time passed, I felt a growing numbness on the right side of my face. So one night I started Googling health websites (the thing they tell you not to do) and came upon this link: Acoustic Neuroma Association. I clicked and read, having never heard of an acoustic neuroma. While reading about the symptoms, it was as though I was staring at my diary. My next thought was “it can’t be a brain tumor.” I turned to my wife behind me and said, “this is what I have.”
The next day I handed the acoustic neuroma information to my doctor, asking, “Would you please order a brain scan?”
Two days after the MRI, I received my doctor’s call while on a golf course. He said, “Mr. Hall, you were right. You have a 2.3-centimeter brain tumor.” (I sent him a bill for my diagnosis, but was never paid–just kidding.) My golfing buddies gathered around and prayed for me on the 17th green, and I went home to break the news to my wife. We had two children at the time, ages two and four. Having just started my own CPA business six years before, I was forty-one years old. So, as you can imagine, I was concerned about my family and business, but strangely, I was completely at peace.
Shortly after that, I was in a surgeon’s office in Atlanta. The doctor said they’d do a ten-hour operation; there was a 40% chance of paralysis and a 5% chance of death. The tumor was too large for radiation–or so I was told.
I didn’t like the odds, so I prayed more and went back to the Internet. There I located Dr. Jeffrey Williams at Johns Hopkins Hospital in Baltimore. I emailed the good doctor, telling him of the tumor’s size. His response: “I radiate tumors like yours every day.” He was a pioneer in fractionated stereotactic radiation, one of the few physicians in the world (at that time) using this procedure.
A few days later, I’m lying on an operating table in Baltimore with my head bolted down, ready for radiation. They bolt you down to ensure the cooking of the tumor (and not your brain). Fun, you should try it. Four more times I visited the table, and I kept noticing everyone left the room–a sure sign you should not try this at home.
Each day I laid there silently, talking to God and trusting in Him. And my wife sat outside, lifting me up in prayer.
Three weeks later I returned to work. Twenty-two years later, I have had two sick days.
I’ve watched my children grow up. They are twenty-six and twenty-eight now–both finished college at the University of Georgia (Go Dawgs!). And a year and a half ago, my daughter had our first grandchild. My wife is still by my side, and I’m thankful for each day. Here’s a recent picture of my family at one of our favorite places: Cades Cove, Tennessee.
So what does a brain tumor story tell us about audits? (You may, at this point, be thinking, “they did cook his brain.”)
Audit Lessons Learned from a Brain Tumor
1. Pay Attention to Signs
It’s easy to overlook the obvious.Maybe we don’t want to see a red flag (I didn’t want to believe I had a tumor). It might slow us down. But an audit is not purely about finishing and billing. It’s about gathering proper evidential matter to support the opinion. To do less is delinquent and dangerous.
2. Seek Alternatives
If you can’t gain appropriate audit evidence one way, seek another. Don’t simply push forward, using the same procedures year after year. The doctor in Atlanta was a surgeon, so his solution was surgery. His answer was based on his tools, his normal procedures. If you’ve always used a hammer, try a wrench.
3. Seek Counsel
If one answer doesn’t ring true, see what someone else thinks, maybe even someone outside your firm. Obviously, you need to make sure your engagement partner agrees (about seeking outside guidance), but if he or she does, go for it. I often contact the Center for Plain English Accounting. I find them helpful and knowledgeable. I also have relationships with other professionals, so I call friends and ask their opinions–and they call me. Check your pride at the door. I’d rather look dumb and be right than to look smart and be wrong.
4. Embrace Change
Fractionated stereotactic radiation was new. Dr. Williams was a pioneer in the technique. The only way your audit processes will get better is to try new techniques: paperless software (we use CCH Prosystem Engagement), data mining (we use TeamMate Analytics), real fraud inquiries (I use ACFE techniques), electronic bank confirmations (I use Confirmation.com), project management software (I use Basecamp). If you are still pushing a Pentel on a four-column, it’s time to change.
Postscript
Finally, remember that work is important, but life itself is the best gift. Be thankful for each moment, each hour, each day.
While auditing debt can be simple, sometimes it’s tricky. For instance, classification issues can arise when debt covenant violations occur. Should the debt be classified as current or noncurrent? Likewise, some forms of debt (with detachable warrants) have equity characteristics, again leading to classification issues. Is it debt or equity—or both? Additionally, leases can create debt, even if that is not the intent.
Most of the time, however, auditing debt is simple. A company borrows money. An amortization schedule is created. And thereafter, debt service payments are made and recorded.
Either way, whether complicated or simple, below I show you how to audit debt.
Auditing Debt — An Overview
In many governments, nonprofits, and small businesses, debt is a significant part of total liabilities. Consequently, it is often a significant transaction area.
In this post, we will cover the following:
Primary debt assertions
Debt walkthroughs
Debt-related fraud
Debt mistakes
Directional risk for debt
Primary risks for debt
Common debt control deficiencies
Risk of material misstatement for debt
Substantive procedures for debt
Common debt work papers
Primary Debt Assertions
The primary relevant debt assertions include:
Completeness
Classification
Obligation
I believe, in general, completeness and classification are the most important debt assertions. When a company shows debt on its balance sheet, it is asserting that it is complete and classified correctly. By classification, I mean it is properly displayed as either short-term or long-term. I also mean the instrument is debt and recorded as such (and not equity). By obligation, I mean the debt is legally owed by the company and not another entity.
Keep these three assertions in mind as you perform your transaction cycle walkthroughs.
Debt Walkthroughs
Early in your audit, perform a walkthrough of debt to see if there are any control weaknesses. As you perform this risk assessment procedure, what questions should you ask? What should you observe? What documents should you inspect? Here are a few suggestions.
As you perform your debt walkthrough ask or perform the following:
Are there any debt covenant violations?
If the company has violations, is the debt classified appropriately (usually current)?
Is someone reconciling the debt in the general ledger to a loan amortization schedule?
Inspect amortization schedules.
Does the company have any unused lines of credit or other credit available?
Inspect loan documents.
Has the company refinanced its debt with another institution? Why?
Who approves the borrowing of new money?
Who approves new leases? Who handles lease accounting and are they competent?
Does the company have any leases that should be recorded as debt?
Inspect new loan and lease approvals.
How are debt service payments made (e.g., by check or wire)? Who makes those payments?
Are there any sinking funds? If yes, who is responsible for making deposits and how is this done?
Observe the segregation of duties for persons:
Approving new loans,
Receipting loan proceeds,
Recording debt in the general ledger, and
Reconciling the debt in the general ledger to the loan amortization schedules
Is the company required to file periodic (e.g., quarterly) reports with the lender? Inspect sample debt-related reports, if applicable.
Does the company have any convertible debt or debt with detachable warrants? Are they properly recorded?
Is the company following reporting framework requirements (e.g., FASB Codification) for debt?
Has collateral been pledged? If yes, what?
What are the terms of the debt agreements?
Has all debt of the company been recorded in the general ledger?
Have debt issuance costs been accounted for properly based on the reporting framework requirements? (FASB requires the netting of such costs with debt.)
Has the company guaranteed the debt of another entity?
If control weaknesses exist, create audit procedures to address them. For example, if—during the walkthrough—we see that one person approves loans, deposits loan proceeds, and records the related debt, then we will perform fraud-related substantive procedures.
Debt-Related Fraud
A company can fraudulently inflate its equity by intentionally omitting debt from its balance sheet. (Total assets equal liabilities plus equity. Therefore, if debt is not reported, equity increases.)
As we saw with Enron, some entities place their debt on another company’s balance sheet. (Enron did so using special purpose entities.) So auditors need to consider that companies can intentionally omit debt from their balance sheets.
Another potential fraudulent presentation is showing short-term debt as long-term. When might this happen? When debt covenant violations occur. Such violations can trigger a requirement to classify the debt as current. If accounting personnel are aware of the requirement to classify debt as current and don’t do so, then the reporting can be considered fraudulent.
Additionally, mistakes can lead to errors in debt accounting.
Debt Mistakes
Errors in accounting for debt can occur when debt service payments are misclassified as expenses rather than a reduction of debt. Also, debt can—in error—be presented as long-term when it is current. Why? Maybe the company’s accountant doesn’t understand the accounting rules.
Some forms of debt, such as leases, can be difficult to interpret. Consequently, a company might errantly fail to record debt when required.
So, what is the directional risk for debt? An overstatement or an understatement?
Directional Risk for Debt
The directional risk for debt is an understatement. So, audit for completeness (and determine that all debt is recorded).
Primary Risks for Debt
Primary risks for debt include:
Debt is intentionally understated (or omitted)
Debt is recorded as noncurrent (due more than one year from the balance sheet date) though the amount is current (due within one year of the balance sheet date)
It’s obvious why a company might want to understate its debt. The company looks healthier. But why would a business desire to classify current debt as noncurrent? For the same reason: to make the company look stronger. By recording current debt as noncurrent, the company’s working capital ratio (current assets divided by current liabilities) improves.
As you think about the above risks, consider the control deficiencies that allow debt misstatements.
Common Debt Control Deficiencies
In smaller entities, it is common to have the following control deficiencies:
One person performs two or more of the following:
Approves the borrowing of new funds,
Enters the new debt in the accounting system,
Deposits funds from the debt issuance
Funds are borrowed without appropriate approval
Debt postings are not agreed to amortization schedules
Accounting personnel don’t understand the accounting standards for debt (including lease accounting)
Another key to auditing debt is understanding the risks of material misstatement.
Risk of Material Misstatement for Debt
In auditing debt, the assertions that concern me the most are classification, completeness, and obligation. So my risk of material misstatement for these assertions is usually moderate to high.
My response to the higher risk assessments is to perform certain substantive procedures: namely, a review of debt covenant compliance and a review of debt and lease agreements—and the related accounting. Why?
As we saw above, debt covenant violations may require the company to reclassify debt from noncurrent to current. Doing so can be significant. The loan could be called by the lender, depending on the loan agreement. So, proper classification of debt can be critical.
Also, some leases should be recorded as debt. If such leases are not recorded, the company looks healthier than it is. Our audit should include procedures that address the completeness of debt and the obligations of the company.
Once your risk assessment is complete, decide what substantive procedures to perform.
Substantive Procedures for Debt
My customary tests for auditing debt are as follows:
Summarize and test debt covenants
Review new leases to determine if debt should be recorded
Confirm all significant debt with lenders
Determine if all debt is classified appropriately (as current or noncurrent)
Agree the end-of-period balances in the general ledger to the amortization schedules
Agree future debt service payment summaries to amortization schedules
Review accruals of any significant interest
Review interest expense (usually comparing current and prior year interest)
In light of my risk assessment and substantive procedures, what debt work papers do I normally include in my audit files?
Common Debt Work Papers
My debt work papers normally include the following:
An understanding of debt-related internal controls
Documentation of any internal control deficiencies related to debt
Risk assessment of debt at the assertion level
Debt audit program
A copy of all significant debt agreements (including lease and line-of-credit agreements)
Minutes reflecting the approval of new debt
A summary of debt activity (beginning balance plus new debt minus principal payments and ending balance)
Amortization schedules for each debt
Summary of all debt information for disclosure purposes (e.g., future debt service to be paid, interest rates, types of debt, collateral, etc.)
If there are questions regarding debt agreements and their presentation, I include additional language in the representation letter to address the issues. For example, if an owner loans funds to the company but there is no written debt agreement, the owner or management might verbally explain the arrangement. In such cases, I include language in the management representation letter to cover the verbal responses.
In Summary
In this article we’ve looked at the keys to auditing debt. Those keys include risk assessment procedures, determining relevant assertions, creating risk assessments, and developing substantive procedures. The most important issues to address are usually (1) the classification of debt (especially if debt covenant violations exist) and (2) lease accounting.
Auditing investments is important, especially when an auditee has large balances. 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.
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
