The Fault in the Audit

In the last few years, there has been a lot of focus on audits and transparency in businesses. The pressure on auditors to present a complete audit is increasing with each new regulation that comes out. Auditors have become the “public watchdogs” for companies because sometimes individuals succumb to the pressures and opportunities to commit financial statement fraud. The pressure on them to find fraud in the financial statements of a company, but not all audits are designed to find fraud.

There are two types of financial statement audits performed—regular financial statement audits and fraud audits. The term “financial statement audits” refers to and audit that looks at all the financial statements in their entirety to determine if the statements are presented fairly. Fraud audits are performed in a completely different manner. Fraud audits look in greater depth at specific elements that might be misstated in a financial statement. A fraud audit is time consuming and very expensive to conduct, but it is the only way to detect material fraud in financial statements.

This is the main reason why regular audits cannot detect fraud. These audits do not go in depth enough to examine every transaction or account, nor is it feasible that they are able to conduct an audit on that level every time. Another reason a regular audit over financial statements may not detect fraud is because it is being hidden by outsiders or people are reluctant to disclose what they know.

While it is important to conduct audits that look at financial statements, it is also important for the auditor to be aware of the different ways the fraud can be hidden from them. The gap in in expectations can lead to costly litigation and realistically auditors should not be expected to detect financial fraud through an audit of financial statements if they are preforming the audits to the quality required of all auditors.

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Preparing for an Audit in a Digital World

The business environment is going through a rapid change with technology. Many businesses are relying on the internet, the cloud, and mobile devises to promote and run their business. What does this mean for auditors? In this age of improved and expanding technology, auditors utilize technology to reach global clientele and improve audit effectiveness.

Advances in data science can be applied to the audit process to make it more effective and provide new forms of audit evidence. There are new methods of data collections and analysis that will help identify patterns, correlations, and fluctuations form data models.

There are significant changes that are required for the auditing process. With the technology at your fingertips, there is a chance to be able to access audit information from anywhere. This allows for continuous monitoring or more frequent monitoring. Auditors will be able to monitor transactions through external audits. This would allow for to be spread out of the entire year, not just during the busy season right after taxes are done.

To prepare auditors for these changes, they will need to make sure that educational needs are met. They will have to be up-to-date in their training in areas such as information technology, statistics, modeling, and machine learning models. Assurance departments should be expanded to accommodate the larger needs of clients in areas such as data quality, security, compliance, and fraud prevention and detection. Procedures should allow auditors to better understand the client’s environment and specialize their audits for the needs of the client.

The use of technology should allow for deeper analysis for companies, and the audits could be spread out over the year to get a better view of the year round workings of the company, instead of a brief glimpse. With all the changes in technology, auditors will needs to change their standards of auditing to keep up with the ever evolving world of business.

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Audit Quality

Audits are an important part of any business. How can you tell if the audit quality is good? This question has plagued professionals. Does the quality relate to the person performing the audit, by their ability to discover misstatements, or their ability to meet legal and professional requirements?

In the past, audit quality has been assessed after the audit is finished. It is determined by if the company’s financial statements require restatement, or if a business fails. Recently the quality has been determines by the number and nature of the findings identified during PCAOB inspections. Congress has even tried to regulate auditors and audits with the Sarbanes-Oxley and Dodd-Frank Acts. However, these efforts have done little to reduce the number of restatements or deficiencies reported during PCAOB inspections.

With the inconsistencies in determining a quality audit, the PCAOB and two other organizations have made it their priority to define what constitutes a quality audit. In an effort to create a guide to quality audits, the AQI has three indicators: better informed regulators about audit quality; aid the decision making of audit committees, investors, and managers; positively influence the practices of auditing firms.

Much of what the organizations are pushing is more transparency of audit firm discoursers. This requires publicly releasing information that in the past has remained confidential. Other information would include the number and nature of deficiencies found, the number and size of auditors that resigned, frequency and impact of financial statement restatements, etc.

While there seems to be no answers yet, they are working towards a common goal. Care should be taken when setting regulations so they do not put any undue stress on smaller auditing firms by creating competitive disadvantage that could put the smaller firms out of business. There will be more debates on what is expected, but the results should be beneficial to everyone involved.

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Audits for Not-For-Profit Organizations

This is the time of year audits are conducted  in full force, but not all audits involve the IRS. Most audits are a review of procedures, internal and external management reviews, etc. Many time federal and state governments require a yearly audit for all businesses, whether for profit or not-for-profit. The federal government requires organizations receiving federal funds of more than $500,000 a year to go through a single audit, which is a yearly audit covering and entire year of the program in question.

If it is determined that your business needs an audit, then it is important that a licensed independent certified public accountant prepares it. The accountant will know that proper forms and procedures that the audit will need, and the requirements for the federal and state government.

Once the auditors determine what is required and beneficial then they can prepare to look into you organization. Auditors will examine many procedures during an audit, but you can expect them to look at:

  • Bank reconciliations
  • Selected restricted donations (To ensure that they are handled properly)
  • Grant letters
  • Physical assets
  • Journals
  • Ledgers
  • Board Minutes

Once they have examined everything then they will formulate a report on the accuracy of the financial reports.

If your company undergoes an audit, the board of directors should establish an audit committee that is responsible for selecting the auditor, reviewing the auditor’s outputs, and meeting with the auditor for the pre- and post-audit to address any issues or questions. This committee typically has ongoing responsibilities for the organization that includes the overall financial over-sight and internal financial controls.

Audits do not have to be a scary thing for companies to go through. It is important to review the internal controls and procedures that run the day-to-day part of the organization. It is important that everything runs smoothly, and audit will help with this process.

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Assessing Internal control Procedures

There are different kinds of audits. The IRS can audit your financial records, but another way to audit is assesses the systems and procedures of your company. Assessing internal controls is an important component to establishing the integrity of a business. By assessing the internal controls, a business owner finds places where they can improve procedures.

When a company goes through an internal audit, there are certain procedures looked at. The first thing is how external factors, such as the environment, economy, or technology, are affecting the business. They also look at how the company has modified their internal controls in response to the external influences.

The auditor also evaluates how management assesses internal controls. Each publically traded company creates a written self-assessment document which demonstrates how well it believes the internal controls are working. This is a good exercise for non-publically traded companies. It demonstrates how well you know your internal controls. When performing a self-evaluation you should review the controls for significant accounts. You should also determine which locations, if you have multiple locations, should be evaluated. Management should also assess the design and operating effectiveness of its controls.

Once management has a chance to review, the current controls it is the auditors turn. They will review what is written and determine how well management is performing. The auditor will fill out a yes and no questionnaire that allows them to evaluate the company’s structure, who performs which employee performs each operating task so the auditor can track down the person who performs the task.

The final step is to test the controls. The auditor will design the test and decide which procedures to test. The test included five procedures which include talking to management, looking through the companies documents, observing the company’s operations, and conducting walkthroughs to trace a transaction, and finally do reperformance by redoing the company’s work though a specific transaction.

This can be a complicated process, but in the end it will make your company stronger and more efficient.

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Warning Signs of an Audit

We know that with tax season in full swing there is another side that will go unnoticed until April. Audits are a part of tax time, and they begin as soon as tax season is closed. Many of us don’t worry about how an audit might affect us. Is there a way to figure out if our tax return might trigger one of those red flags? Let’s look at some triggers that the IRS may find interesting.

There are typical risks that the IRS looks for when deciding if a return needs an audit. One of them is high income. If your income exceeds the $200,000 mark then you have a great chance of an audited. As the income become greater, then so does your chance of an audit. There is nothing more to it. You made so much money that you have earned the special right to a red flag.

Another part of the return that is scrutinized is deductions. The IRS tracks the average deduction taken by individuals in certain tax brackets. Anything above that average can trigger a flag. If you are deducting large items from charitable donations, etc., such as a house or sold off large amount of stock, then specific form are to be filled out and filed with your tax return. Any charitable donation exceeding $250 in one transaction requires paperwork from the charity or organization stating the specifics of the donation.

Another group that is targeted for audits is entrepreneurs. There is something about people running their own business that screams red flag to the IRS. If your business is run from home, the chances are even higher than if you own a place of business. Business expenses that are claimed too aggressively will also cause problems.

The last group is people that own a large amount of real estate. Anyone with a vacation home, especially if the house is rented out, can cause another red flag. Not all vacation home expenses can be deducted and the limitations need to be known.

Remember that lack of information can be just a harmful as too much information. Leaving unanswered questions will also cause problems.

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What Happens Post-Filing

Right now, the IRS is preparing for the busiest part of the year. It is tax return time, but what are they responsible for after all the tax returns. In recent years, the IRS stepped up its efforts to reduce the amount of noncompliance issues, including underreporting income, overstating deductions and credits, non-filing, and non-payments. During the off-season, the IRS will work on the following items:

Audits: The IRS conducts over a half million audits each year. While many people will never be subjected to the audit process, the idea can be scary. The purpose of an audit is to prove that the client’s deductions and credits are legitimate and there were no other reporting issues.

Penalties: Four penalties that make up 98% of all the individual penalties, and they are failure to file, failure to pay, failure to deposit, and accuracy penalties. There can be some relief if penalties occur, but it depends on a case-by-case basis.

Underreporting/Matching Notices: The IRS sends out thousands of notices each year. Many of them are notices of a discrepancy between what was reported and what was earned. The notices are not audits, but may appear similar to some people.

Collection Alternatives: Sometimes clients get into financial problems and are unable to pay their tax bill. There are several alternatives available to them to help pay their taxes in a timely manner. The IRS offers installment payments, offers in compromise (OIC), and currently not collectible statuses are all option for clients if payment is a problem. The IRS usually like the simplest which is guaranteed or streamlined installment payments or extension of time to pay.

Accounting Corrections: In this most unpredictable world, anything can happen. The IRS deal with correction issues that can clog up the process. These problems can lead to holds on refunds, payments posting late or not at all, and other tax return adjustments. If an unexpected notice arrives in the mail, it is important to contact the IRS quickly to resolve the issue.

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Improving Audit Quality: The Debate

There has been a lot of discussion recently about ways to improve audit quality. Two proposals made by the PCAOB that would, in their opinion, improve audit independence and accountability. The two proposals have also received a lot of attention both bad and good. The PCAOB wants to require mandatory audit firm rotations and a signature from the lead engagement partner. While these proposals may seem like a good idea in theory, will it really work in practice?

The ideology behind each proposal is the same; both are discouraging forming social relationships that would interfere with auditor independence and create more transparency with in the audit field. Auditors should question procedures, financial statements, etc. and if they feel like they are too reliant on the client for social or economic status then it may erode their objectivity and skepticism. If the auditor’s objectivity and skepticism are decreased then their overall independence is compromised.

Many of the critics of these proposals feel that it the mandatory rotation will have increased costs and decreased quality. Many companies feel that new auditors will have to spend extra time playing catch up and the efficiencies and specific knowledge about the business will be lost in the change. The supporters of the proposal come from people who feel like the relationship has become too cozy and comfortable. This can then lead to unintended lapses in objectivity. There are always two sides to the coin.

While the mandatory audit firm rotation has garnered the most attention, another proposal of requiring a signature from the lead engagement partner has also come under scrutiny. The proposal is to increase accountability, when what is really does is increase identifiability. When a person is identified on a report, one of two things will happen. They will be very cautious to avoid disapproval, or they will become the scape goat if something goes wrong.

Neither one are perfect and will work the same way every time, but by examining the procedures and mixing in a little of both they may be a way of creating a better solution.

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Targeting Fraud through New Task Forces

In an effort to detect and analyze fraud, the SEC announced recently that is has established three new task forces within the Division of Enforcement to aid in investigations. The new task forces will each have specialized jobs that relate to different aspects of financial fraud.

Center of Risk and Quantitative Analytics (CRQA)

The CRQA is the data and analysis center of the Division of Enforcement. The main focus of the division is to identify risks that could harm investors, and monitor for financial transgressions.  The Division of Enforcement uses the CRQA as a resource that supports investigations through data analysis and risk assessment.

Financial Reporting and Audit Task Force

The Financial and Audit Task Force will help in the detection and prosecution of fraudulent financial reporting. The effort to expand enforcement, the task force will work to detect fraudulent financial statements, issuer reports, and audit failures. Enforcement lawyers and accountants will work to find and identify, through ongoing reviews and performance trends, areas susceptible to fraud.

The Microcap Fraud Task Force

The Microcap Fraud Task Force will focus on microcap securities. The SEC says that microcap securities are most often connected with fraudulent and manipulative strategies to accumulate gains. These small companies do not always report financials to the public and so the SEC wants to concentrate on them to help keep fraud from happening.  This task force will work with the Microcap Fraud Group that formed in 2010, but will not replace them.

Each task force will work to prevent fraud and audit misconduct while working on strategies to improve systems for identifying fraud and improving how audits are conducted.

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Simple Tips to Selecting an Employee Benefit Plan Auditor

Under federal law, businesses with at least 100 participants must provide an audit as a component of their annual return. Even small businesses will benefit from this process. However, selecting an employee benefit plan auditor can seem like a challenge. Numerous companies may tell you they can provide this service to you, but the question may be more clearly defined as, “what should you look for in a business auditor for an employee benefit plan.”

Invest Time in the Selection Process

Perhaps the biggest mistake a business can make when selecting a employee benefit plan auditor is to rush to a decision. This person you bring on board will need to provide a quality audit that looks at the overall financial integrity of the business’s funds and assets. If this process is not conducted with care, not only will the company become required to undergo more thorough investigations of the employee benefit plan, but the company will, undoubtedly be faced with fines and more complications. Choose a well-qualified professional for the job.

Avoiding Errors Is Easy

The Department of Labor reports that the most common reason for reporting failures are inaccuracies filed by a deficient accountant’s reports. To avoid these errors, ensure the auditor is given full information and that nothing is left to be “found” on its own. That is, providing accurate, thorough records and files is important. The employee benefits plan auditor will work closely with you to provide you with methods to fix errors you may have, but not sharing important information sets your business up to fail.

Get an Engagement Letter

At the start of the employee benefits plan audit, the auditor will provide an engagement letter. Read it. Understand specifically what work will be performed and what will not. Ensure that the timing is accurate. It should also clearly list the cost of this service, something you can negotiate if you believe the service is not accurately represented. The letter should also provide a description of the responsibilities of the auditor as well as your employee plan administrator. If there are questions about the engagement letter’s details, review them now. Do not put this off or assume it is a standard form.

When taking these steps, the employee benefit plan auditor can work for you to provide an accurate, detailed outline of what you can expect. You also can ensure that the process will provide you with helpful information that can help you to manage your business. This information is invaluable to you not just to the IRS.

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