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Only If You Really Want to Know

Audit Engagement

The second paragraph of the auditors’ standard report follows:

"We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe our audit provides a reasonable basis for our opinion.”

The key phrases are "reasonable assurance”, "material misstatement”, "test basis” and "reasonable basis”.

Auditing is a testing-samples-of-items business. That’s the way it must be because no one can afford a 100% comprehensive audit in which every transaction and every item of business would be audited. An audit of financial statements is entirely different from an audit by the IRS which may make the taxpayer prove with documentation every single item in a population of items. Also, unlike the IRS, which may assume at the outset that the taxpayer’s return is incorrect, the auditing CPA does not assume that management’s financial statements are incorrect.

Using generally accepted auditing procedures, the auditing CPA selects a sample, sometimes a very small sample, of the population, and tests that sample. If the sample is supported by evidence, then he can conclude that the entire population is supported by similar evidence.

It’s like sampling to predict the outcome of an election. Sometimes even a few minutes after an election, the outcome is known based on the returns of a minute portion (a sample) of the voters. That sample of voters is attributed to the entire population of voters.

In a test basis audit, the auditing CPA has to evaluate the effectiveness of certain matters (so-called risk assessments) and their consequent effect on the degree of his testing. Does management tend to override its own controls? Is the Company’s performance erratic? How stable is the industry? How inherently risky is an item (inventories vs. property)? How good are the system and controls?

There’s a pretty long list of matters to be evaluated and there is a substantial guidance in the profession’s Statements on Auditing Standards. Generally speaking, the greater the tendency of management to override, the more testing there need be. The better the system and controls, the less testing there need be.

Each auditor exercises his own judgement as to risk assessment. An auditing CPA’s evaluations may differ from another CPA's evaluations and still be within an acceptable range.

Assuming all these risk assessments turn out to be low-risk, then the auditor’s testing will be at the low end.

But the auditor can still only provide "reasonable assurance” because the audit is still based on tests of samples. Furthermore, for virtually the same reason, he can only provide reasonable assurance that the financial statements are free of "material” misstatements.

The auditor’s testing of inventories may show an inventory of $97,000 whereas the Company’s financial statements show $100,000. He may conclude, "that’s close enough”; i.e., that’s not a material misstatement. The same kind of conclusion may be reached with something like depreciation which is always an estimate so CPAs’ evaluations may differ and both of them can still be right.

Further, a misstatement may be material standing alone but not material in relation to the inventory but is not material in relation to the financial statements taken as a whole. For example, a $15,000 misstatement in a $100,000 inventory is material in relation to a $1,000,000 stockholders’ equity in the same statement. An undiscovered $25,000 embezzlement may sound like a material irregularity but may be immaterial in relation to both cash balance and stockholder’s equity.

The concept of reasonable assurance applies not only to errors but also to irregularities and illegal acts. Errors are unintentional mistakes whereas irregularities are intentional ones. An audit is designed to provide reasonable assurance of detecting material irregularities. However, because of the characteristics of irregularities, particularly those involving forgery and collusion, a properly designed and executed audit may not detect a material irregularity.

Here are some examples of irregularities that may well not be detected by an auditing CPA: Forged signatures (or the unauthorized use of a signature stamp) of key officials like check signers, credit approvers, or purchase order approvers. Collusion between a cashier and an accounts receivable clerk. Collusion among several individuals in ordering and maintaining inventory records and handling inventories.

These types of irregularities may never be detected or may not be caught until some time after an engagement has been completed. That does not necessarily mean that the CPA performed inadequate audit procedures. Similarly, a material error may not be caught until some time after. That also does not necessarily mean the CPA had not followed generally accepted auditing standards.

Review Engagement

The second paragraph of the reviewer’s standard report follows:

"A review consists principally of inquiries of company personnel and analytical procedures applied to financial data. It is substantially less in scope than an audit in accordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.”

The standards do require him, however, to perform additional procedures if, in the course of conducting his inquiries and analytical procedure, he encounters items or matters which are "incorrect, incomplete or otherwise unsatisfactory.” The additional procedures can run the gamut from simply asking some more questions to, given unsatisfactory answers, performing some audit-type procedures.

Typical inquiries follow: What are your procedures for recording, classifying and summarizing information? Was $xxx in the bank? Were the receivables valued properly (taking into account bad debts)? Did you own the vehicles? Were all accounts payable recorded? Sometimes the CPA doesn’t have to ask questions if he already knows the answer from other experience. But he always has to ask some questions in a review engagement.

Typical analytical procedures follow: Compare this year’s sales with last year’s and explain the difference. Compare this year’s gross profit with the last year and explain the difference. Compare this year’s interest expense with average outstanding debts to see if it makes sense.

The standards do not require a reviewing CPA to design his review to provide reasonable assurance of detecting material errors, irregularities, and illegal acts. The only ones of these items he is responsible for are those that are discoverable in the ordinary conduct of his review and follow-up. Even so, he would not be responsible if he received satisfactory answers to his follow-up questions.

The third paragraph states "Based on our review, we are not aware of any material modifications that should be made to the accompanying financial statements in order for them to be in conformity with generally accepted accounting principles.”

The reviewing CPA is stating that, based on the very limited (compared to an audit) procedures performed, and them only, he is not aware that the financial statements need to be adjusted materially.

Compilation Engagement

The second paragraph of the standard report for compilation engagements follows:

”A compilation is limited to presenting in the form of financial statements information which is the representation of management (owners). We have not audited or reviewed the accompanying financial statements and, accordingly, do not express any form of assurance on them”.

Compilation engagements do not require the performance of any procedures. They do require the compiling CPA to read the financial statements to see if they are "appropriate in form and free from obvious material mistakes” in accounting and disclosures. This means that he must smell the financial statements to see if anything material smells funny. But that’s all.

He might find that the company has large receivables but no bad debt expense. He might find that inventories are up substantially but accounts payable are down substantially and there has been no change in bank debt. He might find that the disclosures on long-term debt are insufficient. His course of action is to ask questions about these items and, if necessary, take further steps. Since he has performed no procedures, he has no responsibility for uncovering material errors, irregularities and illegal acts.

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