Audit

3 financial statements you should know

Successful business people have a solid understanding of the three financial statements prepared under U.S. Generally Accepted Accounting Principles (GAAP). A complete set of financial statements helps stakeholders — including managers, investors and lenders — evaluate a company’s financial condition and results. Here’s an overview of each report.

1. Income statement

The income statement (also known as the profit and loss statement) shows sales, expenses and the income earned after expenses over a given period. A common term used when discussing income statements is “gross profit,” or the income earned after subtracting the cost of goods sold from revenue. Cost of goods sold includes the cost of labor, materials and overhead required to make a product.

Another important term is “net income.” This is the income remaining after all expenses (including taxes) have been paid.

2. Balance sheet

This report tallies the company’s assets, liabilities and net worth to create a snapshot of its financial health. Current assets (such as accounts receivable or inventory) are reasonably expected to be converted to cash within a year, while long-term assets (such as plant and equipment) have longer lives. Similarly, current liabilities (such as accounts payable) come due within a year, while long-term liabilities are payment obligations that extend beyond the current year or operating cycle.

Net worth or owners’ equity is the extent to which the book value of assets exceeds liabilities. Because the balance sheet must balance, assets must equal liabilities plus net worth. If the value of your liabilities exceeds the value of the assets, your net worth will be negative.

Public companies may provide the details of shareholders’ equity in a separate statement called the statement of retained earnings. It details sales or repurchases of stock, dividend payments and changes caused by reported profits or losses.

3. Cash flow statement

This statement shows all the cash flowing into and out of your company. For example, your company may have cash inflows from selling products or services, borrowing money and selling stock. Outflows may result from paying expenses, investing in capital equipment and repaying debt.

Although this report may seem similar to an income statement, it focuses solely on cash. It’s possible for an otherwise profitable business to suffer from cash flow shortages, especially if it’s growing quickly.

Typically, cash flows are organized in three categories: operating, investing and financing activities. The bottom of the statement shows the net change in cash during the period. To remain in business, companies must continually generate cash to pay creditors, vendors and employees. So watch your statement of cash flows closely.

Ratios and trends

Are you monitoring ratios and trends from your financial statements? Owners and managers who pay regular attention to these three key reports stand a better chance of catching potential trouble before it gets out of hand and pivoting, when needed, to maximize the company’s value.

© 2017

FAQs about agreed upon procedures

An agreed upon procedures (AUP) engagement uses procedures similar to an audit, but on a smaller and limited scale. Here’s how a customized AUP engagement differs from an audit and can be used to identify specific problems that require immediate action.

How do AUPs compare to audits?

The American Institute of Certified Public Accountants (AICPA) regulates both audits and AUP engagements. But the natures of these two types of accounting services are quite different. When a CPA firm performs an audit, its client is the company. With an AUP engagement, the client is typically the company’s lender or another third party — a fact that usually alleviates potential conflicts of interest.

Another key difference is that of responsibility. Audits require CPAs to provide a formal opinion on whether the company’s financial statements have been prepared in accordance with U.S. Generally Accepted Accounting Principles (GAAP).

On the other hand, CPAs make no formal conclusions when performing AUPs; they simply act as finders of fact. It’s the client’s responsibility to draw conclusions based on the CPA’s findings.

AUP engagements may target specific financial data (such as accounts payable, accounts receivable or related party transactions), nonfinancial information (such as a review of internal controls or compliance with royalty agreements), a specific financial statement (such as the income statement or balance sheet) or even a complete set of financial statements.

When do you need AUPs?

AUPs boast several advantages over audits. They can be performed at any time during the year — not just at year end. And because you have the flexibility to choose only those procedures you feel are necessary, they can be cost-effective.

Lenders may, for example, request an AUP engagement, if they have doubts or questions about a borrower’s financials — or if they want to check on the progress of a distressed company’s turnaround plan. Or a business owner may decide to hire a CPA to perform an AUP engagement, if he or she suspects that the CFO is misrepresenting the company’s financial results or the plant manager is stealing inventory. These engagements can also be useful in mergers and acquisition due diligence.

Who can help?

An AUP engagement can be used to dig deeper into financial results and identify specific problems that require immediate action. We can help you customize an AUP engagement that can identify problems and resolve issues quickly and effectively.

© 2017

Use qualified auditors for your employee benefit plans

Employee benefit plans with 100 or more participants must generally provide an audit report when filing IRS Form 5500 each year. Plan administrators have fiduciary responsibilities to hire independent qualified public accountants to perform quality audits.

Select a qualified auditor

ERISA guidelines require employee benefit plan auditors to be licensed or certified public accountants. They also require auditors to be independent. In other words, they can’t have a financial interest in the plan or the plan sponsor that would bias their opinion about a plan’s financial condition.

But specialization also matters. The more training and experience that an auditor has with plan audits, the more familiar he or she will be with benefit plan practices and operations, as well as the special auditing standards and rules that apply to such plans. Examples of audit areas that are unique to employee benefit plans include contributions, benefit payments, participant data, and party-in-interest and prohibited transactions.

Ask questions

Employee benefit plan audits are a matter of more than just compliance. The auditor’s report highlights any problems unearthed during the audit, which can serve as a springboard for improving plan operations. The conclusion of audit work is a good time to ask such questions as the following:

  • Have plan assets covered by the audit been fairly valued?
  • Are plan obligations properly stated and described?
  • Were contributions to the plan received in a timely manner?
  • Were benefit payments made in accordance with plan terms?
  • Did the auditor identify any issues that may impact the plan’s tax status?
  • Did the auditor identify any transactions that are prohibited under ERISA?

Experienced auditors can also suggest ways to improve your plan’s operations based on their audit findings.

Protect yourself

Employee benefit plan audits offer critical protection to plan administrators and employees. Your company can’t afford to skimp when it comes to hiring an auditor who is unbiased, experienced and reliable. Contact us for more information on hiring a plan auditor.

© 2017

Are you ready for audit season?

It’s almost audit season for calendar-year entities. A little preparation can go a long way toward facilitating the external audit process, minimizing audit adjustments and surprises, lowering your audit fees in the future and getting more value out of the audit process. Here are some ways to plan ahead.

The mindset

Before fieldwork begins, meet with your office team to explain the purpose and benefits of financial statement audits. Novice staff members may confuse financial audits with IRS audits, which can sometimes become contentious and stressful. Also designate a liaison in the accounting department who will answer inquiries and prepare document requests for auditors.

Reconciliation
Enter all transactions into the accounting system before the auditors arrive, and prepare a schedule that reconciles each account balance. Be ready to discuss any estimates that underlie account balances, such as allowances for uncollectible accounts, warranty reserves or percentage of completion.

Check the schedules to reveal discrepancies from what’s expected based on the company’s budget or prior year’s balance. Also review last year’s adjusting journal entries to see if they’ll be needed again this year. An internal review is one of the most effective ways to minimize errors and adjusting journal entries during a financial statement audit.

Work papers
Auditors are grateful when clients prepare work papers to reconcile account balances and transactions in advance. Auditors also will ask for original source documents to verify what’s reported on the financial statements, such as bank statements, sales contracts, leases and loan agreements.

Compile these documents before your audit team arrives. They may also inquire about changes to contractual agreements, regulatory or legal developments, additions to the chart of accounts and major complex transactions that occurred in 2016.
Internal controls

Evaluate internal controls before your auditor arrives. Correct any “deficiencies” or “weaknesses” in internal control policies, such as a lack of segregation of duties, managerial review or physical safeguards. Then the auditor will have fewer recommendations to report when he or she delivers the financial statements.

Value-added
Financial statement audits should be seen as a learning opportunity. Preparing for your auditor’s arrival not only facilitates the process and promotes timeliness, but also engenders a sense of teamwork between your office staff and external accountants.

© 2016

Tips for efficient year-end physical inventory counts

The basics

Inventory includes raw materials, work-in-progress and finished goods. Your physical inventory count also may include parts and supplies inventory. Under U.S. Generally Accepted Accounting Principles (GAAP), inventory is recorded at the lower of cost or market value.

Estimating the value of inventory may involve subjective judgment calls, especially if your company converts raw materials into finished goods available for sale. For example, the value of work-in-progress inventory includes overhead allocations and, in some cases, may require percentage-of-completion assessments.

A moving target

The inventory count gives a snapshot of how much inventory is on hand at year end. The value of inventory is always in flux, as work is performed and items are delivered or shipped. To capture a static value, it’s essential that business operations “freeze” while the count takes place.

Usually, it makes sense to count inventory during off-hours to minimize the disruption to business operations. Larger organizations with multiple locations may be unable to count everything at once. So, larger companies often break down their counts by physical location.

Proactive planning

Planning is the key to minimizing disruptions. Before counting starts, management can:.

  • Order (or create) prenumbered inventory tags,
  • Conduct a dry run to identify roadblocks and schedule workers,
  • Assign workers to count inventory using two-person teams to prevent fraud,
  • Write off any unsalable items, and
  • Precount and bag slow-moving items.

If your company issues audited financial statements, your audit team will be present during the physical inventory count. They aren’t there to help count inventory. Instead, they’ll observe the procedures, review written inventory processes and cutoffs, evaluate internal controls over inventory, and perform independent counts to compare to your inventory listing and counts made by your employees.

Beyond the count

When the inventory count is complete, it’s critical to investigate discrepancies between your computerized accounting records and physical inventory counts. We can use this information to help you evaluate how to stock items more efficiently and safeguard against future write-offs due to fraud, damage or obsolescence.

© 2016

Overview of inventory reporting methods

It’s critical to report inventory using the optimal method. There are several legitimate options for reporting inventory — but take heed: The method you choose ultimately affects how much inventory and profit you’ll show and how much tax you’ll owe.

The basics

Inventory is generally recorded when it’s received and title transfers to the company. Then, it moves to cost of goods sold when the product ships and title transfers to the customer. But you can apply different inventory methods that will affect the value of inventory on your company’s balance sheet.

FIFO vs. LIFO

Under the first-in, first-out (FIFO) method, the first units entered into inventory are the first ones presumed sold. Conversely, under the last-in, first-out (LIFO) method, the last units entered are the first presumed sold.

In an inflationary environment, companies that report inventory using FIFO report higher inventory values, lower cost of sales and higher pretax earnings than otherwise identical companies that use LIFO. So, in an increasing-cost market, companies that use FIFO appear stronger — on the surface.

But LIFO can be an effective way to defer taxes and, therefore, improve cash flow. Using LIFO causes the low-cost items to remain in inventory. Higher cost of sales generates lower pretax earnings as long as inventory keeps growing. To keep inventory growing and avoid expensing old cost layers, however, some companies may feel compelled to produce or purchase excessive amounts of inventory. This can be an inefficient use of resources.

Specific identification

When a company’s inventory is one of a kind, such as artwork or custom jewelry, it may be appropriate to use the specific-identification method. Here, each item is reported at historic cost and that amount is generally carried on the books until the specific item is sold. But a write-off may be required if an item’s market value falls below its carrying value.

Weighing your options

Each inventory reporting method has pros and cons — and what worked when you started your business may not be the right choice today. As you prepare for year end, consider whether your method is still optimal, given your current size and business operations, expected market conditions, and today’s tax laws and accounting rules. Not sure what’s right? We can help you evaluate the options.

© 2016

Related-party transactions: Think like an auditor

Issues between related parties played a prominent role in the scandals that surfaced more than a decade ago at Enron, Tyco International and Refco. Similar problems have arisen in more recent financial reporting fraud cases, prompting the Public Company Accounting Oversight Board (PCAOB) to unanimously approve a tougher audit standard on related-party transactions and financial relationships. To prevent your company from issuing financial statements with undisclosed or misleading information about these relationships, think like an auditor.

It’s all relative

Under PCAOB Auditing Standard No. 18 (AS 18), Related Parties, Amendments to Certain PCAOB Auditing Standards Regarding Significant Unusual Transactions, and Other Amendments to PCAOB Auditing Standards, related parties include the company’s directors, executives and their family members.

Ultimately, companies are responsible for the preparation of their financial statements, including the identification of these related parties. However, auditors are on the lookout for undisclosed related parties and unusual transactions.

Where to look

Certain types of questionable transactions also might signal that a company is engaged in related-party transactions. Examples include contracts for below-market goods or services, bill-and-hold arrangements, uncollateralized loans and subsequent repurchase of goods sold.

Where can you find evidence of undisclosed related parties? Auditors are trained to consider these types of source materials:

  • Proxy statements,
  • Disclosures contained on the company’s website,
  • Confirmation responses, correspondence and invoices from the company’s attorneys,
  • Tax filings,
  • Life insurance policies purchased by the company,
  • Contracts or other agreements, and
  • Corporate organization charts.

Auditors also scrutinize compensation arrangements and other financial relationships with executives that may create incentives to engage in fraud to meet financial targets.

Leave no stone unturned

AS 18 requires public company auditors to obtain a more in-depth understanding of every related-party financial relationship and transaction, including its nature, terms and business purpose (or lack thereof). Moreover, it requires auditors to communicate with the audit committee throughout the audit process about related-party transactions — not just at the end of the engagement.

Related parties present risks to all kinds of entities, not just public companies. Smaller companies and start-ups also tend to engage in numerous related-party transactions, such as rental and compensation arrangements. These arrangements increase the risks of fraud and legal violations, warranting increased attention for companies of all sizes.

© 2016

Can you claim a home office deduction for business use?

You might be able to claim a deduction for the business use of a home office. If you qualify, you can deduct a portion of expenses, including rent or mortgage interest, depreciation, utilities, insurance, and repairs. The exact amount that can be deducted depends on how much of your home is used for business.

Basic rules for claiming deductions

The part of your home claimed for business use must be used:

  • Exclusively and regularly as your principal place of business,
  • As a place where you meet or deal with patients, clients, or customers in the normal course of business,
  • In connection with your trade or business in the case of a separate structure that’s not attached to your home, and
  • On a regular basis for the storage of inventory or samples.

A strict interpretation

The words “exclusively” and “regularly” are strictly interpreted by the IRS. Regularly means on a consistent basis. You can’t qualify a room in your home as an office if you use it only a couple of times a year to meet with customers. Exclusively means the specific area is used solely for business. The area can be a room or other separately identifiable space. A room that’s used for both business and personal purposes doesn’t meet the test.

The exclusive use rule doesn’t apply to a daycare facility in your home.

What if you’re audited?

Home office deductions can be an audit target. If you’re audited by the IRS, it shouldn’t result in additional taxes if you follow the rules, keep records of expenses and file an accurate, complete tax return. If you do have a home office, take pictures of the setup in case you sell the house or discontinue the use of the office while the tax return is still open to audit.

There are more rules than can be covered here. Contact us about how your business use of a home affects your tax situation now and in the future. Also be aware that deductions for a home office may affect the tax results when you eventually sell your home.

© 2016

The Independent Auditor, Part II

by Frank Stover, CPA/CFF/CGMA, CFE

Audit Manager at Atchley & Associates, LLP

DO’S AND DON’TS

What auditors do

The independent auditor is engaged to render an opinion on whether an entity’s financial statements are presented fairly, in all material respects, in accordance with a particular financial reporting framework (GAAP, GASB, FASB, regulatory basis, etc.) The audit provides users, such as the bond counsels and agents, regulatory bodies, and the general public, with a degree of confidence in the financial statements. An audit conducted in accordance with GAAS and relevant ethical requirements enables the auditor to form that opinion.

To form an opinion, the auditor gathers appropriate and sufficient evidence and observes, tests, compares and confirms until gaining reasonable assurance. The auditor then forms an opinion of whether the financial statements are free of material misstatement, whether due to fraud or error.

Some of the more important auditing procedures include:

  • Inquiring of management and others to gain an understanding of the organization itself, its operations, financial reporting, and known fraud and error
  • Evaluating and understanding the internal control system
  • Performing analytical procedures on expected and unexpected variances in account balances or classes of transactions
  • Testing documentation supporting account balances or classes of transactions
  • Observing the physical inventory count
  • Confirming bank accounts, receivables, and other accounts with a third party

At the completion of the audit, the auditor may also offer objective advice for improving financial reporting and internal controls to maximize a company’s performance and efficiency.

What auditors don’t do

For a clear picture of the role of independent auditors, it helps to understand what you should not expect auditors to do. Emphasis is placed on “independent.”

Firstly, your independent auditors do not take responsibility for the financial statements on which they form an opinion. The responsibility for financial statement presentation rests with management and those charged with governance of the entity being audited.

Auditors are not a part of management, which means the auditor will not:

  • Authorize, execute or consummate transactions on behalf of a client
  • Prepare or make changes to source documents
  • Assume custody of client assets, including maintenance of bank accounts
  • Establish or maintain internal controls, including the performance of ongoing monitoring activities for a client
  • Supervise client employees performing normal recurring activities
  • Report to the board of directors on behalf of management
  • Serve as a client’s bond or escrow agent or general counsel
  • Sign payroll tax returns on behalf of a client
  • Approve vendor invoices for payment
  • Design a client’s financial management system or make modifications to source code underlying that system
  • Hire or terminate employees

Stated briefly, the auditor may not assume the role and duties of management.

Speaking as a practical matter, there are a number of tasks you should not expect your independent auditor to perform:

  • Analyze or reconcile accounts
  • “Close the books”
  • Locate invoices, etc., for testing
  • Prepare confirmations for mailing
  • Select accounting policies or procedures
  • Prepare financial statements or footnote disclosures
  • Determine estimates included in financial statements
  • Determine restrictions of assets
  • Establish value of assets and liabilities
  • Maintain permanent records, including bond or loan documents, leases, contracts and other legal documents
  • Prepare or maintain minutes of the entity’s governance committee meetings
  • Establish account coding or classifications
  • Determine retirement plan contributions
  • Implement corrective action plans
  • Prepare an audit for audit

An audit is NOT a fraud examination, you may engage an audit firm to perform a forensic examination which is performed under different professional standards.

Your independent auditor may assist in the performance of some of these duties under some restrictive guidelines of the American Institute of CPAs, Department of Labor, Government Accountability Office, Securities and Exchange Commission or Public Company Accounting Oversight Board. However, these very same guidelines may also preclude the auditor from performing some of these functions.

The Independent Auditor, Part I

by Frank Stover, CPA/CFF/CGMA, CFE

Audit Manager at Atchley & Associates, LLP

 The Audit

au·dit /ôdət/noun

noun: audit; plural noun: audits

Audit: an official inspection of an individual’s or organization’s accounts, typically by an independent body.

Verb: conduct an official financial examination of (an individual’s or organization’s accounts). “companies must have their accounts audited”

Synonyms, common:  inspectexaminesurvey, go through, scrutinizecheckprobe, investigate, vet, inquire into, assessverifyappraiseevaluatereview, analyzestudy.

Origin: late Middle English: from Latin auditus ‘hearing,’ from audire ‘hear,’ in medieval Latin auditus (compoti ) ‘audit (of an account),’ an audit originally being presented orally.

 

There are different types of audits: external, single-audit, governmental, compliance, internal, and regulatory to name a few.

Description of more common audits:

1. Third Party Verification – An independent or external audit is carried out by a neutral third party, such as a professional accounting firm which is licensed to perform audits. The financial records of an entity including ledgers, bank statementspayroll, tax information, internal financial reports, official published reports, accounts payable, and accounts receivable, will be examined, among other documents.  Further, minutes of meetings of directors, committees, and commissioners’ court, inquiry of attorneys, public databases and internet searches are some of the other techniques used to gather entity information. Standards under which audits are conducted are established by various professional bodies and governmental agencies, such as: the AICPA, SEC, GASB, FASB, OMB, and State Public Accountancy Boards.

2. A Single Audit is an engagement to perform simultaneously three (3) examinations.  They are (1) an examination of the financial statements, (2) an examination of internal controls over financial reporting and compliance, and (3) an examination of an entity’s compliance with requirements that could have a direct and material effect on each major program (in accordance with OMB Circular A-133).  The Single Audit is conducted under standards and guidelines issued by the Office of Management and Budget (OMB) generally using Circular A-133, the Governmental Accounting Standards Board, the Financial Accounting Standards Board, and depending on the source of funds perhaps the State of Texas Single Audit Circular.

A Federal or State Single Audit is required if you expended (not received) $750,000 of grant funds.  A distinction should be made that not all Federal or State funds may be grants, should you have a contract for service these monies are not subject to the Single Audit requirement.  If you are unsure, contact your designated grant(s) administrator(s).

The threshold of expenditures requirement is $750,000 for fiscal years beginning on or after January 1, 2015, for fiscal years beginning before that date the threshold requirement for expenditures is $500,000.

3. A compliance audit is a comprehensive review of an organization’s adherence to regulatory guidelines. Independent accounting, security or IT consultants evaluate the strength and thoroughness of compliance preparations. Auditors review security polices, user access controls and risk management procedures over the course of a compliance audit.

What, precisely, is examined in a compliance audit will vary depending upon whether an organization is a governmental, public or private entity, what kind of data it handles and if it transmits or stores sensitive financial data. For instance, SOX requirements mean that any electronic communication must be backed up and secured with reasonable disaster recovery infrastructure.  Entities, such as healthcare providers that store or transmit e-health records, like personal health information, are subject to HIPAA requirements. Financial services companies that transmit credit card data are subject to PCI DSS requirements. In each case, the organization must be able to demonstrate compliance by producing an audit trail, often generated by data from event log management software.

4. Internal Audit as defined by the Institute of Internal Auditors (IIA), “Internal auditing is an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes.

Internal Auditors’ roles include monitoring, assessing, and analyzing organizational risk and controls; and reviewing and confirming information and compliance with policies, procedures, and laws. Working in partnership with management, internal auditors provide the board, the audit committee, and executive management assurance that risks are mitigated and that the organization’s corporate governance is strong and effective. And, when there is room for improvement, internal auditors make recommendations for enhancing processes, policies, and procedures.”

Part II. All the Do’s and Don’ts for Auditors [coming soon]