Auditing standards require external auditors to consider potential fraud risks by watching out for conditions that provide the opportunity to commit fraud. Unfortunately, conditions during the COVID-19 pandemic may have increased your company’s fraud risks. For example, more employees may be working remotely than ever before. And some workers may be experiencing personal financial distress — due to reduced hours, decreased buying power or the loss of a spouse’s income — that could cause them to engage in dishonest behaviors.

Financial statement auditors must maintain professional skepticism regarding the possibility that a material misstatement due to fraud may be present throughout the audit process. Specifically, Statement on Auditing Standards (SAS) No. 99, Consideration of Fraud in a Financial Statement Audit, requires auditors to consider potential fraud risks before and during the information-gathering process. Business owners and managers may find it helpful to understand how this process works — even if their financial statements aren’t audited.

Doubling down on fraud risks

During planning procedures, auditors must conduct brainstorming sessions about fraud risks. In a financial reporting context, auditors are primarily concerned with two types of fraud:

1. Asset misappropriation. Employees may steal tangible assets, such as cash or inventory, for personal use. The risk of theft may be heightened if internal controls have been relaxed during the pandemic. For example, some companies have waived the requirement for two signatures on checks, and others have reduced oversight during physical inventory counts.

2. Financial misstatement. Intentional misstatements, including omissions of amounts or disclosures in financial statements, may be used to deceive people who rely on your company’s financial statements. For example, managers who are unable to meet their financial goals may be tempted to book fictitious revenue to preserve their year-end bonuses. Or a CFO may alter fair value estimates to avoid reporting impairment of goodwill and other intangibles and triggering a loan covenant violation.

Identifying risk factors

Auditors must obtain an understanding of the entity and its environment, including internal controls, in order to identify the risks of material misstatement due to fraud. They must presume that, if given the opportunity, companies will improperly recognize revenue and management will attempt to override internal controls.

Examples of fraud risk factors that auditors consider include:
• Large amounts of cash or other valuable inventory items on hand, without adequate security measures in place,
• Employees with conflicts of interest, such as relationships with other employees and financial interests in vendors or customers,
• Unrealistic goals and performance-based compensation that tempt workers to artificially boost revenue and profits, and
• Weak internal controls.

Auditors also watch for questionable journal entries that dishonest employees could use to hide their impropriety. These entries might, for example, be made to intracompany accounts, on the last day of the accounting period or with limited descriptions. Once fraud risks have been assessed, audit procedures must be planned and performed to obtain reasonable assurance that the financial statements are free from misstatement.

Following up

Auditors generally aren’t required to investigate fraud. But they are required to communicate fraud risk findings to the appropriate level of management, who can then take actions to prevent fraud in their organizations. If conditions exist that make it impractical to plan an audit in a way that will adequately address fraud risks, an auditor may even decide to withdraw from the engagement.

Contact us to discuss your concerns about heightened fraud risks during the pandemic and ways we can adapt our audit procedures for emerging or increased fraud risk factors.

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With the COVID-19 pandemic well into its second year and the start of planning for the upcoming audit season, you may have questions about how to evaluate your company’s going concern status. While some industries appear to have rebounded from the worst of the economic downturn, others continue to struggle with pandemic-related issues, such as rising inflation, along with labor and supply shortages. For some businesses, pre-pandemic conditions may never return, which can make it exceptionally difficult to project future performance.

How auditing standards have changed

Financial statements are generally prepared under the assumption that the entity will remain a going concern. That is, it’s expected to continue to generate a positive return on its assets and meet its obligations in the ordinary course of business.

Under Accounting Standards Codification Topic 205, Presentation of Financial Statements — Going Concern, the continuation of an entity as a going concern is presumed as the basis for reporting unless liquidation becomes imminent. Even if liquidation isn’t imminent, conditions and events may exist that, in the aggregate, raise substantial doubt about the entity’s ability to continue as a going concern. Today, the responsibility for the going concern assessment falls on management, not the company’s external auditors.

In addition, the time period that the assessment must cover has been extended. Previously, the determination of an entity’s ability to continue as a going concern was based on expectations about its performance for a one-year period from the date of the balance sheet. Now, under Accounting Standards Update No. 2014-15, Presentation of Financial Statements — Going Concern: Disclosure of Uncertainties About an Entity’s Ability to Continue as a Going Concern, the assessment is based upon whether it’s probable that the entity won’t be able to meet its obligations as they become due within one year after the date the financial statements are issued — or available to be issued — not the balance sheet date. (The alternate date prevents financial statements from being held for several months after year end to see if the company survives.)

When disclosures are required

In situations where substantial doubt exists, management then must evaluate whether its plans will alleviate substantial doubt. That is, is it probable that the plans will be implemented, and if so, will they be effective at turning around the company’s financial distress?
Disclosures are required indicating that either:
• The plans will mitigate relevant conditions and events that have caused substantial doubt, or
• The plans won’t alleviate substantial doubt about the entity’s ability to continue as a going concern.

Though management is responsible for making this assessment, auditors will request appropriate evidence to support the going concern disclosure. For example, detailed financial statement projections or a written commitment from a lender or affiliated entity to fully cover the entity’s cash flow requirements might help substantiate management’s assessment. If management doesn’t perform a sufficient evaluation, the auditing standards may require the auditor to report a significant deficiency or a material weakness.

We can help

If your business is continuing to struggle during the pandemic, contact us to discuss your going concern assessment for 2021. Our auditors can help you understand how the evaluation will affect your balance sheet and disclosures.

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An external audit is less stressful and less intrusive if you anticipate your auditor’s document requests. Auditors typically ask clients to provide similar documents year after year. They’ll accept copies or client-prepared schedules for certain items, such as bank reconciliations and fixed asset ledgers. To verify other items, such as leases, invoices and bank statements, they’ll want to see original source documents.

What does change annually is the sample of transactions that auditors randomly select to test your account balances. The element of surprise is important because it keeps bookkeepers honest.

Anticipate questions

Accounting personnel can also prepare for audit inquiries by comparing last year’s financial statements to the current ones. Auditors generally ask about any line items that have changed materially. A “materiality” rule of thumb for small businesses might be an inquiry about items that change by more than, say, 10% or $10,000.

For example, if advertising fees (or sales commissions) increased by 20% in 2021, it may raise a red flag, especially if it didn’t correlate with an increase in revenue. Be ready to explain why the cost went up and provide invoices (or payroll records) for auditors to review.

In addition, auditors may start asking unexpected questions when a new accounting rule is scheduled to go into effect. For example, private companies and nonprofits must implement new rules for reporting long-term lease contracts starting in 2022. So companies that provide comparative financial statements should start gathering additional information about their leases in 2021 to meet the disclosure requirements for next year.

Minimize audit adjustments

Ideally, management should learn from the adjusting journal entries auditors make at the end of audit fieldwork each year. These adjustments correct for accounting errors, unrealistic estimates and omissions. Often internally prepared financial statements need similar adjustments, year after year, to comply with U.S. Generally Accepted Accounting Principles (GAAP).

For example, auditors may need to prompt clients to write off bad debts, evaluate repair and supply accounts for capitalizable items, and record depreciation expense and accruals. Making routine adjustments before the auditor arrives may save time and reduce discrepancies between the preliminary and final financial statements.

You can also reduce audit adjustments by asking your auditor about any major transactions or complicated accounting rules before the start of fieldwork. For instance, you might be uncertain how to account for a recent acquisition or classify a shareholder advance.

Plan ahead

An external audit doesn’t have to be time-consuming or disruptive. The key is to prepare, so that audit fieldwork will run smoothly. Contact us to discuss any concerns as you prepare your preliminary year-end statements.

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