Author: C.O.R.E. Beliefs

More on Management Representations

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The second section of the management representation letter gets into the heart of how you went about disclosing information to the independent accountant.  This section is titled, “Information Provided” and you should be aware of what is actually being stated here.

  • You are stating that you have responded fully and truthfully to all inquiries made.  Keep in mind one of the bigger concerns is related party transactions – if you know one exists but fail to disclose it, you have technically misrepresented yourself.
  • You provided access to all relevant information which deals with the preparation and fair presentation of the financial statements.
    • Contracts
    • Board minutes (if you had a board and kept minutes
    • Schedules requested, like an amortization schedule for interest
    • Most importantly, unrestricted access (my emphasis) to persons within the entity that the accountant felt was necessary to interview to feel confident about the evidence.

As a quick aside, this is a potential for a scope limitation which is an engagement killer for both an audit and review.  We have had client management tell us we cannot interview certain employees.  Sorry, that is a huge red flag issue.  We don’t like wasting our time talking with employees or business partners who cannot provide evidence, but if you have a purchasing manager and we question the values of inventory, to say we cannot talk with that person means we cannot issue our independent report.  You have been warned.

  • You have recorded all transactions in your accounting system and these show up on the financial statements.  You are the entities first line of defense.  We have been involved with engagements where specific transactions were not recorded, only to find out later that someone (like the owner) knew about it but failed to ensure it was included.
  • You are stating you are either have no knowledge of fraud or suspected fraud or have shared with us your suspicions or evidence.  Think about this representation.  As I have discussed in other posts ,we have discovered odd journal entries which were possibly created to misrepresent the financial condition of the company.  We have required management to represent that they had evidence of this misrepresentation and have taken steps to address the action and then state if they know of anything else.  The fact that it the transaction was caught by us and not management is the problem since it never should have been entered in the first place.
  • You are stating that there are either no instances of noncompliance with laws or have disclosed all such instances to us and have either made allowance for it in the financial statements or are disclosing such.  There was one instance where a construction company bid on a job in a new state.  They started the work and failed to file as a foreign corporation, failed to register as a contractor and failed to file for payroll taxes and workers compensation coverage.  Even though it was eventually corrected, we required an accrual of the expenses and also a note disclosure.
  • You state that all possible litigation and potential claims have been identified.  If your company is being sued for, say a hostile work environment, you should let the accountant know so that a proper disclosure can be prepared.  Your relative guilt or innocence is not the question, the fact that there is a risk is the concern.
  • You are stating that you have disclosed all related parties.  By the way, you are required to disclose related party matters even when you are not doing business with them.
  • The last big one, you state that the entity has complied with all contractual agreements that would have a material effect on the financial statements in the event of noncompliance.  Now, before you say it is never a problem, think about a line of credit that is tied to your inventory by way of a borrowing base calculation.  It requires that inventory over 120 days be excluded from the calculation.   At the end of the year you are on day 119 for 50% of your inventory.  You are likely going to be out of compliance and it may have a material impact.

For the most part, management representation letters are simple and straightforward.  But they are designed to protect the independent accountant by putting you on notice that you are making, and they are relying upon, certain representations.  In the event of a problem their defense is that you represented that you told them one thing and obviously something else happened.  So, to protect yourself, don’t be afraid to add specific language which makes the representation letter more effective for you and the accountant.

We hope this journey through the standard management representation letter has been helpful.  If you have questions about the representation letter, feel free to ask.  And if you would like a proposal on audit or review services, go to our website and learn a little more about us.  We have a page where you can request a proposal and we would love the opportunity to be of service to you.

Management’s Representation

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We are often asked, “Why do I have to sign this letter?”  The letter being referred to is the management representation letter.  As to the why, because you as management, the owner, the board, are making specific assertions that we, the independent accountant’s are relying upon.

An important part of management’s representation is the concept of materiality.  The representation letter typically includes this paragraph, “Certain representations in this letter are described as being limited to matters that are material. Items are considered material, regardless of size, if they involve an omission or misstatement of accounting
information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would be changed or influenced by the omission or misstatement.”

In this section you are agreeing to the concept that the dollar value alone is not necessarily indicative of materiality.  I will use a real-world example (one we are currently facing) to explain:  Way back in November 2013, an association approved a special assessment.  Interest was to start December 1, 2013 if the full amount of the special assessment wasn’t paid by November 30.  Unpaid interest earned was about $3,500.  The manager did not accrue the interest for those who hadn’t paid by December 31.    Was it material?  Dollar-wise probably not.  But had it been known that over 30% of owners had not paid their first payment – which would have been obvious had the accrued interest been included – it is quite probably that a reasonable person’s judgement may have been changed.

So what are some of the specific representations you are making?  Regarding the financial statements, you represent:

  • You understand that you are responsible for the preparation and fair presentation of the financial statements.  This is true even if you entrust the preparation of the financial statement to the outside accountant.
  • You acknowledge your responsibility to design, implement and maintain an internal control system and you have fulfilled this responsibility.  This is a big issue; go back to the example above, obviously the control system to ensure that all relevant information was provided in the financial statement was not working properly.
  • You acknowledge your responsibility to design, implement and maintain an internal control system to prevent and detect fraud.  Fraud, by the way, is not just about people stealing it is also about ensuring the financial statements are not intentionally misleading.
  • Related party relationships and transactions have been accounted for and are disclosed.  This could be as simple as renting the building from an LLC owned by the majority shareholder or as complex as contracting with a company where the controller is a silent partner.  You are stating that these types of transactions have been fully documented and are properly disclosed to a reader of the financial statements.
  • Any important events that happened after the balance sheet date are accounted for and/or disclosed.  This means, if you decide to pay a large bonus to key employees after the year-end, at a minimum it needs to be fully disclosed and more likely properly accrued since the bonus no doubt stems from the profit of the year.

These are by no means all the things you are representing regarding the financial statements.  But you get the idea; you have the primary responsibility for all the financial information and making sure it gets in the financial statement.  You can and should bring it up to your accountant (or whoever is preparing the financial statement) if you have the slightest concern that it is something that should be included.

When is that you ask?  The fact it is on your mind means it should probably be disclosed.  The old saying, “When in doubt, let it out.” definitely applies to your financial statements.  Don’t try to suppress bad news or fluff up the good.  You, as management and the board (if it exists) have an obligation to ensure the truth is provided so that the reader can make an informed decision.

If you need help with preparing financial statements or designing an effective internal control system, feel free to contact us through our website.  We have worked with many large and small businesses, non-profits, and associations as auditor and also consultants.  We are here to be of service to you.

Review Procedures

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I was asked yesterday to explain my blog about reviews the other day and how the CPA overlooked the fact that the manager recorded the full special assessment instead of unearned interest income.  It was a great question.

What actually tipped us was the foot note for the receivable.  It said, in part, that monthly payments were required by owners (including interest).

When we looked at the manager’s profit and loss statement for the special assessment fund, it showed

Interest income $0
Interest expense $20,000

The second clue was looking back at the special assessment fund balance.

2014 $80,000
2015 $65,000
2016 $50,000

Each year the equity is being reduced because the interest expense was being recorded but there was no offsetting interest income.  Since there was a special assessment receivable, an effective review test would be multiplying the average receivable balance by the stated interest rate.

In this case, the average receivable balance was $300,000.  This multiplied by the 6.0% interest rate meant $18,000 of interest income would be expected.  The association recorded no interest income.  This is a very large deviation from expectations.

Under SSARS, Statement on Standards for Accounting and Review Services, the accountant performs certain analytical tests and compares those to industry standards, historical evidence and certain expectations driven by experience with both the client and the particular industry.  In this case, our experience with special assessment receivables led us to believe that there should have been interest income.  Although if the accountant simply compared it to the prior year, then the zero matched the zero in the prior year and even the year before that.

This would be incorrect though.  Another requirement of SSARS and GAAS is to maintain professional skepticism, or the willingness to look beyond the assumption that an explanation may be correct.

So, we said, “Wait a second, how can it be zero if we calculate $18,000?  How could the prior year be zero when the average receivable was $400,000?  We then asked the question of management and they said it was always zero.

And our response was, so what?  It didn’t feel right.  In short, we were skeptical that their explanation was sufficient.  Remember, the foot note said each payment included interest.  This meant that somewhere along the way the preparer of the financials read a document that stated this.

Sure enough we found that document.  Sure enough we found the next document which showed the original entry and that it included the full amount of the special assessment – including interest.  That is, by the way, why the fund balance had a positive balance all the way back when it was created.  The special assessment “revenue” was higher than the costs of the renovation project.  It should have, at best, been a  break even.

We could then model it and show the board how the financial statements were incorrectly reporting the special assessment.  We then showed them how it was supposed to be.

No, it hasn’t been cheap for the association.  It was all driven, unfortunately, by not having the financial statement reviewed in the year of the special assessment.  Having the statements reviewed years later almost guaranteed that it would be overlooked.  It is possible that it could have been overlooked in a review of that year too, I am not saying that it would have been caught necessarily, but the odds would have definitely been improved.

So yes, board members, especially treasurers, you can run your own analysis.  If you would like, I can send you a spreadsheet with some of the more common ratios and analysis to help you get a good overview of your financial statements before your accountant sets in on the review.  It can’t hurt and could potentially head off a disaster.

Have a great day.  If you would like to learn more about how to analyze your non-profit, business, or property association, feel free to contact me and request the spreadsheet.  C.O.R.E. Services is here to be of service to you.

The Dilemma of the Review Engagement

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GAAP can be incredibly complex.  A review engagement under SSARS requires the independent accountant perform analytical tests to determine if GAAP is being complied with.   A review is not an Audit.  It is “substantially less in scope than an audit…” which is a fancy way of saying that the reviewer is not looking deeply into the financial statements.  This means that some complex GAAP issues can be overlooked during a review because the analytic procedure may not discover the problem.

Case in point:

Alpha Condo Association was faced with a dilemma.  The 20 unit complex had substantial leaking through the roof last winter.  Sadly the roof was at its end of life and was going to cost $200,000 to tear-off and replace and also upgrade their elevator and HVAC system.  The association had only $50,000 in their reserve fund.

No, I am not going to rant about the lack of foresight by the board.  My other blog is addressing that issue.  What I am going to discuss is how things can go sideways and it might take years to discover.

Back to the issue at hand.  The board votes to have a special assessment for $10,000 per unit to deal with the problem.  The owners approve the special assessment 13 to 7.  Here is where things go wrong.

The board apparently provided owners two payment options.  Full payment within 30 days or payment over 10 years with interest.  The resolution which passed stated the interest rate charged was going to be equal to the interest rate on any bank loans taken out.

Five owners paid the $10K within 30 days.  The remainder took the payment option and the board borrowed $200,000 from the bank to do the work.

Apparently the board decided that, to make things easier, they would include the interest due from the owners in the initial assessment.  So, instead of their special assessment being $10K, it was $16,000.  Yes, that’s right.  The bank’s interest rate times the ten years for the repayment term of the special assessment.  The actual interest ended up being about 9.6%.

Ignore, for the moment, the fact that this does not calculate out to 6.0% interest, the real problem is that the management company recorded a receivable of $290,000 and special assessment revenue of $290,000.  The special assessment of $200,000 and the interest charge of $90,000.

The financial statements were reviewed by several different independent CPA’s (not us) over the years which reported the financial statements were prepared according to GAAP.

No they weren’t.  The original entry was incorrect by treating the interest as special assessment revenue.

Today’s missive is not about GAAP per se, it is about the inherent risk of a reviewed financial statement.

I am not trying to defend the fact that the CPA’s overlooked the problem.  In hindsight it is obvious that the $90,000 was not “earned” as special assessment but it was rather unearned interest on the special assessment receivable.  Now, almost a decade past the original special assessment we are performing the review and we stumbled across this matter.

Of course, like any good story there is lots of murkiness.  Like the fact that the unit owners voted to pass on having a review in the year of the special assessment as well as the two years after.  It wasn’t until 3 years after the transaction that the CPA was asked to review the financial statements.  And sadly, this issue was overlooked.

Again, this isn’t about GAAP; directly.  This is about the fact that the owners decided against spending money on an assurance service.  That’s right, hiring a CPA to perform an attest function on your financial statements is a means to ensure that what you are being told in those statements is prepared according to the rules everyone agreed to.

Most state condominium laws require at least a review of the association’s financial statements.  The law also typically requires that the financial statements be prepared according to GAAP.  But the law also typically gives boards and/or owners the right to waive compliance with the attest of the financial statements.

The owners agreed to waive the preparation of the financial statements for three straight years.  For three straight years the presumption is everyone was cool with how the accounting was done.  Finally a review is done and, because the reviewing CPA missed the original transaction, they want the CPA’s head on a platter.  Talk about shooting the messenger.

If you, as a non-profit board, as a business owner, as an investor, take a pass on hiring an independent CPA to perform an attest service, don’t blame the CPA when things don’t go right.  And, if you think saving money by having a review instead of a very painful (and valuable but costly) audit performed is a great idea, don’t be surprised when things are not working like you were lead to believe.  After all, the accountants’ report clearly states that a review is substantially less in scope than an audit… buyer beware.

No one likes to make mistakes but it happens.  As professionals we are ok with being held accountable for our work.  But when you elect to take the cheap route and things are wrong, don’t go looking to blame the professionals when it suddenly comes to bite you in the butt.

We haven’t worked out yet how we are going to handle this.  It is a problem to be sure – on several levels.  But the point is, don’t skimp on an audit if you want reasonable assurance that the financial statements are prepared correctly; and don’t skimp on a review if you are not involved in the day-to-day operation of the entity.  Neither service will catch everything that might be wrong but, what doesn’t get told in a financial statement is often worse than what is in there.

Have a great day.