Auditor Independence

One of the more challenging aspects of being an auditor is having to turn down potential work.  It is not so much the money we could be paid for that other work, although that is nice in most cases; it is the recognition that our experience and problem-solving ability is valued and desired.  But, if auditors take their ethical responsibilities seriously they should not take additional projects on for their audit clients.

Doug and I discuss this frequently.  For instance, we have intentionally chosen to not prepare tax returns for individuals and businesses and we will only do the most basic 1120-H or 1120 for property associations.  Why?  It is the concern that a reader could question if the tax preparation work would cause us to subordinate our judgement as the auditor.

I know, you are saying, “It’s only a tax return.” And you are right.  But think about it: Let’s say an auditor prepares the tax return for a board member and his small business.  Then the auditor is asked to audit the small business.  The auditor discovers that $100,000 of scrap metal sales was not reported as income by the business.  Or the owner.  And the auditor is also auditing the condo association where the small business owner is also the chair of the board.  And it just so happens the auditor discovers that the association has a contract with the chair’s company to install new piping.  Are you still certain it is only a tax return?

But it can become even more challenging for an auditor if it looks like the fees they charge for that “other service” to the client appears more lucrative than the audit.  First, lets say that you charge $20,000 to a client for an audit.  At the same time the board approves the audit, management dangles a $50,000 consulting fee.  Is this a potential independence problem?

Unfortunately for the profession, many practitioners say “No” or worse, “Not necessarily”.  But think about it.  You are reading the financial statement the auditor attested to and which said there were no problems.  You then find out one of the issues above exists.  Would you, as the reader and who is relying upon that financial statement, be concerned that either of these situations could cause the auditor to issue an inappropriate report?

You see, I can unequivocally state that our opinion is not for sale.  But that is an assertion which is challenging to believe when I receive payments for services that are not audit related.  And I don’t think it matters if it is the board which offers the consulting work or management.  Our engagement is to audit the financial statements prepared by management and to which the board signs off on.  The board engages the auditor on behalf of the owners – but the board still might have its own agenda.  Thus, It is the risk that a reader could believe that our independence – from management AND board – could be impaired that matters.  Accepting money for additional services to an audit client should inevitably lead to the concern that the auditor’s independence is impaired.

Now, I understand that some professionals would say that this is an extreme position.  That is their right.  But I believe that the profession accepting the concept that non-audit fees do not impair independence is one of the primary reasons the auditor and the audit opinion are not held in high regard.

If you want to offer audit or review services to a client, then I think you have to accept that this is all the work you can do for that client.  At C.O.R.E., we believe that an auditor must maintain independence in both action and appearance.  It sucks sometimes.  We have turned down consulting arrangements because we audited the prior year financial statement.  We have turned down audit engagements because we proposed a consulting arrangement in the prior year.

It is our responsibility to do so.



To Whom does the Auditor Answer?

One of my google alerts brought an interesting article about the auditor and the relationship the audit firm has with management and the board.  It seems that many boards are concerned that the auditor appears aligned with management and not the shareholders.  This is, sadly, not a new problem, but it is one that C.O.R.E. is trying to address is our own little world of auditing.

At C.O.R.E., we understand our loyalty lies to the reader of the financial statements – that is, the shareholders.  We are engaged by the board on behalf of the owners to audit management.  Ensuring that current and prospective owners get the best information about their association is key to our success, but sometimes getting owners the best information means upsetting management.

Upsetting management, however, potentially hurts the pocketbook of the auditing CPA firm.  In many situations, management offers very profitable consulting opportunities to the auditor.  Systems design, software evaluation, and other arrangements are absolutely essential to the financial health of an organization and a CPA is highly qualified to offer those services.  The problem is the potential for the auditor to be compromised – that is, does the auditor get the consulting gig because they went soft on management?

If you don’t think it is a very real possibility think again.  Can you imagine anyone hiring a consultant who just got through bashing them?  If a CPA firm had the chance to earn $100,000 consulting with management or $30,000 auditing the client (or both hopefully), is it possible that the auditor might turn a blind eye to a problem found on audit for the chance to earn more money?

And in the small and medium sized entity market, it is potentially even more painful.  The small CPA firm gets most of its new business by referral.  But referrals are hard to come by when your work upsets management.  This has impacted us directly – we have had to issue specific communication about management violating internal control systems to an entity’s board.  The Chair of the board was also the president who hired his son, the person who broke the rules.  That organization and six other companies found a new CPA firm because they wanted someone less “negative”.   Seven entities is a lot of billing.  Financially, would we have been better off remaining silent?

This is not an attempt to justify the auditor’s failure to live up to their responsibility to protect owners and stakeholders.  An auditor who accepts a consulting job with a client needs to consider it a bribe, or worse, an attempt to make them complicit in management’s failure.  That is the auditor’s failure.

But the greater failure is on behalf of the boards of directors who have the primary responsibility to protect the shareholders.  When you ask management to interview auditors, when you accept management’s recommendation to terminate the CPA, when you accept management’s excuses for their misdemeanors, you are abrogating your responsibility.

But you can start to address the problem.  It will require boards to start holding management accountable.  And, when it comes to engaging the auditor to attest to your organization’s financial statements:

You, not management, should

  • request proposals from auditors
  • interview the auditor
  • determine if the auditor takes any fees from management for consulting
  • ask how auditors get clients – board or management referral
  • never allow management to dictate non-GAAP policies without auditor approval
  • interview new auditors every 3-5 years
  • demand that the auditor refuse to accept any consulting arrangement with management

As long as the board, or its audit committee, continues to allow management any involvement in the process of selecting, engaging and compensating auditors, this problem will not go away.  The board must make it clear to management that the auditor is the board’s tool to review management and its adherence to appropriate accounting policy and not someone who is there to help management look good.  And the board must make it clear to the auditor they look to them to protect the owners and their investment.  This is your chance to hold both auditor and management accountable, will you step up to the challenge?

Financial Audit or Control Audit

We are often asked by boards if we believe that the management company’s processes are effective.  The answer is, we have no way of knowing as we are conducting an audit of the financial statements, not an audit of the managers’ internal control system.  To which the response is typically a look of bewilderment as most board members don’t understand the difference.

An audit of the financial statement does require the auditor to understand the internal control structure put in place by management so we can plan and perform the audit.  But what typically happens is that the auditor says, “That’s great, but we are going to assume management doesn’t follow it and plan our audit as though the system doesn’t work.”

Given the size and simplicity of the transactions in the typical association, it is faster and more effective to avoid testing the internal control system to ensure it works.  Take accounts payable; walking a single transaction through the entire control system and documenting the steps would take about an hour.  In order to rely upon the system to ensure it leads to the correct recording and reporting of the transaction we would have to test several dozen.  But, since this is a financial audit and we are concerned with ensuring that vendor invoices are reported to the correct period, we can simply review the individually significant invoices reported in the subsequent period to determine the period in which it was incurred and recorded.  We can go through the 4 or 5 invoices in about 10 minutes.

Since we didn’t rely upon the control system to ensure the invoice was recorded correctly, we completed the procedure faster and determined the results just as effectively as though we had relied upon it.  If we find invoices in the subsequent period (typically January) that should have been recorded in the prior period, we propose a journal entry.  The internal control system might have worked but we can’t say that, even if we didn’t find an invoice posted to the wrong period.

We understand that boards are concerned with the effectiveness of the internal control system and agree that it is important.  But the individual board does not want to engage an auditor to test the management company’s system.  Boards should require their management company to have a SOC audit.

A SOC, or Service Organization Control, audit is performed by an auditor on the service provider: In this case the management company.  The SOC audit ensures the appropriate controls are in place and function as required.  While there are different levels of SOC audit, the end result is the same – reporting on the effectiveness of the providers internal control system.

Frankly, state law should require a management company to have a SOC audit in addition to requiring the association to have a financial audit.  Associations which outsource the receipt and payment of funds need to know that the company they use has the right systems in place and those systems work.  The annual financial audit is not designed to offer an assurance that this is the case.

We realize that a SOC audit could be expensive.  To be honest, it might not even substantially reduce the cost of the association’s financial audit; although I think there would be some cost savings.   If a manager could produce a SOC audit which stated that the controls were in place and effective, we could probably drop our audit charge by 10-20 percent.  But beyond the potential savings you would have a strong marketing tool.

The feedback we have received is that an association board would rather have a report which says that the internal control system is in place and works.  We would like to offer this to a board but this type of report is not cost effective at the association level. But it could be at the management company level.  And it is quite possible that having a SOC audit report can help you land new clients – since everything else being equal, having a documented and tested internal control system is much more important to boards than knowing their financial statements are prepared according to GAAP.

Something to think about.

Accounting Standards

One of the big issues we face, as auditors, is an entity following an accounting standard for its financial statements.  Which begs the question, what is an accounting standard?

The best way to look at it is that an accounting standard is the expectation of how transactions should be recorded and disclosed in financial statements.   For generally accepted accounting principles, also called GAAP, this way of recording and reporting transactions is presented in the Accounting Standards Codification, or ASC’s.

Why should anyone care?  That is the question we are struggling with this week.  It seems that there are some, even in professional accounting, who are unsure why GAAP should be followed.  I have shared with you some of our more interesting conversation with clients and their management but we have similar discussions within the profession.

The simplest answer is, eliminating confusion.

GAAP, with all its faults, is just what it says it is, generally accepted.  This doesn’t mean universally accepted but it does mean that most of us agree that transactions should be recorded and reported a particular way.  By agreeing, up front, on how transactions should be completed, we get rid of the guesswork and the uncertainty of everyone deciding on their own.

Yes, this is all wonderfully theoretical but the vast majority of small businesses, non-profits and HOA’s don’t care about GAAP, is the argument we hear.  No doubt.  But the people who put their money into it should.

On a simple level, you are approach by a friend, a contractor lets say.  He wants you to be a guarantor on a project.  It seems he can’t get bonding.  You agree but only if you look at his financial statements so you know what you might be getting into.

He hands you a single piece of paper.  On it it says,

Cash        $500,000
A/R       $2,500,000
Profits                 $3,000,000

Are you ready to sign on the dotted line to guarantee this upcoming project?  If so, please write me immediately because I have an investment idea for you!

Of course you are not going to accept it.  Not because you question the numbers, per se, but because you don’t understand how they came into being.  In short, this is confusing isn’t it?

What would you like to know?  How about how he decides to recognize his income?  Perhaps how he elects to record expenses?  Does he have any debts that are not on the books?

You are interested in his accounting principles.  Now, if you happen to know how most (not all) contractors do accounting, you could ask something like,

Other contractors I know record revenues based on how much of the work is completed, is that how you record it?  I have read several other financial statements from contractors and they all have some amount of construction costs, how do you record costs?

If everyone could pick and choose the policy they want to follow we don’t have standards.  You would not have an ability to compare one company against another in the exact same industry – you would not even be able to follow a single company from year-to-year.  Accounting standards enable you to do this.

Look, we know GAAP can be complex.  But in all fairness, your entity is complex.  If you are a retailer of candy bars and you sell for cash only, you have very simple accounting.  If you take money today for work that will be done over the next three years, you created complexity.  And if you do work today and allow people to pay you over the next three years but only in relationship to how effective your work is, you created a nightmare.

As a reader, you should want to know how an entity records and reports transactions.  You should want to feel comfortable that a lot of other similar entities are doing the same thing.  In short, you want to feel good that the financial statements you are looking at are, in fact, generally accepted.

If you don’t like GAAP, then don’t play with other people’s money.   Don’t ask lenders, don’t ask investors, don’t ask me.  If you are the only person who relies upon how you do the accounting do it any damn way you please.  I mean, lets be honest, you won’t even look at a financial statement.  You will log into your bank to see how much cash you have and make all your decisions based on that.

But if you expect others to put their faith in you, then embrace GAAP.  Ensure you prepare financial statements for them to read that comply with the standards the accounting profession has provided.  The standards don’t exist to make your life miserable, they exist to help you get the funding you need.  Overwhelm your reader with good, actionable information and they will return the love.  They may not give you money, but they will likely do what they can to help you succeed.

Because honesty and integrity are still rewarded in this world, even if it often doesn’t seem like it.

Have a great weekend.  And if you are looking for an auditor or CPA firm to review your financial statements, or just help you make sure your financial statements are useful to your readers, feel free to get more information and contact us through our website.  We are here to help you rely upon your management, even if that is you.