Nine out of 10 start-up businesses failed in 2015, according to Forbes. As a business owner, you probably think about risk in terms of its effect on competition, safety, expansion, new lines of business, price increases or staffing. However, your certified public accountant (functioning as the company’s external auditor) is primarily thinking of risk as it relates to the company’s financial statements.
Why? Because the auditors’ work ultimately is distilled down to one result: their opinion on your financial statements. To quote the auditors’ report, it is the auditors’ responsibility to “obtain reasonable assurance that the financial statements are free from material misstatement.”
Auditors carry the burden of tremendous risk in their practice. If they fail to choose the right procedures or if they interpret results of those procedures inappropriately when forming their opinion on the financial statements, the report may be deeply flawed.
As a result, material misstatements may go undiscovered. These misstatements are the result of either errors or outright fraud. Errors can occur from lack of experience of the client’s accounting personnel or from basic human error. Of course, fraud occurs when someone purposely manipulates financial statements to show better results or when someone steals from the company.
However, it is critically important to understand that the service of annually auditing your company’s financial statements is not specifically designed to uncover fraud. The external auditor’s job is to identify material misstatements, not every error or instance of fraud. The auditors assess risk during the audit solely to determine what procedures to perform and the extent of those procedures.
Planning is an important component to any audit, and auditors spend significant time designing their approach. A wide range of factors surrounding your business may be considered. For example, a snapshot of your industry, external factors, your operating results, financing obligations, the owner’s relationship to day-to-day operations and overall integrity of management. Additionally, an auditor can look into the segregation of duties within the accounting function, internal ethics, and so on.
Auditors act as investigators during their fact-finding process. Because they must obtain a thorough understanding of the company’s accounting cycles and internal controls over the financial reporting process, interviews with key employees are essential.
Typically, meetings are held with owners, management, board members, department heads and line employees. They meet with employees both within and outside the accounting department to determine where risks might be. The company may be particularly susceptible to financial reporting errors or fraud.
After data collection is complete, auditors make their assessment of where the risk is and how fraud might occur. All of this is done to determine the nature and extent of audit procedures. The auditor also incorporates elements of unpredictability in determining audit procedures. Ultimately, no single audit is the same from one year to the next.
As the audit moves toward completion, procedures may be modified as new information becomes available. Auditors make adjustments as necessary and consider materiality throughout the audit. Adjustments below materiality are sometimes made at the request of the client. (All adjustments, unless deemed trivial, must be approved by the client.)
Before deemed complete, the auditor’s work is reviewed with respect to professional standards compliance. The reviewer checks to ensure that audit procedures identified earlier were employed and if those procedures addressed all appropriate risks. Analytical procedures in the final stages of the audit serve to highlight any unusual fluctuations not previously identified and addressed.
A time gap exists between the year-end and the date the report is issued. Auditors must also consider more recent events to determine whether there are additional risks not previously identified. Occasionally, additional accruals or disclosures are required.
Finally, the audit report is drafted based on the auditors’ conclusions and formation of an opinion on the financial statements. The audit report on the financial statements is presented to management prior to issuance.
The greatest value to the business owner (as well as the board of directors or others charged with governance) occurs when the auditor reports their comments and observations. This meaningful feedback enables the client to improve operations.
No owner has yet to be witnessed crying for joy at the sight of their audit teams visit. In reality, many view audits as a necessary evil to placate the needs of bankers. Yet, some companies see the task as an opportunity to improve. Auditors maintain their independence at all times. It is through their experience that they are able to identify best practices for improving operations through better controls and processes. Acting on auditor recommendations, companies can reduce costs, improve cash flow and protect against fraud.
Frank Pawlowski is a certified public accountant and co-managing director of Hunter Group CPA LLC. He has over twenty years of experience assisting closely held businesses with his tax, accounting, audit and business consulting expertise.