Preparing client for year end audit

I recently worked with a client to prepare them for their first audit. Here are some of the issues I reviewed with the client to clean up their financial statements and anticipate questions that will be asked by the auditors. The auditors often want to see schedules to support general ledger account balances and ensure invoices entered are posted to the correct general ledger account. They also inquire about employee use of company assets like computers, cellphones, credit cards, etc. to ensure controls are in place to reduce the risk of employee fraud or theft.

Of course any names of employees and vendors have been removed to ensure client confidentiality.

 

Accrual for year-end bonuses-Part of payroll accrual?

Accrual for 2011 audit and tax fees-Also attorney & consulting; Typical accruals-rent, phone, utilities

Accrued payroll for any given cut off period-12/19 to 1/1 Paid 1/6. Need accrual.

Financial covenants

Revenue cutoff (target date Jan 16, 2012)

Vacation and sick days accrual-None

Open invoices cutoff-Jan 13

Leases-Equipment, Vehicles, etc.

 

Balance Sheet

1.  Accounts Receivable-Need for an Allowance account. Is there a schedule that reconciles revenue by customer and the related customer deposit, accounts receivable and cash payments that equals the revenue by customer? Client should be able to access invoices for use by auditors.

2.  Construction in Progress-Need the list of CIP for both the asset and the liability side.

3. Inventory-Need inventory detail listing. Auditors will request individual invoices to do price testing. Is there an entry needed for obsolete inventory?

4. Property and equipment-Need  invoices for fixed asset additions for 2011 and FA and depreciation schedules carried forward from 8/31/11 review as used by auditors. Need to carry forward.

5. Security deposits-Need invoices for additions in 2011.

6. Accounts payable-Auditors will probably need individual invoices for testing.

7. Line of Credit-Need statements for a few months in 2011. Each monthly interest payment should be posted to the same G/L account. It appears there should be an entry to interest expense/interest payable when recognized by bank then an entry to interest payable/cash when bank takes interest. At Dec 31, there may need to be a payable for the amount taken by the bank in January.

8. Accrued Severance-Need a schedule for the detail supporting the amount.

9. Warranty Obligation-Need to recalculate liability as of 12/31/11.

10. Officer Note Payable-Need schedule to support note payable and the contract which created the NP.

11. Members’ Equity-Need agreements and schedule to support equity activity throughout 2011.

Income Statement

1. Revenue and Cost of Sales-Auditors will test percentage of completion calculation and client rationale to ensure revenues and costs match and are consistent for all projects and with past reviews. The auditors will probably test details of client’s entries and Excel schedules. This was probably done for 12/31/10 and 8/31/11 Reviews.

2.  Advertising- Account 30100 has 4^th quarter payments to newspapers. Are these for expenses that extend over a fixed time period between 2011 and 2012? Account 66800 has 6 invoices all over $1,000 paid to vendor. Are these for marketing that extends over a fixed time period between 2011 and 2012?

3. Bank charges-There is $4,600 of credits in the account. There is also a $9,750 entry to close a LOC. Are these valid bank charges or should they be somewhere else? Checked with client.

4. Contributions-Donations to charity not equity contributions. Do they have a fixed time period that extends into 2012?

5. Miscellaneous-Needs to be reviewed. There are about a dozen entries that make up most of the balance. Maybe can be moved into more appropriate GL accounts.

6. Utilities-Most of the activity is in Account 62450 Disposal which isn’t utility expense. Should be changed.

7.  Guaranteed Payments-Need a schedule of agreed upon payments to partners and an agreement or a contract. Contract amount divide by 26 for bi-weekly pay.

8. Payroll Expenses (includes federal and state taxes)-Auditors will try to reconcile wages to taxes by comparing the percentage of taxes paid compared to wages. They may want to see examples of how the payroll is posted to ensure it’s being posted correctly. There should be an accrual entry at the end of each month and at the end of the year.

9.  Commissions-Schedule of how they are calculated and entered.

10. Auto & Truck-Auditors may ask about who has credit cards and how they are used and if this amount is excessive relative to the business. Are there any leased vehicles?

11. Bad Debt-should be reviewed and revised for expected bad debts as of 12/31/11.

12. Computer and Internet expenses-There are 4 invoices over $500. Should they be capitalized as fixed assets? Any computer leases?

13. Insurance expense-Account 63340 Liability. Auditors will want to see a schedule of the cost over each month and if the policy extends into 2012 which will require an entry into Prepaid Insurance. For health insurance, there may need to be an accrual for Dec 2011 not paid until Jan 2012.

14. Meal and Entertainment-Similar to auto & truck, auditors may ask who is authorized to spend on M & E and if this amount is excessive relative to the business.

15. Office Supplies-There are close to 20 invoices over $500 some paid to Staples. Should some of these be fixed assets?

16. Professional Fees- Majority with 3 vendors.

17. Rent Expense-Office rent is $75,000. The other payments should be to equipment rentals?

18. Telephone Expense-What are the various types of expenses in the account? Landline, cell phone, internet, conferencing. Maybe separate cell phone. Are there controls over the use of cell phones?

19. Travel Expense-Is the amount reasonable? Are there controls over who is charging travel?

20. Fees-Needs to be reviewed and reclassed into other accounts or into new accounts. Biggest amount is Utility company = $32,000. Township = $20,000.

21. Interest Expense-Are all LOC interest payments included? What are other interest payments for?

New Rules Taking Shape For Tax Preparers

The IRS is attempting to create a minimum standard for tax preparers by requiring that preparers pass a test, receive continuing education and be finger-printed. The finger-printing would allow the FBI to perform a background check to see if the preparer has committed a felony and therefore would be denied the opportunity to prepare tax returns for a fee. Some professionals like CPAs would be exempt from these requirements for the time being because CPAs already pass a test and receive continuing education. CPAs would be exempt from the finger-printing and subsequent background checks as well. These new IRS rules are in addition to recently passed rules that require tax preparers to register for a preparer ID number. Of course there are fees to fulfill all these requirements.

I think this new minimum standard is a good idea but I wonder if it’s over-reaching, a clever way to generate revenue and another way to feed the government bureaucracy. I suppose requiring every tax preparer to register and receive a preparer ID number allows the IRS to track every preparer’s history with the IRS. If there’s a pattern of deception by a preparer, I suppose the IRS will be able to react more quickly and take steps to stop anyone who has a pattern of suspicious behavior or wrongdoing.

The new rules for testing, continuing education and background checks which apply to anyone not considered a licensed professional in a related field will create a minimum standard. But how many people fall under that category? Are there thousands of people, not in the business of tax preparation, who are lurking and looking to prepare fraudulent returns for unsuspecting victims in exchange for a fee? There’s got to be an easier way to defraud people, and if there is, criminals are already doing it.

The issue many honest preparers worry about is the increased regulations, the cost, and the expansion of these regulations. Will the cost of obtaining a preparer ID number rise over time to unreasonable levels? Will all exempt professionals eventually be required to submit to a background check for a fee? Will there be even more regulations and more fees in the future? As far as I know, the IRS has not disclosed how much money these regulations will save taxpayers but I suspect the number is very small. I hope these new regulations provide some  increased consumer protection but I’m concerned the cost and burden of regulations will outweigh the benefits.

Bill Introduced Allowing IRS to Prepare Tax Returns for Some Taxpayers

Recently, Tennessee Representative Jim Cooper (D) introduced H.R. 1069 “to amend the Internal Revenue Code of 1986 to provide an election for unmarried, nonitemizing individuals to have their returns prepared by the Secretary of the Treasury, and for other purposes.”

The IRS would take income information from an individual’s W-2 and 1099 and prepare a tax return for the taxpayer. The taxpayer would have the option of using the prepared tax return or filing his or her own tax return. Rep. Cooper’s goal is to save taxpayers time and money.

However, as anyone who has ever filed income taxes knows, there’s more to a tax return than a person’s income. This bill maximizes a person’s income and essentially ignores any deductions a taxpayer might take to lower his or her taxable income. While this bill is for single, non-itemizing individuals, it may assume a person is single and doesn’t itemize year after year unless the taxpayer informs the government that his or her situation has changed. Some taxpayers might be tempted to sign a government prepared tax return and miss out on deductions that could lower the person’s taxes. This bill sounds like an attempt to entice people to ignore deductions which would increase their tax liability.

A BETTER solution would be to allow people to have access to their file with the IRS. Taxpayers could log on to the IRS website or the government could mail a list of an individual’s W-2s and 1099s. Apparently, the government has access to this information, so why not provide it to taxpayers? Giving people easy access to their W-2 and 1099 information would also save the government money in audit costs. Taxpayers will know what income items are on record with the government.

Which plan would you prefer? Rep Cooper’s bill which will save some taxpayers some money and can only increase taxpayers’ tax liability because they are missing deductions OR my plan which gives people more access to their information held by the government and reduces the government’s cost to do business?

Facts About Fraud

The Association of Certified Fraud Examiners studies fraud and has come up with some interesting findings:

• A company loses approximately 5% of its revenues to fraud and it generally takes 18 months for it to surface.
• Persons with no criminal history are responsible for 90% of frauds.
• Smaller businesses suffer more disproportionate losses because they do a poor job preventing or detecting fraud.
• Most fraud is committed by the accounting department or upper level management.
• Generally the most common type of fraud is theft of funds through fraudulent invoicing and payroll. In many cases, the person committing the fraud will setup fake employees or vendors and issue payments to him or herself.
• The most costly fraud occurs when the company falsifies their financial statements. This results in misleading information being issued to shareholders, banks and the public.
• Fraud is discovered most often due to tips from employees or others. Other ways it is detected is through internal audits, external audits, and by accident.
• Many perpetrators of fraud are never prosecuted. Many cases are handled internally within the company or a private settlement is reached. Most often bad publicity prevents companies from prosecuting perpetrators.
• In half the cases, none of the funds are ever recovered. Twenty five percent of the time, up to 25% of the funds are recovered. In 15% of cases, all the funds are recovered.

These statistics are sobering. They show that fraud remains a potential problem for most companies. The key is to setup checks and balances in a company so one person does not have control over all the accounting functions. When possible, split up a person’s duties so another person may detect the fraud. Management can prevent fraud by strongly discouraging it and taking disciplinary or criminal action when it occurs. This will set an example for other employees. The key is to uncover fraud as soon as possible after it begins so it can be stopped with minimal or no loss to the company.

Managing Earnings-What is it and How Does it Happen?

Managing earnings occurs when companies manipulate earnings to reach a pre-determined earnings target. This is done by intentionally entering revenue and expense transactions that benefit a company’s earnings. Due to pressure from banks and shareholders there is tremendous pressure to report the most positive financial results. When managing earnings becomes abusive or material, it misleads the users of the financial statements.

Some of the most common ways to manage earnings include:

• Over/under accruing-Companies will over or underestimate the dollar amount of expenses for the current year that are paid next year. Accruals should have proper documentation like an invoice paid the following year or the payroll report that shows the last payroll of the year being paid the following year.
• Capitalizing repairs and maintenance-Capitalizing allows the company to expense the cost over the life of the asset, generally 3 years or greater depending on the asset, instead of expensing the entire cost in one year. Capitalizing over a number of years instead of expensing immediately will decrease expenses and increase earnings. If the repair increases the life or the effeciency of the asset, it should be capitalized. Otherwise it should be expensed.
• Using incorrect lives on assets-There are guidelines on how many years assets can be depreciated that vary depending on the asset. While there is some flexibility in determining lives, the goal is to be consistent. If a particular asset has a 7 year life, all similiar assets should have a 7 year life which means the cost is spread over 7 years. If a company wants to decrease expenses and increase income, it could start using a longer life so the cost per year is lower. The key is to be consistent.
• Over/understating Prepaid Expenses-Prepaid Expenses are payments made up front for services not rendered at payment date. For example, a company signs a one year maintenance contract in November and pays for the entire contract. But at year-end, only one month has expired so the vendor has 11 months of service left to honor. The problem occurs when a company posts the entire expense immediately instead of leaving 11 months as a prepaid expense which is not an expense item. This increases expense and reduces income. Just the opposite happens when a company puts the entire payment in prepaid but doesn’t move out what is an expense. This reduces expenses and increases income.
• Under/overstating revenue-Overstating revenues happens when a company shows revenues in one period and the goods have left the warehouse or the service is rendered in the next period. Understating, which is usually less common, happens when the goods leave the warehouse or the service is rendered but revenue is posted in the following reporting period. The key is to make sure the actual service or shipment occurs in the same period as the revenue is recognized.

These examples of managing earnings, if immaterial and infrequent, can be corrected so the financial statements are reasonably stated. But widespread and abusive manipulation can be considered fraud. Outside auditors, depending on the kind of engagement, will test to determine if a company is potentially managing earnings. Auditors may be required to ask about and test for fraud. The best way to prevent manipulation is to have ethical management that doesn’t tolerate it and doesn’t put pressure on employees to manage earnings.

Understanding Financial Ratios

Ratios are used to measure the financial health of a company. They are used in the same way percentages and averages are used in pro sports and any other field that relies heavily on numbers to measure performance.

Profitability Ratios measure the health of the income statement. The Gross Margin ratio measures the gross margin as a percentage of sales.  The gross margin is the amount that remains after subtracting the cost of sales from sales. So the ratio measures what percentage of dollars are remaining after a company produces its products. The Operating Income ratio measures the operating income as a percentage of sales. The goal is to maximize both ratios because the higher the ratio, the more profitable the company.

Effeciency Ratios focus on the health of the company’s balance sheet and income statement. Net Sales to Assets ratio measures the rate of return on all assets, which are what a company owns. The Net Sales to Fixed Assets ratio calculates the effeciency of the assets purchased to produce a product. The goal of this calculation is to maximize the cost of buying machinery and equipment. The Effeciency Ratios show the rate of return on assets.

Liquidity ratios focus on the health of the balance sheet. The Current Ratio determines the company’s ability to pay its current liabilities (all payments due in the next 12 months) with its current assets. The Quick Ratio is similar to the Current Ratio but inventory is not included in the calculation as a current asset. This is important because the company doesn’t want to sell its inventory at a discount to raise cash. These ratios measure the liquidity of a company. If a company had no income but still has to pay bills, these ratios measure the percentage of assets that are available to be sold to pay its liabilities.

There are dozens of ratios that can be used to calculate a company’s financial health. The goal of these calculations is to not only see the percentages and interpret them but to also see if a trend is developing over the years. It’s not easy to look at financial statements and see a trend over time unless these ratios are calculated. Companies that do these critical calculations will see negative trends developing and will be able to be proactive when planning for the future.

Study: Office temps most used; Business and Financial temps soar

According to a study by the U.S. Bureau of Labor Statistics, up to 30% of all temporary workers are employed in either office and administrative support or business and financial operations. The study, which is based on 2008 statistics, places the office and administrative support category at the top of the list at almost 25% of all temporary workers. Other top categories include transportation and material moving, production, construction and extraction, and healthcare practitioner.

The report also studied the change in categories from 2004-2008. The number of temporary workers in the business and financial operations category jumped almost 50% in the five year period. This group had one of the highest increases in the time period. Other categories showing huge increases include legal, computer and mathematical, education, training and library, and community and social services.

The study concluded that use of temporary workers is shifting into service industries and out of labor intensive industries. This reflects the trend in society as a whole.

Preparing Financial Statements

Running a company is challenging and time consuming. The owner or management of the company needs to invest in the business, hire employees and make sure the product or service meets the customer’s expectations. But the company also needs to be profitable or else it won’t be in business for very long. The company should also know its liquidity position which is the value of its assets compared to its liabilities. The best way to measure profitability and liquidity is to prepare financial statements.

Financial statements are prepared so companies can see if the company is making or losing money. In addition, financial statements show the financial position of the company and how the company is spending its money. The financial statements prepared are the Income Statement, Balance Sheet, and Statement of Cash Flows.

The Income Statement shows company’s profitability. It starts with revenues and subtracts the cost to provide the revenue to arrive at the gross profit. The gross profit fluctuates based on the level of sales. This is critical because the next section of the Income Statement consists of operating costs such as payroll, rent, legal and marketing. These costs generally don’t fluctuate so the goal is to keep the gross profit greater than the operating expenses. The gross profit less the operating expenses equals the net profit or loss. This format can vary slightly depending on the format presented.

The Balance Sheet is a summary a company’s financial position at a given point in time. The Balance Sheet shows what a company owns (assets) and what a company owes (liabilities). The assets include cash, accounts receivable, inventory, equipment, land, office equipment, and notes receivable. The liabilities include accounts payable, notes payable, taxes payable, and accrued expenses. The equity section consists of the money invested in the business and the accumulated value of past profits less losses. If the worst case scenerio occurred and the company had to sell assets to pay its liabilities, this statement would show if the company would have enough assets available to pay its liabilities.

The Statement of Cash Flows shows the uses of cash in a given period of time.  It is seperated into three parts: Cash flows from operations, Cash flows from investing activities, and Cash flows from financing activities. The cash flows from operations consists of the cash received or spent in the ordinary course of business. These include cash collected from customers and cash expenditures for payroll, inventory, and other adminstrative expenses. Cash flows from investing include cash paid or received as a result of buying or selling equipment. Cash flows from financing include cash paid or received from loans.

The Income Statement, Balance Sheet, and Statement of Cash Flows are critical because they help a company measure the results of its day to day operations. That’s why it is so important for companies to record every sale and every expense and keep the books up to date. These statements should be prepared for management use but they are often required by vendors, banks and other financial institutions. Once a company starts using financial statements, the goal should be to prepare them on a monthly basis so the company can measure its profitability and liquidity and make any changes based on the results.

The 4th Quarter is almost here

If you are a small business owner, now is the time to ensure you’ve entered all your cash receipts and checks paid. Reconcile your bank account. Make sure your general ledger is cleaned up. These small but significant steps will save you time at the end of the year when it’s time to give your financial information to your tax accountant. I’ve worked with a few companies who waited until January to begin this process and it’s usually not an enjoyable experience for the client. The key is to be proactive.

How to Avoid Internal Check Writing Fraud

Here’s a scary comment. The administrator of two local municipatities stole funds because “nobody was checking on what I did.”

This is true for many entities whether they are governments, non-profits or small companies. They give the bookkeeper complete freedom to write checks with no controls in place. A few ways to reduce the chance of theft include:

1. Hiring a competent person. A family member or friend who may have taken an accounting course in high school is more likely to steal funds. The temptation is too great. The family member or friend’s reputation is not on the line because being a bookkeeper is not their occupation.

2. Have someone review every check written. This is standard procedure for most small entities. It takes a lot of time but it is critical to ensure the bookkeeper is not defrauding the company. Often the person who signs the checks will mail them as well. This avoids giving the bookkeeper a signed check to tamper with.

3. Have someone else reconcile the bank account. This person is responsible for making sure checks are accounted for and are cashed by the intended party, not the bookkeeper. Most banks provide copies of the checks right on the bank statement so the person reconciling the account can see the payee on the check.

These simple common sense steps will ensure that, if followed, should help small governmental agencies, not for profit and for profit companies avoid this all too common fraud.