Lender Contracted Auditors - A Hypothesis
Times read: 51
07/02/08
Francine McKenna posted a recent entry on her blog that pointed out some of the flaws in the current audit model. Flaws included the usefulness and relevance of the information provided to financial statement users. It also seems to hint at the flaws around auditor independence which have been debated ad nauseum since the inception of the profession. Where as that post was largely focused on the top tier accounting firms (primarily the Big 4) it seems that there are many takeaways here for smaller firms as well. From an independence stand point I have often wondered whether in the small business attest environment if it makes sense for the banks requiring audited financial statements as part of the loan agreement to independently contract with accounting firms to perform the audit for the organization receiving the loan. I would have to guess that this idea has been considered or tried before but I was unable to identify any cases through a quick Google search. It seems like this sort of arrangement would be ideal considering that the ability to maintain independence from the financial statements would be increased. Fees would continue to be paid by the borrower, however now it would simply be done through an escrow arrangement. The lender would select the audit firm, negotiate the fee and the auditor would report the results of the engagement to the lender. A report to the company's board or management would still be part of the attestation as well. On numerous financial statement audit engagements I worked side by side with the lender's internal bank auditor. It comes across a little redundant and it points out that for the lender the audited financial statements are not fulfilling their need for relevant and useful information.
Wouldn't this type of arrangement result in both increased auditor independence and professional skepticism? Also wouldn't this better align the goals of the target end-user of the financial statements and the auditor? In a public company the audit committee serves to create this type of arrangement with the audit firm, but in many smaller organizations no audit committee will exist to serve this function. It would seem logical that lenders would want to step in to fill this void in their smaller lending customers. One tremendous benefit from this is that it would also help to alleviate some of the pressure on fees for smaller engagements. Often this pressure is the result of a few 'bad apple' professionals making unrealistically low bids on engagements to win them and then performing deficient audits. Lenders would generally be more likely to be wary of firms that came in with the lowest bid in fear that those firms would attempt to cut corners to realize higher margins exposing the bank to more risk. That in connection with market forces to keep lending rates and fees low would establish an equilibrium price for engagement fees that would be reasonable for all parties (lender, borrower and auditor).
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Independence and Profitability
Times read: 65
06/24/08
I have had the opportunity to work with a large number of accounting firms of varying sizes, from sole practitioners up to the top ten largest firms in the nation. One thing I have observed across the board is that those firms that implement standardized processes for monitoring independence with respect to their clients tend to be able to charge a higher premium when it comes to their fees. This correlation is also observed in the fact that larger firms tend to have more standardized processes and typically charge the highest rates. Part of the increased independence that these firms maintain is a result of the relative insignificance any one SMB client has to the firm as a whole. Larger firms are more easily able to walk away from a 'problem' client since the revenue impact may be slight.
It is quite common in the SMB environment for smaller firm audits to require significant adjustments to the financial statements in order to properly present them in accordance with GAAP. Although recording adjustments approved by the client's management is a permissible non-attest service under 101-3, there is no question that it results in diminished independence and in diminished profitability for the firm. All firms would benefit greatly if they began to not only recognize this trend but to also start taking steps to move toward a more independent stance from their clients.
One solution is to systematically begin to identify those attest clients where a significant portion of the time budget on a job is spent providing non-attest services allowed under 101-3. The firm can begin to transition services to these clients from attest engagements to solely non-attest work. This provides the firm a way to continue a relationship with the client and to continue generating a revenue stream. The attest work will need to be referred to another firm. It is likely that overall fees for both your firms services and the new firm will be higher than the original fees under the single firm model so it is necessary to properly manage the transition and present the overall benefit to the client. The primary benefit will be that you will be able to provide a higher level of advisory service to the client (and you must provide concrete examples) and at the same time reduce the overall disruption and discomfort associated with the annual audit. Just like with larger firms that may have the luxury of walking away from SMB clients, all firms that can maintain a higher degree of independence will likely be able to maintain higher profit margins on their engagements (attest and non-attest alike).
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AT&T Tilt - Best Windows Mobile Device I Have Ever Used
Times read: 112
06/17/08
For those looking for a solid extremely feature rich PDA Phone and those who can get over the next gen iPhone hype, check out the AT&T Tilt. The Tilt is a windows mobile 6.0 phone and is ideally suited to mobile professionals who may need to access corporate networks. The phone's trademark feature is its slideout qwerty keyboard and tilting screen that give the device a laptop-'esque' feel. This is all in a package that is a similar size to the iPhone with the exception that the device is not as thin as the iPhone and has a great deal of heft to it. The feature list is numerous but some of the features are: HSPDA broadband, GPS, Wi-Fi b/g, Bluetooth, 3.0 MP Camera, Email, Instant Messaging, Web Browsing, Office Mobile, Active Sync, Windows Media Player and the phone can even act as a tethered broadband modem or dial-up networking modem over bluetooth. The phone makes use of both a touchscreen and the qwerty keyboard. One drawback of the phone is that it lacks a dedicated dialing keypad. Numbers have to be dialed on the touchscreen or you have to slide out the full qwerty keyboard. A dual slider mechanism would have been greatly appreciated here but over time I have gotten pretty good at dialing via the touchscreen. For text messaging and email on the road, I have yet to come across a better device. The keyboard is spacious and easy to use.
I currently use my tilt to easily access multiple email accounts and sync my calendar and contacts from Outlook. By adding on a .pdf viewer I can view .pdf files along with the standard office documents through Office Mobile. The phone also can take advantage of Windows Vista Sideshow (a separate install is required) which allows for various sidebar gadgets on your laptop to display and update on the phone even when the laptop is closed or shutdown. I have even been able to control a power point presentation using the sideshow function and the phone as the presentation remote. Web browsing is done through Windows Mobile Internet Explorer. The browsing experience is pretty basic but the phone is Java enabled and there is a lot of compatibility with many of the sites that I regularly use.
For my media fix, I can also sync my music, podcasts, videos and recorded TV from windows media player. The conversion process takes awhile so I set this up to sync in the evenings and then the next morning everything has transfered over to the phone. The phone supports up to 32 GB of micro SD memory. I currently use a 4 GB card and have no problem syncing over 20+ hours of music playlists along with 10-15 hours of video and recorded TV (the syncing process automatically handles compressing the video).
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Will the Risk Standards be a Fad?
Times read: 128
06/03/08
I realize that the risk assessment standards are here to stay as part of our auditing standards, but what I am wondering is whether the impact of the risk assessment standards will virtually disappear by the end of the 2008 calendar year. I believe that for the majority of CPA firms providing audit services that although a 'risk based methodology' has been imposed, the practical methodology still applied to small and medium size business audits will be substantive balance sheet testing, analytical review of the income statement and no reliance placed on internal controls. So now that the audit firms have had a chance to document their clients internal controls (or lack thereof) will the audit process essentially revert back to how it has always been done?
Firms will obviously have to continue to update their files for changes in their clients control and identify new risk factors. But with the limited supply of staffing resources that most firms have at their disposal, it seems that the overall impact of the risk standards will diminish over time. There is certainly an opportunity to be seized here for firms looking to add value to their services by using the risk assessment process to identify risk factors and recommend solutions to their clients. In the end though, will we see much change in how audits are actually conducted going forward.
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Applying Projection Modeling to Analytical Review
Times read: 146
05/29/08
Traditional analytical review techniques are usually premised under the assumption that prior year activity is representative of current year expectations. In many cases this logic stands up. If no significant changes in a company's operations have occurred than expecting the status quo is reasonable. Certain revenue and expense account also tend to exhibit behavior that is predictable based on historical trends. But all too often in practice we typically find ourselves looking at financial data that has changed dramatically from prior periods. In this situation a new model for analytical review needs to be applied in order to develop meaningful expectations about account balances.
In identifying an appropriate model for analysis, one place we can look to is our clients' internal financial management tools. The officers of a business regularly adjust their strategic and operational goals. In making these adjustments they must rely on forecasts and projections to understand the implications for the enterprise. Underlying a projection is the assumption that certain relationships in the financial statements should exist. It seems that this same approach can be used effectively for evaluating the actual financial performance of a company with our own independent expectations. Essentially the auditor can develop an independent budget and sales forecast for the company based on their knowledge of financial accounting and then compare this to actual results.
One method of developing this type of forecast is the sales growth driven model. The accountant starts by developing an expectation about sales for the period. Historical time series analysis can be a good predictor for this. Also many industry specific drivers exist that can also be applied in making this initial assumption. The client's actual sales will also be an important factor here. Once an independent forecast has been developed the auditor needs to evaluate that in the context of actual sales reported by the client. Any major variances must be dealt with before proceeding with the remainder of the analysis. Since sales is the primary driver for the analysis, any significant variance here will result in a forecast that is no longer comparable to what is portrayed on the client's financials.
Once sales have been forecasted, cost of goods sold can be back into based on gross margin percentage and trends in expense accounts can be developed. For the balance sheet, the relationship for many accounts will be tied directly to sales or cost of goods sold. Typically we expect certain turnover relationships between revenue and accounts receivable, inventory, fixed assets and payables. Once the capital needs associated with fixed assets have been identified we can develop expectations about what sort of financing would be needed to maintain the forecasted sales level. Many other factors can be tied into this type of forecast such as principal and interest payment amounts from loan amortization schedules or depreciation expense from fixed asset software projections. Finally, cash can be calculated using the indirect cash flow method to determine the change in cash from the prior period.
By integrating this type of approach into your analytical review process, a thorough understanding of where unexpected or unusual relationships in the financial statements can be obtained. Although traditional historical comparisons are still necessary as a starting point for analytical review, applying a projection model to develop independent expectations is essential for properly planning a meaningful engagement.
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Flaws in Preliminary Analytical Review
Times read: 163
05/23/08
By Alex Vuchnich, CPA, CFE - With the official release of SSARS No. 17, our standards have once again reflected the trend that their is an increasing focus on what types of analytical procedures should be performed in a review engagement and how those procedures should be documented. We have seen a similar trend in audit standards. Recently the risk assessment standards and SAS 99 have both placed increased emphasis on the need to perform more effective analytical techniques in both planning and performing the engagement. Traditional techniques used in preliminary analytical review have consisted primarily of period to period comparisons of account balances and key financial ratios. Firms that have developed niche practices typically will also identify the key drivers for their niche and use available economic or industry data to supplement the analytical review process. However this traditional analytical review framework is primarily founded on the concept that the prior year's results are an effective benchmark for developing expectations about the current year financial activity.
Although I do not dispute the importance of scanning current year and prior year amounts on the trial balance and financial statements as a procedure to orient the auditor during planning, the question is whether this procedure alone is effective enough. If this is the main preliminary analytical technique performed during planning then it is essential that it is highly effective not only in providing context for evaluating the account balances but also in developing expectations about relationships between financial statement accounts. Ratio analysis is intended to provide a simple means for relating financial statement elements but with the emphasis on prior period comparison I believe the effectiveness of this technique has been impaired. When we use prior periods as the sole baseline for comparison then the tendency is to try and explain away the changes we see rather than to obtain an understanding of what relationship should be present. In order for the analysis to be effective, what we need to do is develop analytics that are predictive in nature (forward-looking) so that we can establish a reasonable basis for expectations about what the account balances should be. I propose that we need an analytical framework that incorporates prospective financial analysis into the historical trend analysis that has been the cornerstone of our analytical review process.
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Demonstrating ROI
Times read: 149
05/20/08
By Alex Vuchnich, CPA, CFE - I think often we expect our clients to just accept that our services are valuable without demonstrating value in concrete terms. Some might suggest that this is due to the compliance nature of our work. However, I would argue that this is actually a cause of why our services are devalued and perceived as commodities rather than evidence that they are compliance services. If we can demonstrate that some ROI can be achieved through our service than we have an argument that the services we provide rise above mere commodities. In order to illustrate this to our clients and thereby begin to shift perception of our services we can start by going back to audit and accounting theory as a starting point. The simplest value proposition of attest work lies in the assurance it provides to third parties, such as potential lenders. We can demonstrate to our clients the additional interest costs associated with higher risk loans that waive audit or review requirements or the opportunity cost for lost profits associated with a client who is unable to obtain the necessary financing for a particular project. I concede that this may not be as compelling a value proposition for many clients but in the current credit environment lenders are exercising more scrutiny and so the additional assurance we provide is more relevant than it may have been over the past several years.
Moving past theory, ROI can be demonstrated in many other engagements as well if we just take the time to identify inefficiencies and ineffectiveness in our clients operations and tactfully point out what it is costing them. For example, in the course of performing an audit, a staff auditor determines that the client has been prepaying their health insurance premiums two months in advance. Typically the $25,000 premium is due by the first of the month so one month of prepaid expense is expected. However, due to a lag in posting by the provider, the bill always show a prior balance due so the client has doubled up on payments to 'catch up'. The client also carries a $100,000 operating line of credit for working capital needs. The line has a net balance of $50,000 and carries a rate of 8.75%. By simply pointing out this operational inefficiency the auditor can save the client $2,187.50 a year by simply deferring the overpayment and using the freed up cash to reduce the line of credit by $25,000. In larger engagements this may fall under the guise of immateriality but few clients will pass up this cost savings if they are made aware of it. The important step though is that we communicate these types of demonstrable value propositions to clients so they can begin to understand the benefit of our services.
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Compliance Services Are Not a Commodity, Part III
Times read: 145
05/16/08
By Alex Vuchnich, CPA, CFE - In the previous posting, I explained why it was important for CPAs to begin to better communicate the value of the services we provide if we want to change the current trend of commoditization with our professional service offerings. In many cases I think that as CPAs we sometimes lose perspective on how challenging financial information can be for our clients to grasp. Things that seem so obvious to us when we look at a set of financial statements can be completely lost on our clients. Good use of technology and software can bridge this communication gap when used effectively. A variety of products exist that can be used to help communicate and analyze the numbers we are presenting in a more accessible format for our clients. We can use tools such as Excel and Powerpoint which have excellent charting and graphing options and more powerful business analytic and financial analysis applications to demonstrate key points of interest. The key to effectively using any of these applications is to use it to highlight a few meaningful insights in the financial statements. What we want to get away from is the information paralysis that occurs when we put a complete set of GAAP basis financial statements in front of our clients who are not versed in financial reporting and analysis.
A practical example of this is an analysis of the cash flow gap. I tried to explain this to a client by preparing a beautiful (in my eyes) spreadsheet which detailed out their inventory, accounts receivable and accounts payable turns and days. I prepared a calculation of the number of days of float between the time they paid their vendors and when they collected on their customer accounts. They were not impressed and did not see what the big deal was all about. Convinced that if they could understand the benefits of narrowing the gap, I could save them a lot of money and demonstrate the value of my services I modified my spreadsheet and added a graph to it. I simply created a bar chart for each of the key turnover metrics and positioned them in a time-line format using Excel's built-in charting features. I colored the section representing the cash flow gap in red and included the interest rate on their operating line of credit in that section of the graph. Voila, they got it. They began immediately looking into what procedures could be implemented to narrow the gap.
Although a few bar graphs set side-by-side comparing revenues, ratios or cash-flows from one period to the next may seem elementary to our professionally trained eyes, this type of visual analysis can speak volumes to our clients.
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Compliance Services Are Not a Commodity, Part II
Times read: 148
05/14/08
By Alex Vuchnich, CPA, CFE - One of the things that has been a contributing factor to the perception that professional services such as audit and tax work are a commodity is our profession's aversion to 'marketing' our services. Part of this is driven by the fact that there is so much demand for our services that it obviates the need to actively seek out or market them. However, in doing so we have lost the opportunity to properly position the value or our services. The impact has been that the services we perform are perceived as having no value and are simply things that must be done in order to comply. The compliance aspect is certainly a fact, but in reality, many additional benefits are derived from the professional services we provide. How often though, do we communicate those further benefits?
In the course of a small business audit engagement, I uncovered a $5,000 charge receipt that never cleared the client's bank account. The client's reconciliation process was inadequate and did not catch the error. It turns out that the charge card had failed to process and so the client never received the funds. It actually took several attempts to convince the client that their customers payment had failed to reach their bank account but once I presented the proper support they finally got it. It was then a simple matter to communicate the value of my services to my client over and beyond the simple compliance aspects. I was also able to reinforce the importance of implementing various internal control recommendations I suggested in order to avoid future errors. Opportunities to communicate the value of our services exist in almost every engagement, we need to begin to better communicate this to our client's if we want to shift the perception away from just being another compliance service.
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Mobility, State Licensing and Self Regulation
Times read: 185
05/08/08
By Alex Vuchnich, CPA, CFE - The AICPA put out a news release yesterday regarding the progress that has been made so far with establishing uniform laws governing the practice of CPAs across state lines and the enhanced mobility this provides for licensed CPA professionals. For much the same reason as having a valid drivers license allows your typical driver to travel across state lines without concern for whether they are in compliance with the driving statutes of that state, uniform mobility for CPAs improves the reach of services that CPAs can render without fear of violating professional codes of conduct. Unfortunately this is an issue where state licensing boards, in an effort to protect the public, have the regulatory power for deciding who will practice as a CPA in their state. This is an area where self regulating bodies are ideal for establishing licensing requirements (especially considering that the AICPA already does this in substance). Having obtained my certification as a Certified Fraud Examiner, this is exactly how our certifying body handles this to no detriment of the public. This of course leads to deeper ethical considerations though, such as whether our profession and its members have the innate discipline to allow for freedom of self-regulation. Assuming we do have the discipline, then there would be the tremendous legislative hurdles to overcome. Until that time we can hope that the AICPA has continued success in working with state licensing boards to enact national uniform mobility.
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Compliance Services Are Not a Commodity, Part I
Times read: 202
05/06/08
By Alex Vuchnich, CPA, CFE - Why is it, that even in a time when accounting services are in high demand our profession continues to see increased pressure to keep costs of core audit and tax services low? The root problem seems to stem from the commonly accepted perception that audit and tax compliance are a commodity. This is particularly true in the case of how our clients typically perceive these services. It seems however that as a profession we have grown complacent with this view and have just accepted it as how we must do business. I fear that this mentality has already had an impact on the overall quality of the services we provide and in the long run will continue to weaken our image as one of the top and most trusted professions. Recent standards and pronouncements have further echoed this sentiment with an emphasis being placed on more strict guidance (i.e. more regulation) and the risk based audit approach in an effort to increase both audit efficiency and effectiveness.
The consensus appears to be that in order to compete in a compliance driven industry the only competitive advantage has been reduced to price. Many firms taut that their client service is their core competitive advantage but how many are able to translate that into higher profitability and realization? Exceptional client service may create a great reputation and get your foot in the door, but many smaller firms still have to bend to the pressures of price competition. This increased price competition naturally leads to slimmer margins and can eventually result in lower quality when short cuts are taken to keep an engagement profitable. This situation is generally a no win for the firm. The only way to increase net profit when margins are slim is to make it up on volume. Attempting to increase the volume of engagements coupled with the lack of available qualified staff in our profession will result in a strategy that will ultimately fail.
The purpose of pointing out these concerns is not an attempt to spread doom and gloom on the profession. This is simply a first step in identifying a problem facing many CPAs from sole practitioners up to the top tier national firms. There are already many CPAs in practice who have found compelling solutions for managing client perception of their services or transitioning from compliance service to management advisory service. In order to begin to turn the tide on the perception of the value of CPAs, there are certain realities that firms must face and certain resources firms need to leverage. Key among the realities that must be faced is that firms need to accept that for many of their clients it may be time to reevaluate their relationship. This includes taking another look at the firm’s independence and objectivity while also evaluating the client for dependency. Many firms may be independent from the firm’s perspective but often in smaller organizations clients feel a significant amount of dependency on their CPA to ‘keep the books straight’. The next few series of posting will focus on the tangible steps firms can take to face these challenges as well as the resources that can be leveraged in doing so.
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