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Auditing in turbulent economic times: plan ahead and apply skepticism and judgment.

The news media report daily on the dismal state of the economy on a regional, national, and international scale. Currently, the economy's prospects for the near future appear dim. The credit market is practically nonexistent, especially for fiscally weak enterprises seeking loans. The press has reported on the failures in the subprime mortgage market, the collapse of the Auction Rate Securities (ARS) market, and the pervasive effect of these failures throughout the entire credit market. These failures have resulted in significant losses in the financial sector, leading to the demise or forced mergers of large financial institutions, with many others seeking equity capital to survive.


The major frauds that have come to light and the global nature of the problem add to the brewing financial storm, setting the stage for a challenging period during which to perform any attest engagement and issue a report for any enterprise--public, private, or not-for-profit. Performing audits in accordance with generally accepted auditing standards (GAAS)--the highest level of assurance service--will present a great challenge to auditing professionals.

The existing and evolving conditions of the economy and the resulting loss in investment values are not restricted to financial services or real estate. Available credit for all enterprises looking to maintain liquidity, or grow, is extremely limited. This condition will not correct itself immediately and will lead to more bankruptcy filings, particularly for those enterprises that may currently be profitable but need a steady revolving stream of liquidity to maintain their existence. The unemployment numbers increase with every business failure or downsizing, which stems from a diminished demand for the enterprise's products or services. There is a domino effect with the reduction of the total purchasing power of the consumer, multiplied by a reduction in credit purchases and a pay down of consumer debt.

The state of the economy and its impact on an enterprise, directly or indirectly, will affect the procedures used in conducting a GAAS audit of that enterprise. Its effect will begin during the planning phase of the audit and will not end until the opinion is signed and distributed.

Management Integrity

Management's integrity is a key element in the efficacy of a GAAS audit. When management's integrity is in question, the underpinning of a GAAS audit may be destroyed. The foundation of such an audit involves using verification and evaluation techniques as well as procedures focused on a limited number of transactions, rather than doing more extensive work generally associated with a fraud audit. The enterprise's financial statements are management's representations, and the embodied assertions that are tested in a GAAS audit are management's assertions. Management is in a position to override the system of internal control and suppress audit evidence. Management will be under significant pressure this year-end to meet loan covenants to maintain the borrowing necessary to sustain operations, to present financial statements that will have sufficient strength to obtain new funding, and to meet owners' expectations. Owner-managers will naturally want to protect their business, to have it survive "until things get better." Even honest managers will be tempted by--and some will succumb to--the pressure to "shade" or violate accounting and reporting rules.

The guidance on how to deal with these conditions exists in the current auditing standards, and examples are included later in this article. Presently, the extent and strength of the adverse economic conditions coupled with the psychological pressures on enterprises' managements, will test those standards and their use on audit engagements. The AICPA has posted on its website Practice Alert 2001-2, "Audit Considerations in Times of Economic Uncertainty." The practice alert cautions:
  As a result of perceived external pressures, companies may be tempted
  to manage earnings through conduct of non-recurring transactions or
  through changes in the method of calculating key estimates, such as
  reserves, fair values or impairments. Companies may also adopt
  inappropriate accounting practices resulting in improper recognition
  or omission of financial transactions. Material non-recurring
  transactions may require special disclosure to facilitate the
  reader's understanding of the reported financial results, and the
  guidance in APB No. 20, Accounting Changes, should be applied in
  reporting on the effect of changes in estimates. Inappropriate
  transactions or accounting practices that may result in errors
  requiring adjustments of financial statements might include premature
  recognition of revenue, failure to record returns, inflating
  inventories, failure to appropriately accrue for contingent
  liabilities that are probable and estimable, and failure to record
  "misplaced" or otherwise unpaid purchase invoices. Additionally, an
  auditor should be particularly skeptical of non-system adjustments or
  fourth-quarter events that result in significant revenue recognition,
  loss accrual or non-cash earnings

In early 2009, the AICPA issued another alert, "Current Economic Crisis: Accounting and Auditing Considerations--2009," which updates and expands Practice Alert 2001-2. This alert gives guidance on many issues, including regulatory interventions, fair value, other-than-temporary impairment, and liquidity restriction, as well as accounting, auditing, and ethics pronouncements.

GAAS standards are resilient and flexible enough to withstand the shock of the economic downturn. The audit procedures necessary to report on an enterprise's financial statements will have to focus on the new, heightened risks and must be applied more intensely in situations where judgment is a significant component. Greater care in the selection and use of procedures and narrower tolerances for errors will be required.

Estimates and Judgment

Preparers and auditors of financial statements are aware of the risks and uncertainties embodied in those statements. Management is responsible for applying the reasonable judgment necessary to make financial statement decisions on the appropriate application of generally accepted accounting principles (GAAP). This includes the development of the estimates necessary to record, value, summarize, and categorize assets and liabilities that are not subject to precise quantification, such as inventory obsolescence reserves, allowances for doubtful accounts, contingencies, or other asset valuation allowances. The auditor is responsible for auditing management's judgments used in the application of U.S. GAAP, setting valuation and contingency allowances, and estimating the financial impact of transactions in various stages of completion.

The auditor must apply professional judgment in the selection and application of auditing procedures. Professional judgment requires the application of the auditor's training, knowledge, and experience, in tandem with professional literature and the facts, circumstances, and economic conditions surrounding the audited enterprise. Reasonable people can differ in applying judgments in a given set of circumstances. If an auditor's determination is based only on a judgment of a set of facts and conditions, it may be insufficient because it is not supported by the standards or sound logical analysis. There can be variances in the results of the application of professional judgment, but the area of tolerance surrounding the mean of the theoretically correct result cannot be so wide as to include every possible result. It is unacceptable to assume that an auditor's judgment is automatically in compliance with GAAS. There can be differences in judgment, and different approaches to the audit can be GAAS-compliant. Auditors must document their reasoning carefully and succinctly in the workpapers to explain how the surrounding facts and circumstances bore on their reasoning and the selection of audit methods and procedures.

The analysis of management's judgments and estimates should not be made in a vacuum; that is, it cannot be parsed into separate decisions without considering all of the different judgments and estimates collectively and in natural groupings. Management's propensity to be either too "liberal" or "conservative" (all of the results being in either the upper or lower segment of a range of possible amounts) should be considered in the auditor's evaluation of the fairness of presentation of the financial statements taken as a whole. If the judgments and estimates are all at the top of the acceptable range for the recognition of revenue or deferral of expenses, management motivation should be given serious consideration.

The thoughtful consideration and acknowledgment of the current economic conditions and their impact on the audit, including an atmosphere that is conducive to significant fraud, should be a part of the auditor's thought process in designing and implementing a GAAS audit.

Professional Skepticism

Professional skepticism is exercised when an inquiring mind analyzes the financial data and facts and circumstances surrounding an audit; however, the analysis should be conducted with the knowledge that fraud and error are only a possibility, not an inevitability. It is an approach that requires more critical analysis and corroborating evidence when the motivations to commit fraud, or the conditions that lead to errors, are more prevalent than usual. Professional skepticism is an inquisitive attitude, but not one that sees an ulterior design in every facet of every activity of the enterprise or its management.

Issued in December 2008, the Public Company Accounting Oversight Board (PCAOB) Release 2008-008, "Report on the PCAOB's 2004, 2005, 2006, and 2007 Inspections of Domestic Annually Inspected Firms," notes insufficient exercise of professional skepticism as a contributing factor to a continuing trend of audit deficiencies in critical areas. This finding should cause auditors to more critically evaluate their compliance with the requirements of due care and to exercise greater professional skepticism, especially in the current economic environment.

GAAS requires that the auditor not be satisfied with less-than-persuasive evidence and, particularly during times of economic crisis, to exercise appropriate professional skepticism and verify management representations. Some aspects of the audit that may require additional attention include the following:

Audit risk and materiality:

* detection risk and the adequacy of substantive procedures

* qualitative materiality considerations

Management representations:

* responses to analytical reviews

* representations about asset recoverability

* oral representations

* accounting estimates and accruals, especially for nonroutine events and transactions

Fraud considerations:

* earnings-based management incentives

* availability of original source documents

* top-side or nonsystem adjustments

* large year-end adjustments

* unusually complex transactions, particularly at or close to year-end.

By intensifying the emphasis on professional skepticism in the planning and execution of the audit, auditors may avoid the increased risk of potential problems or audit failure in times of economic turmoil.

Audit Planning

Part of the planning phase of a GAAS audit is gaining an understanding of the audited enterprise and the industry in which it operates. Understanding the financial strength of the enterprise is an important factor in planning. Does the enterprise have access to the capital or lending markets? Does it need a variable, but constant, stream of funding to sustain its business activities? How does liquidity affect the value of its assets? These are some of the questions that need to be answered during the audit planning phase, particularly given the state of the economy.

The standards give examples of conditions and events that may indicate the existence of risk of material misstatements, which may include--

* operations in economically unstable regions;

* going-concern and liquidity issues, including loss of significant customers (or actual or pending bankruptcy of customers or suppliers);

* constraints on the availability of capital and credit; or

* activities or balances that involve significant measurement uncertainty, including accounting estimates.

Planning also includes determining audit materiality directed toward designing the nature, timing, and extent of auditing procedures and tests required to satisfy GAAS guidance. When determining materiality criteria, the auditor should use professional judgment when determining the consequences of significant changes in the economy as a whole and in the industry in which the entity operates. Qualitative characteristics of materiality, such as an adverse perception of management's integrity, are as important as the quantitative characteristics.

A GAAS audit is an iterative process. Information obtained in different stages, or from different parts, of the process must be evaluated in light of procedures previously performed, to be performed, or performed in different parts of the audit. GAAS requires a continuing reevaluation of the procedures designed to comply with the standards and a reassessment of materiality criteria when additional relevant information is discovered.

Application of Audit Procedures

Whenever the account balance being tested requires the application of judgment by management, the auditor must understand the process and controls in place to ensure a reasonable result. Management's judgment should be examined to determine if it is reasonable in light of the surrounding circumstances, including the current and expected economic climate. For example, AU section 312.56 states that because estimation regarding future events is inherently subjective, there is a greater risk of material misstatement, particularly when data used in the estimation are inadequate, inappropriate, or misapplied. The risk is increased in times of economic instability and uncertainty.

The current and expected future economic climate can affect the value assigned to inventory. Evaluating obsolescence, particularly for the electronics and fashion industries, generally includes assessing the enterprise's ability to market and sell its inventory. If retail sales are depressed--as they currently are--the calculated inventory turn could lead to a conclusion that some of the inventory needs to be valued at net realizable value.

The economic climate could play a more defined and significant role in determining the amount of an allowance for doubtful accounts (or loans, in a financial institution). The enterprise should consider the current economic climate in evaluating the collectability of its receivable balances or loans receivable. The auditor should also evaluate the impact of the economic situation on the reasonableness of management's determination of an adequate allowance. Historical experience will not be persuasive unless it is adjusted for the dynamic circumstances.

The failure of the ARS market created a liquidity squeeze in an economy heading into a recession of unknown duration and in the throes of a real estate bust. Many enterprises other than financial institutions had investments in ARS, funds of ARS, or instruments grounded in mortgages, but this is only the tip of the iceberg.

Some timely questions the auditor needs to answer include the following:

* Does the enterprise have any connection with investments in ARS or mortgage-collateralized securities, and, if so, is there an effect on other comprehensive income?

* Does the lack of liquidity in the marketplace have any effect on the enterprise's ability to get any funding needed to continue operations or to refinance maturing debt? Is there a going-concern issue?

* Has the enterprise taken the current economic conditions into account in determining its allowance for credit or other losses? Will its financially weaker customers be able to pay their balances due the enterprise?

* Is the inventory properly valued?

* How does the economy affect the enterprise's ability to expand, and does this have an effect on the current financial health of the enterprise?

* Have all related-party transactions been disclosed, or is there evidence of nondisclosed related-party activity that would require extended audit procedures?

The auditor must address these and many other questions. The enterprise is responsible for its financial statements, but the impact of the current and expected economic climate will affect the design and implementation of the procedures selected to comply with GAAS.

Going-Concern Evaluation

An important consideration in an economy with poor liquidity and in a recession of unknown depth is whether the auditor is faced with a going-concern issue. AU section 341, "The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern," addresses the auditor's responsibility to assess the audited enterprise's ability to continue as a going concern. The following are excerpts from the guidance given to the auditor in AU section 341A.02-.03:
  02 The auditor has a responsibility to evaluate whether there is
  substantial doubt about the entity's ability to continue as a going
  concern for a reasonable period of time, not to exceed one
  year beyond the date of the financial statements being audited.
..The auditor's evaluation is based on his or her knowledge of relevant
  conditions and events that exist at or have occurred prior to the
  completion of fieldwork. Information about such conditions or events
  is obtained from the application of auditing procedures planned and
  performed to achieve audit objectives that are related to
  management's assertions embodied in the financial statements being
  audited [emphasis added]. ...
  03 The auditor should evaluate whether there is substantial doubt
  about the entity's ability to continue as a going concern for a
  reasonable period of time in the following manner:
  a. The auditor considers whether the results of his procedures
  performed in planning, gathering evidential matter relative to the
  various audit objectives, and completing the audit identify
  conditions and events that, when considered in the aggregate,
  indicate there could be substantial doubt about the entity's ability
  to continue as a going concern for a reasonable period of time. ...
  b. If the auditor believes there is substantial doubt about the
  entity's ability to continue as a going concern for a reasonable
  period of time, he should (1) obtain information about management's
  plans that are intended to mitigate the effect of such conditions or
  events, and (2) assess the likelihood that such plans can be
  effectively implemented.
  c. After the auditor has evaluated management's plans, he concludes
  whether he has substantial doubt about the entity's ability to
  continue as a going concern for a reasonable period of time. If the
  auditor concludes there is substantial doubt, he should (1) consider
  the adequacy of disclosure about the entity's possible inability to
  continue as a going concern for a reasonable period of time, and (2)
  include an explanatory paragraph (following the opinion paragraph) in
  his audit report to reflect his conclusion. If the auditor concludes
  that substantial doubt does not exist, he should consider the need
  for disclosure.

The going-concern analysis requires taking economic and market liquidity conditions into consideration. Judgments and estimates will form a major part of the evaluation, particularly relating to the auditor's evaluation of management plans, such as a plan to dispose of assets or plans to borrow money and restructure debt.

Designing Audit Procedures in Turbulent Economic Times

The economy is an important consideration in conducting a GAAS audit. Auditors should be familiar with the economic effects on the enterprise being audited, but are not responsible for predicting future conditions or events with certainty. Properly documenting the considerations used and applying those considerations in the design of auditing procedures, particularly in assessing the reasonableness of management's judgments, are important audit procedures.

During these turbulent economic times, auditors must take the following factors into consideration when designing the audit procedures necessary to comply with GAAS, performing the audit, and coming to a conclusion on management's financial statement assertions:

* The economy's impact on the enterprise being audited;

* The economy's effect on the probability of the incidence of fraud;

* The importance of management integrity to a GAAS audit;

* The need for heightened professional skepticism in conducting an audit in difficult economic times;

* The need to exercise reasoned professional judgment based on the training, knowledge, and experience of a competent auditing professional after evaluating all of the pertinent facts and circumstances; and

* The need to integrate the different areas of the audit and constantly reevaluate the auditing procedures used, based on findings throughout the audit.

Auditors must also give serious consideration to the enterprise's ability to continue as a going concern by evaluating the enterprise's financial condition, management's expectations, and the current and expected future economic conditions.

The basis for auditing judgments, particularly in areas where judgment and estimation are significant factors, should be adequately documented in the work-papers.

Vincent J. Love, CPA, is a managing partner of Kramer, Love & Cutler, LLP, New York, N.Y., and a member of The CPA Journal Editorial Board. Celia Lawson, CPA, CFE, works with Kramer, Love & Cutler, LLP, on forensic accounting engagements, including professional malpractice claims.
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Title Annotation:auditing
Author:Love, Vincent J.; Lawson, Celia
Publication:The CPA Journal
Geographic Code:1USA
Date:May 1, 2009
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