This course provides an intensive conceptual and applied introduction to auditing in society. It focuses on concepts and applications related to financial-statement auditors’ professional responsibilities as well as major facets of the audit process including risk assessment and audit reporting. In the U.S. financial-statement audits and related services generally are provided by Certified Public Accountants (CPAs). To succeed in this course, you should anticipate engaging in critical thinking and thoughtful communication about audit professionals' decision environments, decision processes, and deliverables. Additionally, you should understand the macro-level learning objectives in each of the course's weekly modules.
Quality of Earnings Part IV
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Из курса от партнера University of Illinois at Urbana-Champaign
Auditing I: Conceptual Foundations of Auditing
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MODULE 8: Audit Quality
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Mark E. Peecher, PhD, CPAAssociate Dean of Faculty and Deloitte Professor of Accountancy
Department of Accountancy
Now when you talk to the audit committee and you're the auditor,
you want to focus on overall indicators of earnings quality.
So when you talk to the audit committee,
they're going to want to know things like
the consistency of the accounting policies from year to year or quarter to quarter,
or the overall degree of estimation or subjectivity in determining earnings.
You can think of 2 different companies and you can have 1 company
have a million dollars and net income and
another company have a million dollars in net income.
But if company A's million dollars in net income,
if 80% of that comes from easy to identify
measurable phenomena and only 20% is from highly uncertain estimation,
that's going to make investors have a high degree of confidence in those earnings number.
If you have company B where that same $1 million of net income exist,
if 90% of that is from estimate derived accounts and those have high subjectivity,
you're going to have more questioning by third parties about this reported net income.
It is the case that if you bring in an independent audit for both of the situations,
that the high degree and the low degree,
the gap will close between the two,
but an auditor is not a magician,
they cannot take earnings that are highly uncertain and estimate based
and put them on par with earnings that
are much more measurable and not based on estimates,
but they will reduce that gap.
Some other things that you want to talk to in a frank way with those charged with
governance about is trends in reserve balances.
So if it's a bank,
what type of action is happening in the allowance for loan loss reserves?
From a bank's perspective,
one of the biggest assets is the payments that
they'll be receiving over time on mortgages,
car loans, business loans.
And they have to estimate
a contract account to those loan receivables and that's the loan loss reserve.
Another thing would be accounts receivable reserves.
Another thing might be warranty reserves,
a liability for...that you're incurring today as a result of selling products today,
knowing that some products are not going to work properly
and if there's a warranty,
there's going to be a cost to the company.
Those costs are not to be deferred and
recognized only in the future on the accrual basis of accounting.
And you'll want to, as an auditor, be looking at indicators of
the production quality and using that as a check on the warranty reserve.
You also want to talk to management and the audit committee about
the complexity of the discussion and analyses that management is putting forward
and your overall sense to which management is communicating fairly
and representation faithfully about their accounting policies and about
how different their reported numbers might
be if they had used in a different accounting policy.
You also want to talk to the audit committee about
the presence of pro forma measures of earnings,
and you want to talk to them about whether it has been
adequate disclosure of related party transactions.
Let's take a look at both of those in turn.
Pro forma is really one of the biggest things happening in today's space.
Sometimes what you'll have is companies not like
the generally accepted accounting principles based earnings number
and so what they will do is come up with their own measure.
Now, I'm making it seem as though have more latitude than they actually do.
There are industry wide practice's where firms will take out certain types
of expenses that they think is really not
a fair type of expense for measuring performance and this may be things like,
some types of depreciation and amortization, that is really
just a cost allocation approach
for how they take assets and then write them down over time.
And they will often like to get to an alternative measure of earnings.
When you do that, you need to be careful to reconcile
that pro forma measure to a generally accepted accounting principles based measure.
The other thing you want to watch for is, are you giving
equal play to the gap measure verses the pro forma measure?
It's not as though companies can say,
here's our pro forma measure,
and have that come in neon lights and then
the gap measure B in a size eight footnote font.
I'm exaggerating just to make the point.
Now, the disclosure related party transactions is critical, not
because related party transactions are illegal, no.
The issue is if it's a related party transaction is not at all clear that the terms of
that transaction are sustainable or that
would be fairly reach within an arm's length transaction.
So, if the reason a company's performance looks like they're doing
much better than competitors because of a related party transaction,
well you want the users of
the financial statements to be able to take that into account.
A couple of other things I want to drive home and before we leave this lesson,
you also want to look at the ratio of net income to
cash from operations, especially over time.
You know it's one thing if a company has net income on accrual basis in
any one period even though when it comes to cash from operations is negative.
But you cannot really sustain multiple periods
of accrual basis net income and negative cash from operations,
that is a hard thing to sustain.
Think about the only way that's going to sustain is if company management can somehow
convince other parties to finance their operations until they do reach profitability.
So it's really nice to look at the trends in these items over time.
The last thing I want you to think about, if you're
an auditor, is you need to walk the audit committee,
that is those charged with governance through the uncertainties and
contingencies that are disclosed in
the footnotes in and Management's Discussion and Analysis.
It could be that the future performance of a company can change
quite a lot depending on things like how a lawsuit is ultimately resolved,
and sometimes these contingencies can be
so worrisome that an auditor actually has to step back and think,
would that entity continue as
a going concern if this worst-case scenario were to occur?
So what you're looking for as an auditor, and if you were the audit committee,
you should be asking probing questions about,
are we being forthright and telling
the users of the financial statements that these contingencies exist?
And are they being referred to a footnote
in the part of the financial statements that refer to these contingencies?
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