A Year for Real Audit Risk

November 18th, 2008

The new audit risk standards SAS no. 104 to SAS no. 111 issued by the AICPA in June 2006 will really come home to roost this year. They will put more pressure on auditors to apply the standards in the spirit they were designed because of the economic downturn. The risk for fraudulent misstatement of financial results will escalate due to the pressure on business owners and managers to report better results. Some of the reasons include avoiding violation of lending covenants and making a business look better in preparation for a possible sale. There can be any number of reasons.Typically auditors follow a checklist, but now they will be required to think and use appropriate judgment about the business. There will changes in management personnel, including key managers. When competent executives and advisors leave it puts the business in a weakened condition just when it is critical to make good decisions. In the past it was easy for management teams to run a company because it was hard to make a mistake. Now tough economic and competitive conditions demand seasoned professionals with good judgment. Many of today’s executives have never been required to deal with the uncertainty they face today.

Many of the audit teams conducting audits never audited publicly traded companies where Sarbanes-Oxley and the PCAOB established the rules. The new audit risk standards apply to privately owned companies and both owners and auditors are in for a surprise. They will have to wake up and smell the coffee and deal with a whole new world of reality.

The checklist days are over because auditors need to make inquiries, observations, in addition to gathering audit evidence to support their conclusions. Brainstorming sessions are mandatory to determine areas where fraud and material misstatements could occur. Assertions about account balances need to be evaluated. Account balances have to exist, the entity must have legal title to assets, accounts must be complete, and they must be properly stated at cost (or market if it is lower).

Cost or market could be a problem because assets may no longer be worth what was paid for them. This is an issue for inventories whose value could have slipped. Accounts receivable will be under pressure since businesses have gone downhill pretty fast and companies might not be able to meet their obligations. Therefore, bad debt write-offs could soar beyond normal ranges. Companies utilizing asset based financing will be put under significantly greater pressure.

Entire industries could be rapidly transformed and be subjected to high levels of stress. Bank covenants will come under significantly greater pressure. In addition, because banks are feeling more pressure they will start paying more attention to internal control risks. This is occurring when many companies have accounting personnel who lack the appropriate level of accounting and financial reporting training and skills.

This is the time for CPAs to go back to basics and focus on providing solid advice to their clients both on the potential risks from internal control weaknesses and on financial management of their business. It is no longer possible to survive just on preparing tax returns and financial statements.