FASB’s Controversial CECL Accounting Standard for Loan Loss Recognition

Source: FASB’s Controversial CECL Accounting Standard for Loan Loss Recognition

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FASB’s Controversial CECL Accounting Standard for Loan Loss Recognition

After the financial crisis in 2007-2008, the Financial Accounting Standards Board (FASB) decided to revisit how banks estimate expected credit losses. Expected credit losses are recorded in the general ledger account named allowance for loan and lease losses (ALLL). The FASB and the International Accounting Standards Board (IASB) agreed that the way ALLL’s were being calculated prior to the financial crisis delayed expense recognition for credit losses and contributed to the financial crisis of 2007-2008 (Golden, Siegel & Schroeder, 2016). To help prevent future financial crises, the FASB began studying how to change the accounting standards so that a better way of accounting for credit losses could be used. After much research and many discussions with accountants, auditors, stakeholders, bank officers, and company managers, the FASB issued the current expected credit loss (CECL) standard on June 16, 2016. Under CECL, banks are to use historical experience, current conditions, and reasonable and supportable forecasts to calculate estimated credit losses (Golden, et al., 2016).
The current expected credit loss (CECL) standard took effect in June 2016 and will be fully implemented by 2020. CECL requires banks to use the new CECL standard instead of the incurred loss method. The incurred loss method assumes that the outstanding loans are going to be repaid until the occurrence of a trigger event causes the accountant to record the loan asset at a lower value. With the new CECL standard, banks must assume a more forward-looking approach and reflect all estimated credit losses on financial statements on the loan origination date (www.fasb.org). Loan loss reserves (LLR) are entries made by banks to cover estimated credit losses. Increases in the balances of LLR accounts are called loan loss provisions. Decreases in the balances of LLR accounts are called net charge-offs. The new CECL calculation increases the LLR balance, resulting in a decrease in net income and less profit. Therefore, some banks opposed the new CECL standard fearing that it will lead to an increase in bank losses (www.fasb.org).
The FASB’s proposed current expected credit loss (CECL) standard increases a bank’s loan-loss reserves, thus it also decreases a bank’s net income resulting in bank losses. Since it is not known whether banks could absorb the losses brought about by the CECL, a controversy about whether the new CECL standard should be imposed developed (Golden, et al., 2016).
The FASB wants the new CECL standard to take effect to decrease the likelihood of another financial crisis. Also, investors favor the new CECL since it gives them more informative financial statements, reflecting future predictions of expected losses. On the other hand, some bank managers do not want the CECL because it is expensive to implement (McLannahan, 2017). They also fear that the CECL will negatively affect company profits. Some smaller community banks oppose the new standard because they lack the complex information technology and big data capability of larger banks. Big data capability is needed to calculate the expected loss and smaller banks are at a disadvantage (McLannahan, 2017).
Although controversial, FASB’s proposed current expected credit loss (CECL) standard was issued in 2016 and is currently planned to be fully implemented by 2020. When the new standard is fully implemented, it will increase a bank’s loan-loss reserves and decrease net income resulting in less profit (Golden, et al., 2016). Whether bank managers could curtail the losses brought about by having to comply with the new current expected credit loss (CECL) standard is still unknown.

References
Golden, R., Siegel, M., & Schroeder, H. (2016, June 16). http://www.fasb.org (News Release 06/16/2016). Electronic media: Why a New Credit Losses Standard? Video retrieved from http://www.fasb.org/cs/ContentServer?pagename=FASB/FASBContent_C/NewsPage&cid=1176168232900www.fasb.org
McLannahan, B. (2016). US banks chafe at new loan loss rules. Financial Times. June 20, 2016. Retrieved from https://www.ft.com/content/f94bd13e-34d4-11e6-ad39-3fee5ffe5b5b
http://www.fasb.org

Comparing and Contrasting Audit Procedures and Reporting

Introduction

The goal of this paper is to compare and contrast audit procedures and reporting within a business context. This paper provides answers to the following questions:

  1. Discuss the different audit reports. Under what circumstance is each report used?
  2. Outline the auditor’s code of professional conduct and independence in relation to the audit reports.
  3. What specific information would be examined during an audit that would require analytical procedures?
  4. Include test examples of the cash and collection cycle.

This paper also includes a comparison of the Explanatory Report to the Standard Report. In comparing these two reports, specific procedures and steps will be identified, keeping in mind that theoretical application and the actual application differ from one another. Auditing is a very complex process of checks, designed to ensure information is correct as identified.  In many ways, auditing is a numbers-based analysis. It is important to be able to audit the procedures of the past to recommend future improvements for success.

Auditing Reports

Several types of Auditor’s Reports exist. These include standard (unqualified), explanatory, qualified, disclaimer, and adverse. The Standard Auditor’s Report is unqualified.  Unqualified means that in the auditor’s opinion, there are no special circumstances to report and the financial statements are presented fairly without material misstatements. Auditors may issue reports showing their opinions are something other than unqualified.  These include explanatory, qualified, disclaimer, and adverse.

Explanatory reports have an explanatory paragraph added to the standard unqualified report. The explanatory paragraph follows the opinion paragraph. “Four situations require the addition of the explanatory paragraph: 1) Reference to the audit of internal control for public companies 2) Substantial doubt to the ability of the entity to continue as going concern 3) Lack of consistency due to accounting changes, and 4) A need for additional emphasis (Messier, Glover, & Prawitt, 2012, p. 616).”

Qualified reports are used for a departure from Generally Accepted Accounting Principles (GAAP). “The report describes the nature and impact of the departure. This could be because of faulty accounting. A qualified report means the financial statements are presented fairly except for this departure GAAP (Messier, Glover, & Prawitt, 2012, p. 619-620).” In qualified reports misstatements may exist but they are not material misstatements. If material misstatements exist, then an Adverse Report would be used instead.

Disclaimer reports are used when an auditor withholds his opinion on the financial statements.  An auditor may withhold his opinion either because of insufficient appropriate evidence to form an opinion or because of lack of independence. The auditor must be independent, meaning they have no connection with the client personally or financially. If the auditor cannot maintain professional independence, then he/she cannot provide an unbiased opinion. “In the disclaimer, the auditor states the reason why he/she was unable to provide an opinion and explicitly states that no opinion is expressed (Messier, Glover, & Prawitt, 2012, p. 619-620).”

An Adverse Report is issued when the financial statements do not present fairly due to a departure from GAAP that causes a material effect on the financial statements overall. “In an adverse report the auditor explains the nature and size of the misstatement and states the opinion that the financial statements do not present fairly in accordance with GAAP (Messier, Glover, & Prawitt, 2012, p. 619-620).”

Auditor’s Code of Professional Conduct and Independence

The Principles of Professional Conduct Responsibilities are shown below. They are also listed on the AICPA website.

In carrying out their responsibilities as professionals, members should exercise sensitive professional and moral judgments in all their activities.

The public interest: Members should accept the obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate commitment to professionalism. Integrity: To maintain and broaden public confidence, members should perform all professional responsibilities with the highest sense of integrity.

Objectivity and independence: A member should maintain objectivity and be free of conflicts of interest in discharging professional responsibilities. A member in public practice should be independent in fact and appearance when providing auditing and other attestation services.

Due care: A member should observe the profession’s technical and ethical standards, strive continually to improve competence and the quality of services, and discharge professional responsibility to the best of the member’s ability.

Scope and nature of services: A member in public practice should observe the Principles of the Code of Professional Conduct in determining the scope and nature of services to be provided (Messier, Glover, & Prawitt, 2012, p. 652).

Regarding the subject of auditor ethics, independence has become a frequently discussed topic. With the complexity of the issue at hand, the AICPA has devoted multiple pages of interpretations and rulings regarding independence. Also the SEC and the now defunct ISB contain rulings about independence issues (Messier, Glover, & Prawitt, 2012, p. 654).

In the Rothenburg Construction Company case, Jay Rich, CPA, held 10 percent of the stock in Rothenburg Construction Company. Therefore, Mr. Rich could not maintain professional independence while conducting the audit.  The objectivity and independence clause of the “Principles of Professional Conduct Responsibilities” would have been violated if Mr. Rich had conducted the audit. He cannot conduct an audit for a company for which he holds part of the stock.

Specific Information during an Audit Requiring Analytical Procedures

            Material misstatements discovered during audits can be more difficult to recognize in audits concerning fraud than in audits concerning errors. One solution for detecting fraud is the use of analytical procedures. Analytical procedures are “evaluations of financial information made through analysis of plausible relationships among both financial and nonfinancial data (Messier, Glover, & Prawitt, 2012, p. 121).”

Auditors must realize the possibility for financial fraud exists and act with professional skepticism. Auditors can evaluate financial statement accounts by using analytical procedures.  Non-financial data can be gathered using inquiries and observation. This data can be compared to the results obtained from analytical procedures. Results of evaluations must be communicated clearly and concisely to others. These efforts should be supported during both the planning and performance stage of the audit with brainstorming meetings between the engagement team members. Results of evaluations must be communicated clearly and concisely to others.  Auditors must understand the Fraud Risk Triangle and know that with enough pressure, and the opportunity, even an honest person can rationalize unethical behavior. Managers often are involved in fraud because they have the opportunity access accounting records and the incentive to make profit. Auditors can use the confirmation process to obtain evidence from third parties about financial assertions made by management.

Upon completion of an audit, the auditor should be able to ascertain whether the accumulated audit procedures may cause the financial statements to be materially misstated.  Based on the understanding of the entity and its environment, the auditor should assess the risk of material misstatement at the assertion level and determine necessary auditing procedures based on the risk assessment results.

Test Examples of the Cash and Collection Cycle

            The cash and collection cycle is the process of ensuring that employees and management properly control customer billing and cash receipts. When auditing a cash a collection cycle, the auditor should be looking for fraud.  However, according to Dyck (2011), it is more likely that the financial statements would be materially misstated due to unintentional bias than due to fraud (Budescu, Peecher, & Solomon, 2012, p. 26).  If fraud is suspected the usual audit procedures may be extended to include the following:

  • Extended bank reconciliation procedures.
  • Proof of cash.
  • Tests for kiting (Messier, Glover, & Prawitt, 2012, p. 552).

Extended Bank Reconciliation Procedures

If the auditor suspects some type of fraud has been committed, then the auditor would examine the bank reconciliations of two consecutive months to ensure that all reconciling items were handled properly. The deposits would be traced to the bank statement to verify that they were deposited in the bank. Deposits in transit would be traced to the following month’s cash receipts journal to verify that they were recorded. Checks listed as outstanding on the bank reconciliation would be traced to the cash disbursements journal, and the canceled or substitute checks returned in the next month’s bank statement would be examined for propriety. Other reconciling items such as bank charges, NSF checks, and collections of notes by the bank similarly would be traced to the accounting records for proper treatment (Messier, Glover, & Prawitt, 2012, pp. 553-554).

Proof of Cash

The primary purposes of the proof of cash are:

( 1) to ensure that all cash receipts recorded in the entity’s cash receipts journal were deposited in the entity’s bank account

( 2) to ensure that all cash disbursements recorded in the entity’s cash disbursements journal have cleared the entity’s bank account, and

( 3) to ensure that no bank transactions have been omitted from the entity’s accounting records (Messier, Glover, & Prawitt, 2012, p. 554).

“The reader should note that a proof of cash will not detect a theft of cash when the cash was stolen before it was recorded in the entity’s books (Messier, Glover, & Prawitt, 2012, p. 554).” The auditor may suspect that cash was stolen without being recorded in the entity’s books, when during the audit test for the completeness assertion it appears that not all cash receipt transactions were recorded (Messier, Glover, & Prawitt, 2012, p. 554).

Tests for Kiting

One type of fraudulent scheme that has been around for years is called check kiting. The account holder usually has two accounts and transfers non-existent funds from one account into another one. A kiting scheme generates non-existent revenue and produces questionable account balances. Since this type of bank fraud is common, The Office of the Comptroller of the Currency (OCC) has recently issued an advisory letter to banks on how to identify and combat check kiting. Normally, when people cash checks, the funds supporting the check are actually in the account. However, clearing a check usually takes between one to five days. “During this clearing time, the bank gives the person cashing the check a short-term loan until the money is actually received from the financial institution that originally issued the check. There is a window of time during which the bank that cashed the check does not actually have the money. It is during this window when the bank that issued the check is unaware that the check was issued. The check-kiting scheme takes advantage of this transit vulnerability. Check kiting is a crime prohibited by federal law 18 USC § 1344 (Summerford & Gober, 2003).”  It states that whoever knowingly executes, or attempts to execute, a scheme or artifice—

(1) to defraud a financial institution; or

(2) to obtain any of the moneys, funds, credits, assets, securities, or other property owned by, or under the custody or control of, a financial institution, by means of false or fraudulent pretenses, representations, or promises;

shall be fined not more than $1,000,000 or imprisoned not more than 30 years, or both.

Thus, individuals who perpetrate a check kite are frequently prosecuted and sent to prison. But that often does not help the banks, which are left with the loss after the check kite collapses (Summerford & Gober, 2003).”

            One approach commonly used by auditors to test for kiting is the preparation of an interbank transfer schedule. To test for kiting, an auditor will check to see if the money recorded as transfers was really in the account at the time of transfer.  Kiting can be detected by tracing the check to the cash disbursements and cash receipts journals and to the end-of-the-month bank reconciliation (Messier, Glover, & Prawitt, 2012, p. 554). Another method of testing for kiting is to put a hold on the account the money was transferred into for a few days while waiting to see what day the money in the other account actually becomes available.

Auditing assignments involve examining work papers and checking boxes to trace amounts on bank reconciliations, cutoff bank statements, standard bank confirmations, and proof of cash statements. However, the key issue may not be to just “check the box” but to develop more tools for evaluating and controlling audit failures. Kleinman & Palmon (2014) suggested that we do systematic research to determine how audit quality is effected by national culture, legal systems, accounting standards, auditing standards, and auditing enforcement regimes (Kleinman, Lin, & Palmon, 2014, p. 79).

PricewaterhouseCoopers (2003) and Albrecht and Sack (2000) state that future accountants must learn to solve complex, unstructured problems and communicate their solutions clearly and concisely (Green, 2013. p. 168).”  Accountants must be able to perform inventory audits with accuracy and completeness at the forefront of their audit actions. Also they must be mindful of the potential for inventory losses due to fraud, theft, damages, and obsolescence.  They must realize that inventory valuation methods such as LIFO, FIFO, and Standard Cost must be considered when getting the true value of inventory. Review and observation are the main ways of testing control activities within the organization. Auditors must verify that the inventory actually does exist as well as its physical location. Auditors can perform these verification procedures through the use of substantive tests.

Comparison of the Explanatory Report to the Standard Report

The main difference between the Explanatory Report and the Standard Report is that the explanatory report has an explanatory paragraph added to the standard unqualified report. The explanatory paragraph follows the opinion paragraph. The following four situations require the addition of the explanatory paragraph:

1) Reference to the audit of internal control for public companies

2) Substantial doubt to the ability of the entity to continue as going concern

3) Lack of consistency due to accounting changes, and

4) A need for additional emphasis (Messier, Glover, & Prawitt, 2012, p. 616).

We will look at each one of the situations above separately. We will discuss how each one is simply a deviation of the Standard Report. Both the Standard Report and the Explanatory Report are considered to be Unqualified/Unmodified Opinions (Messier, Glover, & Prawitt, 2012, p. 616). The Explanatory Report is like that Standard Report in that there are no modifications to the wording of any paragraphs.  The Introductory, Scope, and Opinion paragraphs remain the same.  The only difference is that the Explanatory Report has an additional paragraph added after the Opinion paragraph (Messier, Glover, & Prawitt, 2012, p. 616). Some differences exist in the terminology between the Public Company Accounting Oversight Board (PCAOB) and the Accounting Standards Board (ASB) standards relating to these additional paragraphs (Messier, Glover, & Prawitt, 2012, p. 616).

While the PCAOB standards refer to all such paragraphs simply as “ explanatory paragraphs,” the ASB’s standards, which apply to audits of all entities except for public companies, refer to explanatory paragraphs as either “ emphasis- of- matter” or “ other- matter” paragraphs. An emphasis- of- matter paragraph refers to a matter that has been appropriately presented or disclosed in the financial statements. An emphasis- of- matter paragraph is used when the auditor has substantial doubt about an entity’s ability to continue as a going concern, when there is a lack of consistency in the financial statements, or when the auditor wishes to emphasize a particular matter, if such items have been appropriately disclosed in the financial statements. An emphasis- of- matter paragraph would also be used under ASB standards when the financial statements have been prepared in accordance with a special purpose framework other tha(n) GAAP. An other- matter paragraph refers to a matter other than those presented or disclosed in the financial statements but that, in the auditor’s judgment, is relevant to users’ understanding of the audit, the auditor’s responsibilities, or the auditor’s report. For example, an other- matter paragraph is used when the auditor’s opinion on prior period financial statements differs from the opinion the auditor previously expressed or when the distribution of the auditor’s report is to be restricted to particular users. Like the explanatory paragraph in a report for a public company, emphasis- of- matter or other- matter paragraphs are placed after the opinion paragraph, but under the section heading “ Emphasis of Matter” or “ Other Matter.” While the term explanatory paragraph has a slightly more general meaning than the term emphasis- of- matter paragraph, we use these terms interchange-ably throughout the text for simplicity (Messier, Glover, & Prawitt, 2012, pp. 616-617).

Reference to the Audit of Internal Control for Public Companies

            Internal Control over Financial Reporting (ICFR) means controls that address risks to financial reporting. Generally Accepted Auditing Principles (GAAP) help to reduce these risks (http://www.thecaq.org/reports-and-publications/guidetoicfr/guide-to-internal-control-over-financial-reporting). When financial reporting risks are minimized, investors can have confidence in financial reporting. When beginning an auditing engagement, auditors look at the characteristics of the company, the environment, and the scope of the company’s operations. They also look at public policies and current news in the accounting and auditing industry.

            Public companies have specific reporting requirements mandated to them by the Securities and Exchange Commission (SEC) and the Sarbanes-Oxley Act (SOX). These requirements are necessary to fairly present to investors the financial positions of the companies in which they are investing. These companies are publicly-traded on the stock exchange. Using a system of Internal Control over Financial Reporting (ICFR), the managers at these companies are responsible for providing reasonable assurance of the reliability of financial statements. These rules were adopted in June 2003 to implement Section 404 of SOX.  The management must also annually evaluate whether ICFR is effective and disclose the results to investors (http://www.sec.gov/rules/interp/2007/33-8810.pdf).

Management is required to conclude and state in its report that ICFR is ineffective when there are one or more material weaknesses. Companies should provide disclosure to investors so that they can understand the cause for the control deficiency. In this way, the potential impact of each particular material weakness can be seen. Auditors should distinguish material weaknesses that may have a profound impact on ICFR versus those that will have a lesser impact. This type of information will be more useful to investors (http://www.sec.gov/rules/interp/2007/33-8810.pdf).

Management should evaluate the following situations indicating whether or not an ICFR defienciency exists.  If it exists, then it should be determined if the risk is a material risk.

  • Identification of fraud, whether or not material, on the part of senior management
  • Restatement of previously issued financial statements to reflect the correction of a material misstatement
  • Identification of a material misstatement of the financial statements in the current period in circumstances that indicate the misstatement would not have been detected by the company’s ICFR; and
  • Ineffective oversight of the company’s external financial reporting and internal control over financial reporting by the company’s audit committee

(http://www.sec.gov/rules/interp/2007/33-8810.pdf).

Substantial Doubt to the Ability of the Entity to Continue as Going Concern

            A basic assumption that underlies financial reporting is that an entity will continue as a going concern. “Going concern” means “stay in business.” Auditing standards state that 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. When the auditor concludes that there is substantial doubt about an entity’s ability to continue as a going concern, the auditor should consider the possible effects on the financial statements and the related disclosures. If management has adequately disclosed the entity’s financial problems, the audit report typically will express an unqualified/ unmodified opinion but will include an emphasis- of- matter paragraph to emphasize the auditor’s doubt about the entity’s ability to continue as a going concern. In rare cases of extreme and immediate financial distress, the auditor may disclaim an opinion on the entity. If the entity’s disclosures with respect to its ability to continue as a going concern are inadequate, a departure from GAAP exists, resulting in a qualified or an adverse opinion report covering the comparative financial statements (Messier, Glover, & Prawitt, 2012, p. 617).

Shown below is an example of an Unqualified/ Unmodified Financial Statement Audit Report with an Emphasis- of- Matter Paragraph for Going- Concern Problems:

[ Standard introductory, management’s responsibility, auditor’s responsibility, scope, and opinion paragraphs]

Emphasis of Matter The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 6 to the financial statements, the Company has suffered recurring losses from operations and has a net capital deficiency that raises substantial doubt about its ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 6. The financial statements do not include any adjustments that might result from the outcome of this uncertainty (Messier, Glover, & Prawitt, 2012, p. 617).

Lack of Consistency Due to Accounting Changes

A fundamental principle of accounting is that it should result in financial statements that are consistent and comparable across periods. The auditor’s standard unqualified audit report implies that the comparability of the financial statements is not materially affected by inconsistent use of accounting principles. FASB ASC Topic 250, “ Accounting Changes and Error Corrections,” governs the accounting for changes in accounting principles. From the auditor’s perspective, accounting changes can be categorized into ( 1) changes that affect both comparability and consistency in the application of accounting principles and ( 2) changes that affect comparability but that do involve inconsistency in the application of accounting principles (Messier, Glover, & Prawitt, 2012, p. 617).

            Changes Affecting Consistency

 

If a change in accounting principle or in the method of its application materially affects the comparability and the consistency of the financial statements, and the auditor concurs with the change, the auditor should discuss the change in an explanatory or emphasis of- matter paragraph to highlight the lack of consistency. Auditing standards ( AU 708) refer to the following accounting changes as affecting both comparability and consistency and requiring an explanatory or emphasis- of- matter paragraph: 1. Change in accounting principle. An example is a change from straight- line depreciation to an accelerated method for depreciating equipment. 2. Change in reporting entity. An example is the consolidation of a major subsidiary’s financial statements with the parent company’s financial statements in the previous year and accounting for the subsidiary on a cost or equity basis in the current year. 3. Correction of a misstatement in previously issued financial statements. This includes two situations: first, a change in the use of an accounting principle in prior years ( for example, replacement cost for inventory) to an acceptable accounting principle ( such as FIFO) in the current year and, second, adjustments to correct a material misstatement in previously issued financial statements (Messier, Glover, & Prawitt, 2012, p. 618).

An explanatory or emphasis- of- matter paragraph highlighting an accounting change that results in a lack of consistency would contain wording such as the following:

“ As discussed in Note 7 to the financial statements, the Company changed its method of computing depreciation on fixed assets from the straight- line to the double-declining balance method in 2013.” Note that adding an explanatory or emphasis- of- matter paragraph does not eliminate the auditor’s responsibility to evaluate the adequacy of the required financial statement disclosures relating to accounting changes and corrections of errors (Messier, Glover, & Prawitt, 2012, p. 618).

 

Changes Not Affecting Consistency

Other changes may affect comparability but not consistency in the use of accounting principles. These include 1. Change in accounting estimate. A change in the service life of a depreciable asset is an example of a change in estimate. 2. Change in classification and reclassification. If an item was included in operating expenses last year and in administrative expenses in the current year, this is a change in classification but not in accounting principle. 3. Change expected to have a material future effect. This would be a change in accounting principle that has an immaterial effect in the current year but is expected to have a material effect in future years. Changes that affect comparability but not consistency in the application of accounting principles are normally disclosed in the notes to the financial statements. Such changes do not require an explanatory/ emphasis- of- matter paragraph in the auditor’s report (Messier, Glover, & Prawitt, 2012, p. 618).

            A Need for Additional Emphasis

Under certain circumstances an auditor may want to emphasize a specific matter regarding the financial statements even though he or she intends to express an unqualified or unmodified opinion. Such information is presented in an explanatory/ emphasis- of- matter paragraph. Two examples of situations that might cause the auditor to add explanatory language in an emphasis- of- matter paragraph are significant related- party transactions that are appropriately disclosed by the entity and important events occurring after the balance sheet date (Messier, Glover, & Prawitt, 2012, p. 619).

Conclusion

In this paper, different type of auditor’s reports were discussed. The reasons why certain audit report are chosen by auditors was examined. The auditor’s report provides or disclaims an opinion based on whether the entity’s financial statements and related disclosures are presented fairly and conform to GAAP standards. If it is the opinion of the auditor that the financial statements are presented unfairly or contain material misstatements, then an adverse auditor report is issued.

The paper also describes the Auditor’s Professional Code of Conduct and independence. In some circumstances an audit requires the use of analytical reports. This paper outlines specific information during an audit requiring these analytical procedures.

The paper discusses some test examples of the Cash and Collection cycle. The Cash and Collection cycle is a common target for fraud and theft. Analytical procedures can be helpful in detecting accounting theft or fraud.

Finally, this paper includes a comparison of the Explanatory Report to the Standard Report. In comparing, these two reports, specific procedures and steps were identified. In summary, the explanatory report contains important items of interest or concern about a company’s financial statements that an auditor deems necessary to disclose to the public.

In this paper, we explored the concepts of auditing and the application of auditing standards. These include auditing and assurance services, professional standards, audit planning, substantive testing, internal control evaluation, evidence, and procedures used by external auditors, and reports on financial statements.

References

Albrecht, W & Sack, R. (2000) Accounting education: Charting the course through a perilous future. American Accounting Association. Sarasota, FL.

Budescu, D., Peecher, M., & Solomon, I. (2012). The joint influence of the extent and nature of audit evidence, Materiality thresholds, and misstatement type on achieved audit risk. Auditing: A Journal of Practice & Theory, 31(2), 19-41. doi:10.2308/ajpt-10239

Dyck, A., Morse, A., & Zingales, L. ( 2011). How pervasive is corporate fraud? Working paper, The University of Chicago

Green, W. (2013). Key considerations in the audit of inventory: A practice-oriented learning case utilizing “diamonds”. Issues in Accounting Education28(4), 945-973. doi:10.2308/iace-50516

Kleinman, G., Lin, B., & Palmon, D. (2014). Audit Quality: A Cross-National Comparison of Audit Regulatory Regimes. Journal of Accounting, Auditing & Finance29(1), 61-87. doi:10.1177/0148558X13516127

Messier, W., Glover, S., & Prawitt, D. (2012). Auditing and assurance services: A systematic approach. 8th ed. New York, NY McGraw-Hill Higher Education.

PricewaterhouseCoopers (2003) Educating for the public trust. PricewaterhouseCoopers. New York, NY.

Summerford, R. & Gober, T. (2003).Check kiting prevention strategies. The Thomson Corporation and Sheshunoff. Retrieved from: http://www.forensicstrategic.com/wp-content/uploads/2012/08/Check-Kiting-Prevention.pdf

http://www.aicpa.org

http://www.sec.gov

http://www.thecaq.org

Using Standard Costs to Help Manage Costs

A Standard Costing System is one tool a company can is use to help manage costs. In a Standard Costing System, actual costs in the production process are compared against the standard (budgeted) cost. The difference between actual cost and standard cost is called the Cost Variance. These cost variances are examined to find out the reasons for the differences between actual versus standard costs. The differences can be favorable or unfavorable. The standard unit cost for an item is the sum of the direct material, direct labor, and factory overhead costs for producing one unit of the product.

Description of Just-in-Time (JIT) System

Description of a Just-in-Time (JIT) System

 

            A Just-in-Time system is a cost management system where cost savings are realized by providing raw materials and supplies to a manufacturing process just-in-time for them to be utilized in the creation of the finished products. Some companies, especially smaller companies with a low amount of capital can benefit by implementing a Just-in-Time (JIT) system because it creates a reduction in Inventory-on-Hand, avoiding the cost of inventory stockpiles and the cost of the rental of inventory floor space. With JIT, the floor space is freed up creating more efficiency since the extra workspace can be used for additional machinery or personnel. Improved efficiency can result in additional sales and increase asset turnover (sales/total assets) (Jessica & Sorooshian, 2013, p.89). More sales result in higher profits. Increased revenue from more sales and decreased expenses from the cost savings of implementing JIT result in higher net income.

Jessica, Y., & Sorooshian, S. (2013). To study the impact of just-in-time system. Journal of           Management & Science, 3(4), 88-90.

Financial Accounting versus Managerial Accounting

I believe that financial (cost) accounting contributes more to a company’s success than managerial accounting. Even though managerial accountants help to increase profit whereas cost accountants only calculate the bottom-line, I still believe that cost accountants are the most important. Managerial accountants could not even do their jobs without the data provided to them by the cost accountants. Managerial accounts depend on accurate, timely, and clear data in order to direct the operations of the business. Cost accountants provide this data. Also, increasingly cost accountants are asked to take a more pro-active role in management and they are part of cross-functional teams helping to make decisions based upon the information they give. For these reasons, I believe that a cost accountant contributes the most to a company’s success.

The Role of Cost Management in a Business

Managerial accounting has increasingly become more than just cost accounting. In fact, nowadays managerial accounting and cost accounting are so inter-related that it is difficult to distinguish between them. However, cost accountants are more concerned with acquiring and calculating information whereas managerial accountants are more concerned with using the information calculated (Fazal, 2011). “Today, managerial accountants serve as internal business consultants, working side-by-side in cross-functional teams with managers from all areas of the organization (Hilton, 2011).”

The role of managerial accountants in a business is to pursue the organization’s goals through the processes of identifying, analyzing, interpreting and communicating information (Hilton, 2011, p.4). In pursuit of these goals, the organization acquires resources, including human capital (labor) and then engages in a set of activities (Hilton, 2011, p.4). Management activities include decision-making, directing operating activities, planning, and controlling (Hilton, 2011, p.4). When making decisions, the managerial accountant chooses the best course of action among the available alternatives. Directing activities involves running the operations of the business on a day-to-day basis. Planning is developing a detailed financial and operational strategy. Controlling is ensuring that the organization operates according to the strategy and achieves its goals (Hilton, 2011, p.6). The objectives of managerial accounting are: 1) to provide information for decision-making and planning; 2) to assist managers in directing and controlling operations; 3) to motivate managers and employees to meet the organization’s goals; 4) to measure performance against goals; and 5) to assess the organization’s competitiveness. Assessing the organization’s competitiveness also includes working with other managers to ensure long-run competitiveness in the industry. Thus, cost accountants are now taking a more pro-active role as they are involved in both strategy and day-to-day decisions (Hilton, 2011, pp.6-7).

Fazal, H. (2011). What is the difference between cost accounting and management accounting? Retrieved from

http://pakaccountants.com/difference-cost-accounting-   management-accounting/

Hilton, R. W.   (2011). Managerial accounting: Creating value in a dynamic business environment.   Boston, MA   McGraw-Hill/Irwin.   ISBN: 978-0078110917

Suggested Improvements of SOX Legislation

One suggestion for improving SOX is to avoid conflicts of interest. SOX already prevents auditing firms from also providing consulting services. This is definitely a step in the right direction since Arthur Andersen was getting more revenue from consulting than from services (Bumgardner, 2003). But other conflicts of interest situations still exist. For instance, there is a problem with the newly created PCAOB. The five board members are not appointed by the President. The SEC does the hiring and firing. This possibly violates the doctrine of separation of powers (Sell Sarbanes, 2008). If the PCAOB is going to be an arm of the government, then it would be better if the President selected the members of the board.

            Another way to improve SOX concerns the five-year rotation of auditors. Currently, SOX requires the rotation of audit partners but they could still all be from the same firm. A better way for rotation would be to require rotation of the entire firm (Kessel, 2011, p.143).

            One area of SOX that has already been improved is protection for Whistleblowers. Whistleblowers are provided incentives and protection by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and the SEC Office of the Whistleblower. The law prohibits employers from discriminating against a whistleblower. Whistleblowers can report their claim anonymously. The Dodd-Frank Act expanded the reach of the whistleblower protections provided by SOX to include employees of public companies as well as employees of its private subsidiaries and affiliates.

            Recently, whistleblower legislation has been enhanced. On March 4, 2014, in Lawson v. FMR LLC, the U.S. Supreme Court ruled that this whistleblower protection applies not only to employees of publicly owned companies, but also to employees of privately owned contractors and subcontractors of public companies. The recent legislation on whistle-blowing represents one battle won in the ongoing fight against corporate corruption in the United States. Sarbanes-Oxley revisions like the one proposed in 2012 where Congress was poised to pass legislation that would change Sarbanes-Oxley making it easier for private companies to go public are also a way to improve SOX (Geron, 2012). “The potential legislation, which would enable companies with less than $1 billion in annual revenue to comply with certain SOX regulations after they have had their IPO, has rare bipartisan support in a divided Congress (Geron, 2012).” Finally, more revisions to SOX to help smaller companies confront the costs of SOX compliance should be implemented.

Bumgardner, L. (2003). Reforming corporate America: How does the Sarbanes-Oxley impact      American businesses? Graziadio Business Review. Retrieved from

            http://gbr.pepperdine.edu/2010/08/reforming-corporate-america/

Geron, (2012). Retrieved from

            http://www.forbes.com/sites/tomiogeron/2012/02/24/will-sarbanes-oxley-changes-help-      ipo-market/

Kessel, M. (2011). Sarbanes-Oxley overburdens biotech companies. Nature Biotechnology,

            29(12), 1081-1082.

Sell Sarbanes.(2008). Sell Sarbanes-Oxley: Editorial of The New York Sun. Retrieved from

            http://www.nysun.com/editorials/sell-sarbanes-oxley/84635/

Does SOX Implementation Present an Unfair Burden on Smaller Organizations?

Critics of SOX say it has placed an unfair burden on public companies to comply with Sarbanes-Oxley (Orin, 2008, p.143). Complying with sections 404 and 302 is costly. It is not unusual for companies to have accounting costs exceeding 1 million dollars (Kessel, 2011, p.1082). These costs become extremely difficult to pay for small companies like bio-tech companies. A bio-tech company may have $15 million in capitalization and no revenue. Small companies receive an unfair burden of the costs of SOX implementation. New laws may allow companies with less than 1 billion in market evaluation to opt out of SOX. Also there may be provisions to exempt companies for the first five years following their IPO (Kessel, 2011, p.1082). Those in favor of SOX say the benefits of the Act outweigh the costs. SOX has improved the reliability of financial reporting in public companies and left investors in a better position now than they were before SOX implementation. It has also created a heightened sense of awareness of ethical issues throughout the companies from the CEO, to the Board of Directors, to the auditor and all the way down to the employees. Critics of SOX want it revised or repealed because it is unfair to small companies.

The SEC has responded to these complaints by softening some requirements

and pushing back deadlines for others. However, it has insisted that the reasons

behind the Act are valid and that its provisions, on the whole, are in the best

interest of the country. Congress seems to agree, with no indication of repeal

(Sarbanes-Oxley, 2004).

 

Mason & Simmons (2014) describe two modes of stakeholder engagement, “Habermasian” and “Ethical Strategist.” They believed that Habermasian approach was purer in a moral sense because it required CSR decision-makers to place the importance of ethical purity over cost and alignment with strategy. In contrast, the “Ethical Strategist” approach believed there should be no distinction between morality and strategy (Mason & Simmons, 2014).

Akhigbe, Martin, & Newman (2010) found that the wealth effects of SOX were more favorable for large firms expecting to gain improvements in information asymmetry and less favorable for small well-governed firms that were likely to incur high compliance cost (Akhigbe, Martin, Newman, 2010).

Akhigbe, A., Martin, A. D., & Newman, M. L. (2010). Information asymmetry determinants of  Sarbanes-Oxley wealth effects. Financial Management (Wiley-Blackwell), 39(3), 1253- 1272. doi:10.1111/j.1755-053X.2010.01111.x

Kessel, M. (2011). Sarbanes-Oxley overburdens biotech companies. Nature Biotechnology,

            29(12), 1081-1082.

Mason, C., & Simmons, J. (2014). Embedding corporate social responsibility in corporate  governance: A stakeholder systems approach. Journal of Business Ethics, 119(1), 77-     86.

Orin, R. M. (2008). Ethical guidance and constraint under the Sarbanes-Oxley Act of 2002. Journal of Accounting, Auditing & Finance, 23(1), 141-171.

Sarbanes-Oxley. (2004). A guide to Sarbanes-Oxley section 404. Retrieved from

            http://www.soxlaw.com/s404.htm

Social Responsibility Implications Regarding Mandatory Publication of Corporate Ethics

The Sarbanes-Oxley Act requires that each company write a Code of Ethics for senior financial officers to follow (Orin, 2008, p.158). Corporate officers shall be socially responsible to employees, customers, stockholders, and other stakeholders. Prior actions by corrupt corporate officers harmed not only the reputations of their companies but also hurt investors and employees. SOX regulation was aimed at preventing management from harming society anymore in the future. Was SOX successful? Some evidence exists that shows that SOX has been effective, namely the fact that there has not been any major corporate scandal since 2002 (Orin, 2008, p.158). Senator Sarbanes among others debated the issue of whether or not SOX has been successful at a recent forum in New York called COMMIT!Forum. Senator Sarbanes said,

SOX was necessary to create ‘an indispensible safety mechanism’ that

has helped boost investors’ trust in the financial statements they reference

when investing in public companies. The law has unearthed systemic problems and nipped accounting problems in the bud,” he said (Clancy, 2012).

 

Zhang, Zhu & Ding found that SOX has been successful in establishing an independent Board of Directors. Their study of over 500 companies representing 64 different industries showed that a greater presence of outside director and women directors has led to better CSR performance (Zhang, Zhu & Ding, 2013). Cohen & Krishnamoorthy agree that SOX has been effective but say that SOX may have caused too much focus by Boards of Directors on accounting rules. With so much of their attention on the details and the specifics of following SOX rules, they may have missed important clues about the upcoming economic trouble ahead such as the Financial Crisis of 2008. Focusing so much on SOX requirements made them less like to focus on corporate strategy and such things as staying attune with technological advances and with the business environment

(Cohen & Krishnamoorthy, 2013, p.76). This leads one to question what the real motive for social responsibility should be. Perhaps the real motive for social responsibility should be to obtain profits because profits allows the company to pay its employees and distribute dividends to shareholders so they are not hurt by poor business decisions and in turn, will keep investing in our economy. So if the best way to help society is to obtain profits, then perhaps SOX has hindered corporate social responsibility.

            On the other hand, it is known that SOX has helped society in many ways. Cohen & Krishnamoorthy (2013) say it has created a team mentality between management, external auditors, and the audit committee (Cohen & Krishnamoorthy 2013, p.80). Boards are now more devoted to more compliance issues and less strategy but this has caused a reduction in risk-taking among CEO’s (Cohen & Krishnamoorthy & , 2013, p.81). However, according to Wang, Davidson & Wang (2010), evidence exists that SOX reduces investment expenditures and increases management risk aversion (Cohen, 2007). Risk aversion can stifle competitiveness. Small companies may wish to stay private and not go public in order to avoid an IPO which comes with the requirements to follow all of the regulations imposed by SOX.

 

Clancey (2012). How SOX has reshaped corporate responsibility. Retrieved from

            http://www.greenbiz.com/blog/2012/10/04/how-sox-has-reshaped-corporate-responsibility

Cohen, J. R., Hayes, C., Krishnamoorthy, G., Monroe, G. S., & Wright, A. M. (2013). The

            effectiveness of SOX regulation: An interview study of corporate directors. Behavioral    Research in Accounting, 25(1),   61-87.  doi:10.2308/bria-50245

Zhang, J., Zhu, H., & Ding, H. (2013). Board composition and corporate social responsibility:

            An empirical investigation in the Post Sarbanes-Oxley Era. Journal of Business Ethics,       114(3), 381-392. doi:10.1007/s10551-012-1352-0

Orin, R. M. (2008). Ethical guidance and constraint under the Sarbanes-Oxley Act of 2002. Journal of Accounting, Auditing & Finance, 23(1), 141-171.

Cohen, D., Dey, A., & Lys, T. (2007). The Sarbanes-Oxley Act of 2002: Implications for
compensation structure and risk-taking incentives of CEOs. Unpublished working paper, NewYork University.

Wang, H., Davidson, W. N., & Wang, X. (2010). The Sarbanes-Oxley Act and CEO tenure, turnover, and risk aversion. Quarterly Review of Economics & Finance, 50(3), 367-376.