Or — Things That Make You Go “Humph”
The majority of construction companies are private entities closely held by a small group of owners engaged in management. Many owners/managers began the company from scratch and remain active in the company’s day-to-day operations. While very competent in their chosen trade, many are not as comfortable or interested in the accounting related to their construction activities, except for tax savings and strategic planning.
Some construction companies choose to have an annual financial audit. However, most have an audit because it is required by the company’s surety, banker, or a governmental entity. Therefore, audits may be viewed as a necessary but inconvenient part of business ownership.
This article describes and attempts to explain the reason for certain aspects of a construction financial audit that may puzzle or even exasperate operational personnel.
CPA Independence and Professional Skepticism. “Why does the auditor check out the things I tell him? I’ve always been straight with him.” Auditors make a significant amount of inquiries. However, auditors are generally not permitted under generally accepted auditing standards (“GAAS”) to rely on inquiry alone, despite management’s trustworthiness.
The CPA who audits financial statements is required under the AICPA Code of Professional Conduct to be independent. What does independent mean? It means that the CPA is an advocate of his/her own opinion, not management’s opinion. At times, this opinion may be contrary to the views of the company’s management. The end-users of the financial statements expect this independence. Without independence, the assurance provided to the end-users regarding the fairness of the financial statements is useless.
At the heart of this assurance is what is known as professional skepticism. Professional skepticism is defined as “(A)n attitude that includes a questioning mind, being alert to conditions that may indicate possible misstatements due to fraud or error, and a critical assessment of audit evidence.” (AU-C § 200.14). Under the concept of professional skepticism, “(T)he auditor neither assumes that management is dishonest nor assumes unquestioned honesty.” (AU-C § 200.A26). Management could misunderstand professional skepticism as distrust or implication of misdeeds. However, it’s an audit state of mind that perhaps can be best summed up by an old Russian proverb often spoken by President Reagan, “Trust but verify.”
Financial Statement Materiality and Audit Sampling. “The auditor is chasing a small amount that makes little difference – who cares?” At times, management may question why the auditor is raising questions about a small dollar amount. There are two possible explanations. One relates to materiality, and the other to audit sampling techniques.
Materiality is an essential concept in the financial audits of construction companies. Without the materiality concept, audits would never be completed or take much longer than they do. Everything cannot be audited, so auditors use materiality and risk assessment to sort through and determine what should be examined. But it’s not as simple as it may seem.
Materiality is used to determine which financial statement areas should be examined and to evaluate potential misstatements identified during an audit. “In general, misstatements, including omissions, are considered to be material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users that are taken based on the financial statements.” (AU-C § 200.07). However, materiality involves both a quantitative and qualitative analysis. Accordingly, materiality is determined by both the size and the nature of the misstatement. For example, a small amount may be considered material if the misstatement is related to fraud, such as cost-shifting from one project to another. Additionally, a slight variance may be significant if it results in a loan covenant violation or places project managers in a lower or higher bracket for bonus calculation.
The nature of audit sampling drives another reason an auditor may examine a small dollar item. Certain approaches to audit sampling will result in both large and small amounts selected for testing. Any misstatements that are identified in the sample are then extrapolated to the population as a whole. While this saves considerable time because an entire population is not tested, it may result in questions about smaller dollar items.
Fraud Inquiries. “Why was I selected for an interview? Does the auditor think I’m stealing?” GAAS requires auditors to inquire of those charged with governance, management, and others in the company whether they have any knowledge of fraud. (AU-C §240.18 &.21). The auditor performs these inquiries as part of the risk assessment related to fraud and compliance with laws and regulations. In a standard financial audit, and almost without exceptions, those chosen for interviews are not suspected of fraud. They are chosen primarily because of the type of job duties they perform (accounting, shipping and receiving, project management, CFO, etc.). The focus is to inquire of personnel who are in a position to observe a broad spectrum of situations and events, including some that give them concern. The fraud interview is a forum that allows them to voice those concerns in a non-threatening conversation.
Unpredictable Audit Procedures. “No auditor has ever done this before. Why is it necessary this time?” Doing an unexpected procedure, or performing a routine procedure at an unexpected time, for example, is a requirement of GAAS. (AU-C §240.29c). Performing an unpredictable audit procedure “…is important because individuals within the entity who are familiar with the audit procedures normally performed on engagements may be better able to conceal fraudulent financial reporting.” (AU-C §240.A42). The reason is no more complicated than that. Auditors are required to mix things up as a safeguard to thwart those who may be inclined to commit fraud.
Audit Scope Limitation. “I’m not sure we want to pay you to do that audit procedure.” If you’ve been in the audit business long enough, someone in management has probably non-maliciously suggested that an audit procedure is unnecessary. And truthfully, that is management’s prerogative. If management communicates to the auditor that he/she not do a particular audit step, the auditor must abide by their wishes. However, if the auditor cannot obtain sufficient audit evidence due to management’s prohibition, the auditor may have a scope limitation.
A scope limitation occurs when “the auditor is unable to obtain sufficient appropriate audit evidence to conclude that the financial statements as a whole are free from material misstatement.” (AU-C §705.07b).
A scope limitation is not a good thing. If the auditor cannot obtain sufficient appropriate audit evidence to base an opinion but concludes that the possible effects, if any, on the financial statements could be material but not pervasive, he may qualify his opinion on the financial statements.
Or, if the auditor concludes that the effects, if any, on the financial statements could be both material and pervasive, he may go so far as to disclaim an opinion on the financial statements as a whole.
Neither option is beneficial to the company. The best approach is to politely explain the consequences of a scope limitation to management and request that the audit procedure be permitted.