Explaining the virtues of testing

One of the most challenging aspects of my job as a public accountant and auditor is explaining to clients why I’d like to do what I need to do.

Frequently you’ll find in your position as the auditor that client employees will enjoy seeing you twist in the wind and will find the most effective way to cause this is to ask you to justify the test you’re performing.

To juniors, this is kryptonite. They won’t be able to. They simply don’t have a clue. The keeners will try, and they might get far, but to the seasoned client employee, they will always be able to stump the junior auditor.

The key to counteracting this situation is to fall back on the assertions. Existence, completeness, accuracy, valuation. (There are others, but those four are key.) Explain how the test relates to the assertions for the given balance or transaction stream being tested.

This has two possible effects (both good): The client will understand why you’re doing the test, or they will have a better way to test the assertions you’ve mentioned.

And if you can explain the test to the client with reference to the assertions being tested, then you’ll better understand the test itself and be able to perform it more efficiently and identify errors if encountered. It’s a win-win.


Are small-caps better served by mid-size firms?

A little late, but a blog post at about the level of service a small-cap public company can expect to receive from a Big Four auditor compared to a mid-size firm seemed interesting enough to share: reader Kunal Ganguly wrote us to say a company of Catapult’s size, with its $102 million market cap, shouldn’t have been using a giant like Deloitte anyway. A local firm would be a better fit because it likely has more experience handling companies of a smaller size, he thinks. Adds accounting professor Zafar Iqbal: “[Smaller] public accounting firms have more experience with, and better knowledge of, the needs of smaller clients. Thus they are in a position to add more value.”

Catapult Communications is a US company based in California that recently announced it was switching from Deloitte to Stonefield Josephson and saving roughly 45% of their usual audit costs to do so. To be honest when I first read about the move it didn’t strike me as all that remarkable. Companies change auditors and save money doing so all the time. Not 43 to 49% of fees, sure, but it wasn’t as if the sky was falling.

Truth is, the stories in the media made this all about the money, which is why the blog post was special. It focuses on the quality of service and expertise Catapult and other smaller companies can expect to receive from a non Big Four audit firm. Something to think about, if you’re in the market for assurance services.


Enron chronicle provides some holiday reading

I have been on vacation for the last half of this month, and that along with Christmas has resulted in much less activity on this blog than is normally seen.

Additionally, I have been immersed in a great book on the Enron scandal, titled “The Smartest Guys In the Room: The Amazing Rise and Scandalous Fall of Enron.”

The book was originally published in 2003, but was recently republished with an extra chapter. “Now includes the Enron trial and the death of Ken Lay,” the cover advertises.

I’m a little surprised I haven’t read a book on Enron until this point, given how fascinating the fraud is to me. I thoroughly enjoyed it.

The book is accessibly written. You don’t have to be an auditor to undeerstand what caused Enron to implod. That sort of disappointed me – the book didn’t go into enough detail for my liking. But they know their audience, which isn’t exclusively the audit profession.

I was hoping to see some debits and credits and maybe even a T-account or two, dissecting each transaction of each special-purpose entity (SPE) in painstaking detail, but I was out of luck.

I won’t go into too much more detail at this point, as I will pull out some of the more memorable passages in future posts and discuss them there.

Suffice it to say the book was awesome and I recommend it to everyone, not just auditors.


Taking the wraps off materiality

Materiality is an important concept in auditing. The point of an audit is to certify the financial statements as being free of material misstatement. A material misstatement is one which would affect the decisions of a user of those statements.

This recent blog post at the VeraSage Institute, more known for their pioneering work in the area of value pricing for professional services firms than their work revolutionizing the audit report, brings up an interesting idea:

During a specific conversation on materiality and how it should be determined I suggested that maybe the first step to improving our audit reports would be to include the level of materiality used in performing the audit.


Would the reader of audited financial statements utilize and appreciate knowing the level of materiality used to test and determine the correctness and completeness of the associated financial statements?

I think it’s pretty clear that the answer is yes. I also think it would go a long way to closing the expectation gap when it comes to audited financial statements. It further emphasizes that an audit doesn’t mean 100% of transactions are examined, and that there is a level of acceptance for errors within the statements.

Unfortunately, it doesn’t seem to me (with my limited experience) that much is done within the profession until it is mandated by the governing bodies or various governments. Going above and beyond what is required isn’t seen very frequently in terms of the disclosure in financial statements, either in the audit report or the explanatory notes appending the statements.

I don’t think it is entirely the auditor’s fault. The statements are still the responsibility of management, but it is the auditor who is in the unique position to make the suggestion to management that additional details would be helpful. For that matter, auditors need to start making the suggestion to their governing bodies as well.

We’re essentially in the business of ensuring that complete and useful information is provided, and this might be a situation where we aren’t doing a great job.


Value creation mode isn’t just from 9 to 5

I was recently asked what I thought about value pricing as it relates to professional services firms. The billable hour is typically how firms price their engagements, but the idea of value pricing is gaining momentum and acceptance is growing.

I believe in a competitive market, value pricing would occur naturally. Misinformation from vested interests in the status quo and professional inertia are slowing the evolution of the audit market into one priced on value.

That being said, value pricing is the only way a product like an audit should be priced.

When I’m truly creating value, it doesn’t occur according to the clock. I’m not necessarily in “value production mode” from 9AM to 5PM, Monday to Friday. Eureka moments occur in the middle of the night when I’m getting a glass of water, or when I’m shampooing my hair in the morning.

They follow no schedule, and they take no time to create. They are split-second flashes of inspiration that can transform the quality of an audit, but for which the widely used time-based model attaches no value.

Further, the value of individual audit tests stems from the design of the test, which may take time but certainly isn’t defined by it. Actually performing the test will take time but it is only worth the results it provides. A five hour test may be better than one that takes an hour, but there are no guarantees.

The greatest advantage for firms is growth through retaining current clients and earning new ones through referrals. But a secondary incentive will be growth by retaining the best staff and motivating them to develop professionally and build strengths they’re passionate about into niches.

Value pricing for clients is one thing, but firms will need to push to establish its concepts within an existing culture. There is still a strong belief that hours worked equals audit “production”. The firm that is value priced both externally and internally will get the most out of it.