Small Business Audits

Lisa AsherCarolyn CosgroveCameron Goddard

Laura McMartinYoomi Park

Laura Szekely

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

Agenda

• Definition Carolyn

• 6 Characteristics Carolyn

• Audit Value Cam

• Audit Plan Laura M & Lisa

• Case: SqueakyClean Yoomi & Laura S

• Conclusion Yoomi

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

What is Small Business?

• Approximately 2.25 million small business establishments

• Account for 98% of Canadian employer establishments

• Many institutions define small businesses according to their own needs– Bankers: Loan authorization of less than $250,000 – Export: Export sales under $1 million – Industry Canada: # of Employees

Annual Gross Revenue

Size of Assets

Definition

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

6 Characteristics of Small Business

For accounting purposes, a small business is best defined by characteristics, not by size or sales

volume

1) Concentration of decision making power

2) Non-complex organizations

3) Lack of formal systems and authorization procedures

4) Limited segregation of duties

5) Management override

6) Limited accounting knowledge

Characteristics

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

• Decisions made by owner/manager

• Lack of management group decision making

• Owner relies on ‘hands-on’ knowledge of the business

• Obtain outside expertise when necessary

Owner knowledge is a resource for

business knowledge for auditors and the

involvement of owner/manager can

compensate for weak internal controls

Characteristics

1) Concentration of Decision Making Power

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

• Generally less complex in organization, operations and activities

• Less accounting data generated

• Fewer product mix variables

Advantageous for auditor to obtain

knowledge and understanding of the

business during analytical review

Characteristics

2) Non-Complex Organizations

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

3) Lack of Formal Systems and Authorization Procedures

• Systems and authorization procedures are often informal and flexible

• Owner/management involvement reduces need for formal reporting systems to monitor the business

Affects the choice of audit approach

Characteristics

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

4) Limited Segregation of Duties

• Impractical to ensure incompatible duties are segregated

• Weakness that increases the chance of material misstatement

• Errors can go undetected• Irregularities can be perpetuated and concealed

• Auditor may have to rely completely on substantive testing

• Strong supervision and owner knowledge can offset lack of segregation

Characteristics

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

5) Management Override

• Potential for management to override internal controls and policies

• Weakness in small business control environment

• Increases difficulty of auditing

Auditor needs to make judgment about

degree of management override

Characteristics

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

6) Limited accounting knowledge

• Tendency of entrepreneurs is to focus on business focus on sales, marketing, products etc.

• Not necessarily focused on financial reporting and accounting procedures

• Generally a lack of qualified internal accounting personnel

Characteristics

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

PractitionerAuditor Accountable Party

Management

SubjectMatter

AccountabilityRelationship

UsersOwner managers

Financial Institutions

WrittenConclusion

The Assurance Engagement

Audit Value

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

Other Services Provided to Small Business

• Accounting

• Tax

• Business Operations

• Financial and General Business Advice

Audit Value

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

Impact on Objectivity

• The client accepts responsibility for any financial statements as the client’s own

• The member does not assume the role of employee or management and ensures that responsibility for management decisions remains entirely with management

• The member does not develop, as a result of providing other services, a relationship with the client which impairs or would be seen by a reasonable observer to impair the member’s integrity and objectivity

• The member conducts the audit or review engagement in accordance with generally accepted standards of practice of the professional

Audit Value

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

The Complaints

• Financial burden for small companies as users may not benefit from having the audited financial statements

• Internal Control systems unreliable and leads to inefficient audits

• Many reports contain qualification or reservations

Audit Value

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

The Perceived Benefits

• Why get an audit?

• Largest Factors– Prior existence of a lending agreement requiring

audited statements

– Magnitude of fees

– SOX trickle down effects

Audit Value

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

The End Result

• Hong Kong research paper concluded private companies recommended continuing with audits.

• Private Canadian firms continued with audits even though they were no longer required

BUT… maybe they don’t know better• Not aware of compilation or review

engagements which would be of lower cost

Audit Value

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

Audit Plan

Audit Plan

Step 1: Gain Understanding of Client’s Business

Step 2: Establish Materiality

Step 3: Evaluate Audit Risk

Step 4: Understanding of Control Environment

Step 5: Decision of Audit Approach

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

Step1:Understanding of Client’s Business

• Obtain a knowledge of the business that we are going to audit

• CICA Handbook standard 5140.07 “the auditor needs to understand the

industry in which the client competes, its

operations and the client’s position within the industry”

• Help to make decisions regarding the extent of the audit testing needed

Audit Plan

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

Step1:Understanding of Client’s Business

• The auditor often acts as an advisor to the client throughout the year

• Leads to the auditor becoming closely aligned with the goals and objectives of the owner/manager

• Could impair auditors “objective state of mind” –a review of previous years audit can encourage an auditing state of mind

Audit Plan

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

• Speaking with the owner/manager • Identifying controls on which to rely and for applying

analytical techniques • Improves the chances that the auditor will meet the

expectations of the client

• Understanding the current year’s audit environment • Any changes of audit significance in the operations

and activities of the business• Analysis of business and industry trends and future

plans • Obtain an understanding of the control environment

Audit Plan

Step1:Understanding of Client’s Business

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

Step 2: Setting Materiality

A misstatement or the aggregate of all

misstatements in financial statements is

considered to be material if, in the light of

surrounding circumstances, it is probable that the

decision of a person who is relying on the financial

statements, and who has a reasonable knowledge

of business and economic activities (the user), will

be changed or influenced by such misstatement or

the aggregate of all misstatements.

Audit Plan

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

• Quantitative– Materiality expressed as a percentage of adjusted

pre-tax income

– Different established materiality levels for small businesses

– Break-even point issue

• Other Factors– Documentation

– Qualitative factors

– Management of client expectations

Audit Plan

Step 2: Setting Materiality

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

Step 3: Evaluate Audit Risk

The engagement risk is generally considered lowcompared to public companies when

• Parties interested in the financial statements are limited to the enterprise’s single or few owners and a few creditors

• Absolute size of the amounts is small

• The business does not handle public money, such as trust account funds

• Management integrity is high

Audit Plan

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

Step 3: Evaluate Audit Risk

Higher engagement risk applies to a small businesswhen:

• Absentee owner• Low level of management integrity• Prospect that the business will be sold• Plan for significant financial reorganization in the

foreseeable future• Highly leveraged situation

Management Integrity (considerations):• Past experience with the client• Reliability of previous management representations• Receptivity of management to correcting discovered

errors during previous audits• Difficulties in obtaining information and responses during

previous audits

Audit Plan

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

Step 3: Evaluate Audit Risk

Audit Risks greatly depends on

• The integrity of the owner/manager

• The attitude of the owner towards controls

• The existence of factors that may motivate the owner to materially misstate the financial statements such as

• desire to minimize taxes by reducing income• inclination to charge personal expenses to the business• significant strain on the owner’s personal finances• difficulty of the company in meeting financial obligations• propensity for risk taking on the part of the owner/manager

Audit Plan

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

Step 3: Evaluate Audit Risk

Audit Risk = Inherent risk x Control risk x Detection risk

• Inherent risk - particular important because controls are often limited, requiring a high assessment of control risk• Factors in assessing inherent risk include: nature of the item,

prior experience, and use of estimates

• Control Risk - limited segregation of duties it is not unusual for an auditor to assess control risk at high and rely completely on substantive testing to reduce audit risk to an acceptable level

• Substantive Procedures - used to reduce audit risk to an acceptable level (after inherent and control risk is set)

Audit Plan

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

• Necessity to understand the entity and its control environment

• Tone at the Top = Control Consciousness

Def’: In a small owner-managed entity, direct supervision by the owner may instill an overall attitude and awareness of internal control and its importance, even though other control environment factors are not present.

Step 4: Understanding the Control Environment

Audit Plan

Definition

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Audit Value

Audit Plan

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Conclusion

Step 4: Understanding the Control Environment

Indicators of Strong Control Consciousness• Owner/Manager control functions

– Signature approval functions– Supervisory functions– Inspection functions

• Involvement in design and approval of accounting procedures

• Preventing unauthorized access and destruction

• Understanding and using financial statements

Audit Plan

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

Step 5: Decision of Audit Approach

• Substantive Only vs. Combined Audit

• Reasons for not adopting combined approach:– Substantive approach relatively easier

– Smaller number of employees can increase probability of internal control breakdown

– Risk of manager override

– Difficulty in evaluating management involvement

– Lack of documentary evidence

Audit Plan

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

Step 5: Decision of Audit Approach

• Disservice to Client

• Auditor Responsibility

Section 5220: The auditor should communicate to the audit committee or equivalent significant weaknesses in internal control which the auditor identifies during the course of the financial statement audit.

Audit Plan

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

Case Study: SqueakyClean

Case

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

SqueakyClean

• Window Cleaning Business in Kingston

• 2 Owners, 1 Manager

& 1 Part-Time Helper

• New Client: Bank’s Requirement to be Audited

• High family involvement

Case

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

SqueakyClean

– Concentration of Power

– Simple Operation

– No formal authorization process

– No segregation of duties

– Lack of accounting knowledge

Doug & Dave

ManagerAccounting

StudentsCleaning

Crews

• Cleaning• Operation

• Authorization

• Accounting

• Cash Collection

• Accounting

• Meeting the Definition of Small Business

Case

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

What factors should be considered when planning the audit of this

business? Case

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

SqueakyClean

• Step 1: Planning the Audit- Understanding the Business

• General Economic Trends• Stratgis.gc.ca Website• Local news and stories• Review of General Ledger

Difficult in Obtaining Industry

Information

Interviews with Owners and Senior

Managers

Case

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

SqueakyClean

• Step 1: Planning the Audit– Tips on Interviewing Doug and Dave

• Do not use jargons• Prepare questions• Consider objective of interview: Get Information• Corroboration: interview with both owners• Document information

– Interviewing JoeCase

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

What would you consider when setting the materiality of this audit?

Case

Definition

Characteristics

Audit Value

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Conclusion

SqueakyClean

– 5% -10% of adjusted pre-tax income

($1,360 ~ $2,720)

– Qualitative Factors• Bank Requirements

• Tax Implications for the owners

• Weak Controls

The Cleaning CompanyIncome Statement

As of December 31 (Unaudited)

Revenue $1,846,000 $1,747,000

Administrative & operating expenses $553,800 $524,100

Salary Expenses $923,000 $873,500

Operating income $369,200 $349,400

Interest expense $342,000 $321,099

Net income before tax $27,200 $28,301

Income tax expense $9,792 $10,188

NET INCOME $17,408 $18,113

• Step 2: Setting Materiality

Case

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

What are the important risk factors?

Case

Definition

Characteristics

Audit Value

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Conclusion

SqueakyClean

• Step 3: Risk Assessment– Medium Engagement Risks

– Questionable Management Integrity – High Inherent and Control Risks

LOW RISK FACTORS– Limited F/S Circulation– 2 Owners and 1 Creditor– No public money and size of transactions are small

HIGH RISK FACTORS– New Client– Pressure to get unqualified opinion– Low Owner Involvement– Time and $$ Pressure

Case

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

What are the key control issues with Squeaky Cleaning?

Case

Definition

Characteristics

Audit Value

Audit Plan

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Conclusion

SqueakyClean

• Step 4: Understanding Control Environment

Weak Internal Controls

Low Owner Involvement

No AuthorizationProcedure

Lack ofSegregation of

Duties

Indirect Owner

Monitoring

ConcentrationOf Decision

Making PowerCase

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

SqueakyClean

• Step 5: Audit Approach– No reliance on internal controls

– Substantive Audit Approach

– Focus on testing accounts relate to• Revenue

– Look for evidence of reducing revenues by the owners– Possible comparison of Revenue vs. Payroll/Service Booking– Completion: Did all services get recorded? – Existence: Are all the recorded transactions valid?

• Accounts Receivables and Payables• Expenses: May need to follow qualitative factors affecting materiality!!!!

– Big purchases authorized by Joe– Salaries to Board of Directors– Possible inclusion of Personal Expenses

– Possibility of lack of proper and accurate documentations and records to test revenues and expenses

Case

Definition

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Audit Value

Audit Plan

Case

Conclusion

Conclusions

• Importance of the owners/senior managers– Obtain industry and business information– Good way to assess entity control environment

• Limited Segregation of Duties– Small number of employees– Are there compensating controls?

• Characteristics of Small Business – Sizes and number of employees not as relevant– Variety of small business types and variety of risks– Need for Professional Judgment on setting materiality

Conclusion

Definition

Characteristics

Audit Value

Audit Plan

Case

Conclusion

Q & A