Author: C.O.R.E. Beliefs by John

To Whom does the Auditor Answer?

One of my google alerts brought an interesting article about the auditor and the relationship the audit firm has with management and the board.  It seems that many boards are concerned that the auditor appears aligned with management and not the shareholders.  This is, sadly, not a new problem, but it is one that C.O.R.E. is trying to address is our own little world of auditing.

At C.O.R.E., we understand our loyalty lies to the reader of the financial statements – that is, the shareholders.  We are engaged by the board on behalf of the owners to audit management.  Ensuring that current and prospective owners get the best information about their association is key to our success, but sometimes getting owners the best information means upsetting management.

Upsetting management, however, potentially hurts the pocketbook of the auditing CPA firm.  In many situations, management offers very profitable consulting opportunities to the auditor.  Systems design, software evaluation, and other arrangements are absolutely essential to the financial health of an organization and a CPA is highly qualified to offer those services.  The problem is the potential for the auditor to be compromised – that is, does the auditor get the consulting gig because they went soft on management?

If you don’t think it is a very real possibility think again.  Can you imagine anyone hiring a consultant who just got through bashing them?  If a CPA firm had the chance to earn $100,000 consulting with management or $30,000 auditing the client (or both hopefully), is it possible that the auditor might turn a blind eye to a problem found on audit for the chance to earn more money?

And in the small and medium sized entity market, it is potentially even more painful.  The small CPA firm gets most of its new business by referral.  But referrals are hard to come by when your work upsets management.  This has impacted us directly – we have had to issue specific communication about management violating internal control systems to an entity’s board.  The Chair of the board was also the president who hired his son, the person who broke the rules.  That organization and six other companies found a new CPA firm because they wanted someone less “negative”.   Seven entities is a lot of billing.  Financially, would we have been better off remaining silent?

This is not an attempt to justify the auditor’s failure to live up to their responsibility to protect owners and stakeholders.  An auditor who accepts a consulting job with a client needs to consider it a bribe, or worse, an attempt to make them complicit in management’s failure.  That is the auditor’s failure.

But the greater failure is on behalf of the boards of directors who have the primary responsibility to protect the shareholders.  When you ask management to interview auditors, when you accept management’s recommendation to terminate the CPA, when you accept management’s excuses for their misdemeanors, you are abrogating your responsibility.

But you can start to address the problem.  It will require boards to start holding management accountable.  And, when it comes to engaging the auditor to attest to your organization’s financial statements:

You, not management, should

  • request proposals from auditors
  • interview the auditor
  • determine if the auditor takes any fees from management for consulting
  • ask how auditors get clients – board or management referral
  • never allow management to dictate non-GAAP policies without auditor approval
  • interview new auditors every 3-5 years
  • demand that the auditor refuse to accept any consulting arrangement with management

As long as the board, or its audit committee, continues to allow management any involvement in the process of selecting, engaging and compensating auditors, this problem will not go away.  The board must make it clear to management that the auditor is the board’s tool to review management and its adherence to appropriate accounting policy and not someone who is there to help management look good.  And the board must make it clear to the auditor they look to them to protect the owners and their investment.  This is your chance to hold both auditor and management accountable, will you step up to the challenge?

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Financial Audit or Control Audit

We are often asked by boards if we believe that the management company’s processes are effective.  The answer is, we have no way of knowing as we are conducting an audit of the financial statements, not an audit of the managers’ internal control system.  To which the response is typically a look of bewilderment as most board members don’t understand the difference.

An audit of the financial statement does require the auditor to understand the internal control structure put in place by management so we can plan and perform the audit.  But what typically happens is that the auditor says, “That’s great, but we are going to assume management doesn’t follow it and plan our audit as though the system doesn’t work.”

Given the size and simplicity of the transactions in the typical association, it is faster and more effective to avoid testing the internal control system to ensure it works.  Take accounts payable; walking a single transaction through the entire control system and documenting the steps would take about an hour.  In order to rely upon the system to ensure it leads to the correct recording and reporting of the transaction we would have to test several dozen.  But, since this is a financial audit and we are concerned with ensuring that vendor invoices are reported to the correct period, we can simply review the individually significant invoices reported in the subsequent period to determine the period in which it was incurred and recorded.  We can go through the 4 or 5 invoices in about 10 minutes.

Since we didn’t rely upon the control system to ensure the invoice was recorded correctly, we completed the procedure faster and determined the results just as effectively as though we had relied upon it.  If we find invoices in the subsequent period (typically January) that should have been recorded in the prior period, we propose a journal entry.  The internal control system might have worked but we can’t say that, even if we didn’t find an invoice posted to the wrong period.

We understand that boards are concerned with the effectiveness of the internal control system and agree that it is important.  But the individual board does not want to engage an auditor to test the management company’s system.  Boards should require their management company to have a SOC audit.

A SOC, or Service Organization Control, audit is performed by an auditor on the service provider: In this case the management company.  The SOC audit ensures the appropriate controls are in place and function as required.  While there are different levels of SOC audit, the end result is the same – reporting on the effectiveness of the providers internal control system.

Frankly, state law should require a management company to have a SOC audit in addition to requiring the association to have a financial audit.  Associations which outsource the receipt and payment of funds need to know that the company they use has the right systems in place and those systems work.  The annual financial audit is not designed to offer an assurance that this is the case.

We realize that a SOC audit could be expensive.  To be honest, it might not even substantially reduce the cost of the association’s financial audit; although I think there would be some cost savings.   If a manager could produce a SOC audit which stated that the controls were in place and effective, we could probably drop our audit charge by 10-20 percent.  But beyond the potential savings you would have a strong marketing tool.

The feedback we have received is that an association board would rather have a report which says that the internal control system is in place and works.  We would like to offer this to a board but this type of report is not cost effective at the association level. But it could be at the management company level.  And it is quite possible that having a SOC audit report can help you land new clients – since everything else being equal, having a documented and tested internal control system is much more important to boards than knowing their financial statements are prepared according to GAAP.

Something to think about.

When Assessments become loans

We had an interesting one come up last week.  A 100 unit condo Association passed the following in a resolution:

  • Monthly payments of $200 per month
  • Term of the assessment is for 10 years
  • The assessment is transferred to the buyer at time of sale unless the buyer demands it to be paid in full at time of sale

This passed in February of 2016.  The association waived the 2016 audit (not wise) and then contacted us for a 2017 audit.  The dilemma?  How should this transaction be recorded?

The board and management argued that it is a monthly, on-going assessment.  But we are not so certain that is the correct way to handle it.  As we dug deeper we discovered:

  • Bank loan with a principal balance of about $1.8 Million dollars at 4.0% interest
  • Monthly payments on the loan of $20,000
  • Can pay any amount of principal after year 3 of the loan

We believed their assertion was incorrect and requested they capitalize the full receivable as a loan.  Our reasoning?

  • The present value of the payment stream could be calculated using the interest rate provided by the bank as the minimum interest charged
  • The assessment was directly tied to the repayment of the bank loan
  • The assessment was assumable but only if the buyer accepted it, otherwise it had to be paid in full at time of settlement

It is important because most state laws require disclosure of outstanding balances due from owners.  There is a huge difference between stating that the amount in arrears on an assessment is $0 and there is a $20,000 special assessment balance outstanding.  In some instances, the amount disclosed on the resale certificate is the maximum amount of liability that the buyer can assume at closing.  Management disclosed the seller’s maximum amount due on the disclosure.

Finally, since the buyer could assume, but didn’t have to, all the available evidence indicated that it should be treated as a loan to the owners.

Now there is a 10 year receivable to record.  There is interest to charge to the owner which splits their payment into two parts – principal and interest.  And because they didn’t adjust it correctly for 2016, the Association’s cost for the financial statement is going to almost double to correct for the prior year.

All of this could be avoided by consulting with a CPA firm which specializes in association (CIRA) accounting and auditing.  If you are a board that is looking at doing something that hadn’t been done before, it will be well worth the few hundred dollars you will be charged to get an idea of the complexity involved in accounting for the activity.  Can your management handle this type of transaction?  Will their software perform the calculations correctly?  How will our reports change?  All of this is as important as making sure you legally dot your “I’s” and cross your “T’s”.  Otherwise, don’t be surprised when your auditor says, “No, sorry it can’t work that way.”

Ask your accountant or feel free to reach out to us.  We are happy to assist you in any way we can as a little work up front can stop a landslide later.

At C.O.R.E. Services, we focus on being a strong independent check on management and their assertions. Which is why we enjoy working with Property Owner Associations. The boards are dedicated but typically outsource the management who record the transactions and prepare financial statements for the board to review. Our audits are designed to help the board and owners rely upon those statements. You can find more information about us on our website.

You take the left, I’ll take the right

I recently finished re-reading Michael Gerber’s “The E-Myth Revisited”.  It is one of my go-to books whenever I find an organization that appears to be dysfunctional.  I find myself using parts of his model on my own organizations – since typically professional firms believe everyone should do everything.  This isn’t to knock professional firms but this approach is the single biggest obstacle to healthy and effective growth that I know.

“You take corporations and I take LLC’s”, seems like a great business model for accountants but it is simply a permutation of the “You take the left and I take the right” approach to management.  It doesn’t address the actual needs of the business and it doesn’t leave room for growth.  How do you hire an employee to fit that sort of arrangement?

It is even worse for other types of businesses.  I have worked hard to try and straighten out small businesses who grew into a disaster.  It is in those instances that I find comfort in the E-Myth; technicians who didn’t want to work for a boss suddenly have the worst boss in the world and so do his 12 employees.  All of whom are stepping on each other, tripping over inventory, losing tools, upsetting customers and generally eating up profits.

And in the meantime the owner is working 14-16 hours a day 7 days a week. Until he collapses.  What was the owner doing in those hours?  Everyone else’s job.

Organization, structure, discipline are tough to live with.  I get it.  As Mr. Gerber implies, you start your business because you want to simply work – you want a job.  You want to do it your way, meeting your customers needs by you always being available.  And, as he points out, it can’t work.  You simply don’t know it yet.

The problem is inertia.  Actually, that isn’t true.  The problem is the owner-technician’s inertia.  Try to take the owner out of the picture and you are accused of planning a mutiny.  Never mind the reality that the owner has already lost control; he talked to a friend who had a buddy who hired a consultant and that consultant ended up buying the company for almost nothing.  Never mind the reality that a company built around the owner is worth almost nothing.

Are you looking at a situation like that?  Are you the sole owner-technician of a small business where it seems that you re-do everything your employees already did?  Do you feel you are the only person qualified to make a sales call?  To build the widget?  To make a collection call?

Perhaps you are in a partnership and hoped that by making your best friend/employee an owner she would work 140 hours a week just like you?  Re-doing everything someone else already did, calling the same customers, shipping extra widgets…

This is where I depart from the E-Myth.  The author makes it sound like you can be down this path and somehow recover.  Sorry, it simply isn’t going to work that way.  Inertia is working against you.

Think about it.  You hired a bookkeeper because you hated doing the books and it ate into the time to make a sales call and build the product.  You still hate doing the books plus you don’t know how.  And if you do the books who will make the sales calls?  And don’t even get you started on sales people:  They make deals that you can’t keep and then they leave and take the customer.  No, it is better if you keep things they way they are and just work harder, right?

No.  It is not better; not for you, not your business, not your employees.  You can make the change but you can’t fight the inertia.  You may, however, be able to start deflecting your path.  The goal is not to slow you down but rather start changing the direction so that you start going in the direction you want.

More on this in my next article.  Have a great day.