Solving the documentation dilemma.by Wallis, Lloyd
In the next room, Steve Staff has just finished the cash work on the Smith audit. Steven had located an unrecorded service charge and had proposed an adjustment. In addition, Gale had given Steve a few review notes concerning program steps left unsigned and inadequate explanations for some of the procedures performed. After reviewing Steve's corrections, Gale files away the working papers.
Our story now jumps ahead nine months. Thomas & Company is undergoing its triennial quality review. The team captain has selected the Smith audit as one of several engagement to be reviewed as a basis for determining whether the firm's audits were well-planned, appropriately executed, suitably documented, and performed in accordance with professional standards and the firm's quality control policies and procedures. After reviewing the engagement's working papers, the team captain finds no problems with the firm's cash work but has a number of questions regarding the adequacy of the firm's work related to the receivables and inventory accounts.
Specifically, the team captain is concerned about the scope of the firm's procedures in light of the sizable increases in both accounts. The firm's working papers fail to indicate any expanded procedures or considerations. The lack of documentation of these significant engagement matters has presented the team captain with the difficult task of determining whether this is evidence of a deficiency in the firm's audit work or a matter or adequate, but undocumented, performance.
During a lengthy, and at times tense, meeting with the team captain, Gale relates how her decisions were influenced by her long association with the client, her knowledge of the industry and the company's operations, and the dollar amount of any potential adjustments. Based on these discussions, the team captain is satisfied that, although not documented, the firm's procedures were adequate to support its opinion on the financial statements.
Organizational Structure and Working Papers
CPA firms and audit teams organizationally resemble a pyramidal structure in which each level is differentiated by the characteristics that define the staff members' work environment and engagement impact. The lower the member's organizational position the more focused the audit effort, the more structured the procedures performed, the more concrete the evidential matter gathered, and the less judgmental the decisions made. On the other hand, the decisions and judgments of the firm's senior members have the most pervasive effects on the audit, are the least mechanical, involve less persuasive evidence, and require the greatest amount of professional expertise.
Unfortunately, frequently recurring findings in peer and quality reviews relate to the lack of evidence of compliance with professional standards. It is important to note that these deficiencies do not relate to the quality of the auditor's work product but with the failure of the working papers to demonstrate an adherence to professional standards. A common element to these findings is in the fact that the omitted documentation relates to matters most appropriately addressed by the audit team's senior and supervisory personnel.
When this documentation pattern is pointed out to practitioners, their responses tend to fall into one of two groups. There are those who profess that they do not document because they do not want to include anything in the working papers that may prove detrimental to their defense in the event of litigation. The second group maintains work paper documentation is a natural consequence of the supervision and review processes within a firm. Those lower in the organization have more opportunities for their work to be scrutinized and documentation added.
Surprisingly, this lack of documentation of significant engagement matters comes at a time when many in the profession are advocating more extensive documentation as an element in a firm's plan to manage its litigation risk. One step toward improving audit documentation may be a better understanding of the role and importance of working papers in the audit process.
The Role of Working Papers
In the typical audit engagement, the auditor's objective is to express an opinion on the fairness with which the entity's financial statements are presented in accordance with generally accepted accounting principles (or any other comprehensive basis of accounting). The auditor has a responsibility to plan the audit to provide reasonable assurance of detecting errors and irregularities that are material to the financial statements. Most of the auditor's work focuses around obtaining and evaluating evidential matter concerning the assertions encompassed in the financial statements. The amounts and kinds of evidential matter required to support an informed opinion are based on the auditor's professional judgment after a careful review of the circumstances associated with the engagement.
Working papers are both a product of, and a significant element in, the audit process. They serve as the link between the planned procedures, the tests performed, the information obtained, and the conclusions reached. In other words, working papers are the principal record of the auditor's work and the conclusion reached concerning significant matters associated with the engagement.
One of the main purposes of working papers is to provide the principal support for the auditor's report, but they also serve as a record of the auditor's compliance with professional standards. The quantity, type, and content of working papers will vary with the circumstances associated with the engagement. Working papers, however, should demonstrate the auditor's work was planned and supervised; they should indicate that the audit plan was based on an understanding of the client's internal control structure; and they should show the evidential matter afforded a reasonable basis for the firm's opinion.
While relatively few in number, the working papers should include documentation of all matters specifically prescribed by professional standards (e.g., those set forth in SAS No. 41, Working Papers and SAS No. 55, Consideration of the Internal Control Structure in a Financial Statement Audit), the oral communications to audit committees regarding illegal acts and reportable conditions, and written representation from management. In addition, engagement matters that are material and pervasive or highly judgmental should be documented. The auditor's task is to leave a record of what was done and why it was done.
Every audit includes decisions and judgments that have a pervasive effect on the engagement in general or on a specific account. For example, audit planning includes an assessment of factors influencing the risk of material misstatement. This process includes obtaining an understanding of the client's internal control structure, applying analytical procedures, as well as gathering information about the entity's industry and operations. From this information base, the auditor develops a strategy as well as plan for the nature, timing, and the extent of the procedures designed to gather evidential matter for specific accounts. The auditor's working papers should document this information foundation, the audit planning decisions that it influenced, and how the plan was responsive to the circumstances.
Decisions concerning materiality not only have a pervasive effect on the audit planning function but also influence the auditor's final consideration on the presentation of the financial statements. Planning materiality is primarily a quantitative determination; however, materiality decisions during the engagement's final review stage should address both the quantitative and qualitative aspects of the matter under consideration. The auditor's working papers should include a record of factors considered in both types of materiality decisions.
Decisions that are heavily based on the auditor's professional experience and judgment should be documented in the working papers. In many instances, the auditor's conclusions are the result of a critical evaluation of evidential matter of assorted degrees of relevance and reliability rather than an objective set of facts and circumstances. The auditor's judgment is what links together these evidential fragments to form an overall conclusion. The working papers should provide a record of the auditor's decision process and the factors considered.
In addition to the general guidance discussed above, certain engagement situations require special documentation considerations. The client's management is a source of both primary and corroborating evidential matter. Accordingly, the substance of important meetings and discussions with client personnel should be documented in the working papers. A record should be made of both the information the client provided to the auditor and the matters that the auditor conveyed to the client. Both elements are critical if the need ever arises to reconstruct the meeting. Care should be taken, however, to avoid including any derogatory remarks or comments that could be later misinterpreted or taken out of context. The resolution of unusual engagement matters should be documented. If the planned audit procedures produce inconsistent of unusual results, the working papers should include a discussion of what was done and how the issue was resolved. The auditor's task is to leave a record documenting the fact that the matter was not ignored and follow-up procedures were performed.
It is not uncommon for the auditor to encounter an accounting or reporting situation that is not specifically addressed in the standards. Perhaps the complexity or uniqueness of a client situation makes the propriety of its accounting treatment less than obvious. In such instances, the auditor's working papers should adequately document the consultation process undertaken to resolve the matter. Documentation should include the authoritative sources consulted and address not only the position adopted but also any alternative treatments. The focus of the documentation, however, should be on the arguments and logic supporting the position taken while demonstrating competing positions were considered.
Practice aids and preprinted schedules can significantly enhance the documentation process, however, care should be taken to include supplemental information where appropriate. For example, many generalized audit programs include broad procedures such as requiring the auditor to make certain inquiries of management or to determine whether certain steps were taken. While signing off the program indicates the action was taken, the failure to include the additional information leaves an incomplete record of the auditor's work.
Certain aspects of the audit by their nature require more extensive documentation. For example, sampling applications should include the documentation of such matters as the purpose of the test, the population tested, the sample size determination, the procedures performed, the results of the test, and a projection of the sample results to the population. Likewise, the use of analytical procedures as substantive tests require the auditor to obtain other evidential matter to corroborate management's responses concerning significant unexpected differences. The auditor should develop a sensitivity to situations where a record of the process is at least as important as the final determination.
The results of quality and peer reviews suggest that many practitioners need to improve their work paper documentation. Efforts to enhance work paper documentation can be coupled with and incorporated into the consultation, supervisory, and professional development elements of a firm's quality control policies and procedures.
Specific documentation guidance should be developed for all firm personnel to use when consultation is required for an accounting or reporting issue. In addition to reviewing the appropriateness of the "researched" solution, the engagement personnel should consider whether the consultation process has been adequately documented. Incorporating subordinate members of the engagement team into many of the decision- making and judgmental aspects of the audit creates an opportunity for the engagement's supervisory personnel to delegate documentation responsibilities. This process can enhance the professional development of staff members while freeing the firm's more senior members from the actual task of creating the documentation. Such an approach, however, places a greater supervisory responsibility to review the subordinate's work to ensure the documentation correctly reflect the logic and evidence supporting the firm's decisions.
Many firms have incorporated second partner or concurrent reviews as a component in their quality control policies and procedures related to the supervisory element. The scope of these reviews should be expanded to include consideration of both the product of the audit (i.e., the financial statements and report) and the process. The reviewer should consider assuming the role of a devil's advocate and question whether the work paper documentation can support such a challenge.
To be cost efficient a documentation policy should be implemented in conjunction with risk assessment techniques. The risk analysis, which is the foundation of the audit, should be documented in the working papers along with the necessary expanded documentation in those emphasized areas that present the greatest audit risks.
James Schmutte is professor of accounting at Ball State University. Lloyd Wallis, CPA, is a partner of Gaither Rutherford & Co., and former chair of the Indiana Quality Review Committee.
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