Accounting practises: Why auditing of smaller firms can be tougher

By Kazim Alam, The Express Tribune

KARACHI: The single most difficult aspect of auditing a small business can be the ignorance of the business owners and managers when it comes to standard accounting practises and financial statements.

That, at least, is the assessment of Phil Cowperthwaite, a Canadian chartered accountant and member of the International Auditing and Assurance Standards Board (IAASB) steering committee who was addressing a workshop titled “Auditing micro entities effectively and efficiently” at the Institute of Chartered Accountants of Pakistan (ICAP) headquarters in Karachi on Friday.

Highlighting the differences between auditing processes for micro and macro entities, Cowperthwaite said it was unlikely for a small firm to have a chief financial officer. Indeed, many a time, the auditors themselves had a role in preparing the financial statements.

“The one or two managers running the micro entity may know the business really well, but they can be totally clueless about financial statements,” said Cowperthwaite.

Most of the issues in auditing smaller entities generally tend to come out of their tendency not to use accrual-based accounting standards. Simply put, most small businesses record only inflows and outflows, rather than allocating cash for expected outflows and taking into account non-cash expenses. As a result, many tend to overestimate their incomes, which can be a business risk, as well as a challenge for auditors.

From an auditor’s perspective, the main high-risk areas in micro entity audits, according to Cowperthwaite, are fraud, deferred revenue, salary allocations, tax compliance, sales tax issues and related party transactions.

More than most large businesses, smaller entities tend to be susceptible to fraud by their own employees due to a lack of established financial control mechanisms, making it challenging for auditors, since many small companies essentially begin looking to them to act as their fraud control mechanism.

Tax compliance is another big issue, since many firms are either unaware of tax regulations or seem rather keen to fly below the radar and avoid paying taxes altogether.

The Canadian expert, however, pointed out that many accounting regulations simply did not apply to small firms. Cowperthwaite noted that a third of them didn’t apply to micro entities. “The International Standards on Auditing (ISA) are so long because they cover every type of audit engagement and every size of reporting entity for all countries of the world,” he said, referring to the 800-page guide for auditors worldwide.

Nevertheless, he was keen to highlight the importance of those standards, perhaps as a member of the body that creates them. “You won’t ever trust an architect who hasn’t read the building code properly. Similarly, you can’t trust an auditor who hasn’t read the ISAs in detail,” he said while referring to 36 standards along with International Standard on Quality Control (ISQC 1), the professional standards for the audit of financial information, which are issued by the International Federation of Accountants (IFAC) through the IAASB.

Cowperthwaite also spoke about some of the differences in accounting practises and accounting firms in Pakistan and their counterparts in Canada, cracking some jokes that would be funny only to an accountant.

“In total contrast to Canada, a high-risk transaction in Pakistan is one which is not a related party transaction,” he said in what was to him (and most of the audience) a lighter vein.

He said professional standards and objectives for auditors were similar in Canada and Pakistan. However, he said the two countries used different staffing models, as Pakistani auditing firms employed a higher number of staff members. Also, he said Pakistani clients changed auditors more often than their Canadian counterparts.

“Focus on reducing your audit engagement risk, improving communication with your client, and increasing recoveries,” he recommended.

Published in The Express Tribune, January 14, 2012.

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