Auditing standards require auditors to identify and assess the risks of material misstatement due to fraud and to determine overall and specific responses to those risks. Here are some answers to questions about what auditors assess when interviewing company personnel to evaluate potential fraud risks.

What’s on your auditor’s radar?

When planning audit fieldwork, your audit team meets to brainstorm potential company- and industry-specific risks and outline specific areas of inquiry and high-risk accounts. This sets the stage for inquiries during audit fieldwork. Entities being audited sometimes feel fraud-related questions are probing and invasive, but interviews must be conducted for every audit. Auditors can’t just assume that fraud risks are the same as those that existed in the previous accounting period.

Specific areas of inquiry under Clarified Statement on Auditing Standards Section 240, Consideration of Fraud in a Financial Statement Audit, include:

• Whether management has knowledge of any actual, suspected, or alleged fraud,
• Management’s process for identifying, responding to, and monitoring the fraud risks in the entity,
• The nature, extent, and frequency of management’s assessment of fraud risks and the results of those assessments,
• Any specific fraud risks that management has identified or that have been brought to its attention,
• The classes of transactions, account balances, or disclosures for which a fraud risk is likely to exist, and
• Management’s communications, if any, to those charged with governance about its process for identifying and responding to fraud risks, and to employees on its views on appropriate business practices and ethical behavior.

Fraud-related inquiries may also be made of those charged with governance, internal auditors, and others within the entity. Examples of other people that an auditor might ask about fraud risks include the chief ethics officer, in-house legal counsel, and employees involved in processing complex or unusual transactions.

Why are face-to-face meetings essential?

Whenever possible, auditors meet in person with managers and others to discuss fraud risks. That’s because a large part of uncovering fraud involves picking up on nonverbal clues.

Nuances such as an interviewee’s tone and inflection, speed of response, and body language provide important context to the spoken words. An auditor is also trained to notice signs of stress when an interviewee responds to questions, including long pauses before answering or starting answers over.

In addition, in-person interviews provide an opportunity for immediate follow-up questions. When a face-to-face interview isn’t possible, a videoconference or phone call is the next best option because it provides many of the same advantages as meeting in person.

How can you help the process?

While an external audit doesn’t provide an absolute guarantee against fraud, it’s a popular — and effective — antifraud control. You can facilitate the fraud risk assessment by anticipating the types of questions we’ll ask and the types of audit evidence we’ll need. Forthcoming, prompt responses help keep your audit on schedule and minimize unnecessary delays. Contact us for more information before audit fieldwork begins.

How often do you reconcile your company’s internal financial records against your bank statements? Bank reconciliations are an essential internal control procedure that busy owners and managers sometimes overlook or neglect. Here’s why it pays to perform them regularly.

Operational benefits

Weekly or monthly bank reconciliations can improve the accuracy of your company’s financial records. You may uncover errors and omissions, allowing you to take corrective measures before internal problems spiral out of control. Bank reconciliations can also be an effective antifraud control. In addition to revealing fraudulent transactions, bank reconciliations may deter dishonest workers from engaging in criminal activity because they know someone is checking their work.

Moreover, bank recs improve accounts receivable management. For instance, if you notice bounced checks and bank overdraft fees when reconciling deposits, you might consider changing the credit terms for certain high-risk customers.

The reconciliation process

Typically, a bank reconciliation statement starts with the cash balance from the bank statement. After adding deposits in transit and subtracting outstanding checks, you’ll arrive at the adjusted bank balance. In other words, you’re adjusting the bank balance for transactions entered in the company’s books but not yet posted to the bank account.

Next, reference the checking account balance from the company’s accounting records. You’ll arrive at the adjusted book balance after adding interest income and subtracting bank fees. The bank has posted these transactions to the account, but they aren’t yet recorded in the general ledger.

The adjusted bank balance should equal the adjusted book balance. If not, you’ll need to determine the source(s) of the discrepancy.

Automation tools

Accounting software dramatically simplifies the bank reconciliation process by automating much of the matching and reporting. However, it’s not entirely hands-off. Regular review and manual adjustments may still be necessary to ensure accuracy and address discrepancies.

For example, manual review is often necessary for certain transactions that may be unrecognizable due to:

• Discrepancies in dates, amounts, or descriptions,
• Bank errors,
• Duplicate transactions, and
• Adjustments for such items as bank fees, interest income, or manual journal entries.

Initially, accounting personnel may need outside help setting up rules within the software to categorize recurring transactions.

Business intelligence

Reviewing the reports generated by your accounting software can help you manage cash flow more effectively and detect fraudulent activity. For example, you may unearth unauthorized transactions, altered checks, or phishing scams targeting the business’s account.

It’s critical to report fraudulent automated clearing house (ACH) transactions immediately. Reporting timeframes may vary by bank and jurisdiction, with some requiring notification within 24 hours. Notification for fraudulent checks is typically 30 to 60 days but can vary by state and financial institution. The sooner you report fraudulent transactions, the better. It will give you and your bank more time to protect your funds, including closing existing accounts and opening new ones.

From discrepancy to clarity

Regular bank reconciliations are more than bookkeeping tasks — they’re crucial for safeguarding a business’s financial health and operational integrity. Contact us for more information. We can help streamline the reconciliation process, determine the sources of hard-to-find discrepancies, and investigate suspicious activity.

Owners’ equity is the difference between the assets and liabilities reported on your company’s balance sheet. It’s generally composed of two pieces: capital contributions and retained earnings. The former represents the amounts owners have paid into the business and stock repurchases, but the latter may be less familiar. Here’s an overview of what’s recorded in this account.

Statement of retained earnings

Each accounting period, the revenue and expenses reported on the income statement are “closed out” to retained earnings. This allows your business to start recording income statement transactions anew for each period.

Retained earnings represent the cumulative sum of your company’s net income from all previous periods, less all dividends (or distributions) paid to shareholders. The basic formula is:

Retained earnings = Beginning retained earnings + net income − dividends

Typically, financial statements include a statement of retained earnings that sums up how this account has changed in the current period. Net income (when revenue exceeds expenses) increases retained earnings. Conversely, dividends and net losses (when expenses exceed revenue) reduce retained earnings.

Significance of retained earnings

Lenders, investors, and other stakeholders monitor retained earnings over time. They’re an indicator of a company’s profitability and overall financial health. Moreover, retained earnings are part of owners’ equity, which is used to compute certain financial metrics. Examples include:

• Return on equity (net income/owners’ equity),
• Debt-to-equity ratio (total liabilities/owners’ equity), and
• Retention ratio (retained earnings / net income).

A business borrower may be subject to loan covenants based on these ratios. Care must be taken to stay in compliance with these agreements. Unless a lender waives a ratio-based covenant violation, it can result in penalties, higher interest rates, or even default.

Retained earnings management

Profitable businesses face tough choices about allocating retained earnings. For example, management might decide to build up a cash reserve, repay debt, fund strategic investment projects, or pay dividends to shareholders. A company with consistently mounting retained earnings signals that it’s profitable and reinvesting in the business. Conversely, consistent decreases in retained earnings may indicate mounting losses or excessive payouts to owners.

Managing retained earnings depends on many factors, including management’s plans for the business, shareholder expectations, the business stage, and expectations about future market conditions. For example, a strong retained earnings track record can attract investment capital or potential buyers if you intend to sell your business.

Warning: Excessive accumulated earnings can lead to tax issues, particularly for C corporations. Federal tax law contains provisions to prevent corporations from accumulating retained earnings beyond what’s reasonable for business needs. We can prepare detailed business plans to justify an accumulated balance and provide guidance on reasonable dividends to avoid IRS scrutiny.

For more information

Many companies consider dividend payouts and plan investment strategies at year-end. We can help determine what’s appropriate for your situation and answer any lingering questions you might have about your business’s statement of retained earnings.

A chart of accounts is the foundation of accurate financial reporting, so it needs to be set up correctly. A disorganized chart or one that lumps transactions into broad, undefined “buckets” of data can make it difficult for management to evaluate financial performance and identify unmet customer needs — or open the door to accounting errors and fraud. Here’s some guidance on how to create a robust chart that’s right for your situation.

Why it matters

A chart of accounts is a structured list of general ledger accounts that are used to record and organize financial transactions. An organized chart simplifies the preparation of tax returns and financial statements that comply with formal accounting standards, such as U.S. Generally Accepted Accounting Principles.
Additionally, a detailed chart provides insight into profitability and asset management. It can help you identify financial and operational areas in need of improvement and make better-informed strategic decisions.

In turn, these insights can help you communicate with stakeholders, such as lenders and potential investors, about your business’s financial performance. This can be useful, for example, when applying for new loans, seeking additional capital contributions, or selling your business.

Numbering and naming conventions

Essentially, the chart of accounts mirrors the financial statements; it includes major balance sheet and income statement accounts. Each account is assigned a unique identification number and an account name.

The following sequence is customarily used for account numbering:

• 1000-1999 for assets, such as cash on hand, undeposited funds, accounts receivable, equipment, machinery, vehicles, real estate and inventory,
• 2000-2999 for liabilities, including accounts payable, accrued expenses and outstanding loans,
• 3000-3999 for equity, for example, retained earnings and capital accounts,
• 4000-4999 for revenue, such as contract revenue, change order revenue, reimbursements and retainage, and
• 5000-5999 for expenses, for instance, materials, labor, payroll and benefits, rent, utilities, equipment leasing, marketing, insurance, depreciation, and administrative costs.

Subcategories are generally created for key accounts within each main category. For example, current assets could start at 1100, fixed assets at 1200, and other assets at 1300. As your business grows or its reporting needs change, you might add more accounts within a range.

Following best practices

There’s no one-size-fits-all format for the chart of accounts. The appropriate structure will depend on the number, nature, and complexity of your company’s financial transactions. Most companies start with industry-specific templates provided by their accounting software packages. Then, they customize those templates to fit the company’s needs.

When setting up your chart, consider these best practices:

•  Leave space between account numbers to accommodate business growth,
• Use simple, easy-to-understand naming conventions,
• Add a description for each account to help accounting personnel enter transactions into the correct general ledger account,
• Select the correct account type (asset, liability, etc.) to facilitate financial statement and tax return preparation, and
• Review the chart at year-end and make any necessary adjustments.

A simple chart of accounts might work initially, but more complexity may be needed as your company evolves. For example, management might want to track results by department, project, or region. This may require additional account segments or layers to allow for segmentation in reporting. A new business line might also require changes to an existing chart. More complex charts are common in certain industries, such as health care or construction.

For more information

Setting up a chart of accounts isn’t a one-off task that produces a template you can use forever. Contact us for help setting up a new chart of accounts or reviewing an existing one. Our experienced accounting and bookkeeping professionals can help you capture the relevant information your business needs to succeed.

The pretax (accounting) profit that’s reported on your company’s income statement is an important metric. Lenders, investors, and other stakeholders rely on pretax profits to evaluate a company’s financial performance. However, business owners also need to keep their eyes on taxable income to optimize tax outcomes and manage cash flow effectively. Here’s an overview of how these profitability metrics differ.

Crunching the numbers

Under U.S. Generally Accepted Accounting Principles (GAAP), pretax profit includes all revenue and expenses (except income taxes) for the accounting period. Accrual-basis accounting rules require revenues earned during the period to be “matched” with the expenses that were incurred to generate them. Reporting higher profits on the financial statements is generally preferable because it’s equated with more robust financial performance.

In contrast, taxable income is reported to tax authorities using applicable tax laws. Higher taxable income leads to higher tax obligations. Accounting professionals can help companies implement legitimate tax planning strategies to reduce taxable income.

The tax rules and accounting standards may differ for certain items (such as depreciation methods, expenses, and deductions). This may lead to differences in timing and amounts between the two metrics.

Understanding common differences

To illustrate, consider the following calculations: A hypothetical calendar-year C corporation earns $10 million of revenue and incurs $4 million of general operating expenses for book and tax purposes in 2024. Under GAAP, the company’s income statement also reports the following items for 2024:

• $1 million of depreciation using the straight-line depreciation method,
• $500,000 of bad debt expense based on management’s estimated allowance,
• $600,000 of accrued bonuses, and
• $700,000 of regulatory fines to the Environmental Protection Agency (EPA).

So, the company’s pretax profit is $3.2 million ($10 million − $4 million − $1 million − $500,000 − $600,000 − $700,000).
On the other hand, the company’s Form 1120 reports the following for 2024:

• $1.6 million of depreciation using the accelerated depreciation methods, and
• $300,000 of bad debt expenses based on actual write-offs.

Under federal tax law, accrued bonuses are generally deductible in the year employees earn them, but only if they’re paid within 2.5 months of the year end. This company routinely pays year-end bonuses on April 30 of the following year. So, it can’t deduct its 2024 accrued bonuses until 2025. In addition, fines and penalties paid to a governmental agency aren’t deductible under current tax law. As a result, the company’s taxable income is $4.1 million for 2024 ($10 million − $4 million − $1.6 million − $300,000).

Most differences — such as those related to depreciation methods, accrued expenses, or bad debt deductions — are temporary and will reverse over time. But permanent differences, including nondeductible EPA fines, don’t reverse. It’s also important to note that state tax rules may differ from federal rules, adding complexity.

Why it matters

Had the business owners in this hypothetical scenario paid estimated taxes using only pretax profit estimates, they likely would have underpaid tax for 2024. This could result in a surprise tax bill, which also might include an underpayment penalty. Coming up with funds on Tax Day could be challenging.

Anticipating differences between pretax profits and taxable income is essential for tax planning and cash flow management. For instance, the company could reduce taxable income for 2024 by paying year-end bonuses by March 15, 2025. The owners also could adjust estimated tax payments or set up a tax reserve to avoid a shortfall when filing the company’s return.

We can help

Our experienced accounting professionals can help you understand how pretax profits and taxable income may differ based on your company’s situation and plan accordingly. Contact us for more information.