Is Your Organization Ready for Its Year-End Audit?

As the end of 2015 approaches, many organizations are in the process of preparing for their year end audits. By now, your auditor has contacted you to discuss the nature, timing, and extent of the work to be performed, which included an upfront planning meeting to address any significant events and transactions that occurred during the year.

Preparing for your annual audit can be a bit of a juggling act as you work to close out the year, report preliminary financial results to your board and other constituents, and prepare for the audit. All of these tasks are transpiring while you are simultaneously addressing events and transactions currently affecting your organization. This can be a daunting time of year for chief financial officers, controllers, and their staff.

As you continue to prepare for your upcoming audit, here are several common areas to consider that hopefully will help facilitate a smooth audit, reduce any internal control findings, and minimize significant audit adjustments.

Inadequate Segregation of Duties

Continued volatility in the global economy has resulted in many organizations cutting costs and operating at reduced staffing levels. As a result, fewer individuals are being asked to perform more duties, which can potentially lead to inadequate segregation of duties.

For example, an organization that previously had the monthly bank reconciliation prepared and reviewed by separate individuals may no longer have the resources available to adequately accomplish this segregation. Without an independent review of the bank reconciliation, a key control is absent related to the organization’s most liquid asset.

In situations such as this, organizations need to consider what compensating controls they can implement to utilize the resources they have available. One potential solution is to provide a copy of the monthly check register and bank statement to a member of the organization’s finance committee. Because this individual is independent of the daily reconciliation and transaction-approval process, he or she offers an independent and unbiased review of the transactions and can request support for any item deemed questionable or unusual.

Incomplete Documentation

Many organizations have good internal controls in place over their monthly close process, which includes preparation and review of significant account reconciliations, review and approval of manual journal entries, and investigation of significant budget-to-actual variances. However, those controls are often performed without any verifiable evidence documenting their execution.

For example, the controller may review all reconciliations and manual journal entries posted by the senior accountant each month, but without documenting this review, the auditor has no way of verifying that the review actually took place. Proper documentation is essential to confirming that a control exists and is timely and properly executed.

This documentation can be noted by signing and dating reconciliations as they are prepared and reviewed. If your organization is less paper intensive, the use of a monthly close checklist may be helpful. The checklist would detail the monthly closing procedures and provide the preparer and reviewer the ability to sign and date the form as items are completed. This checklist creates a trail of the procedures performed and enables the auditor to verify that the control objectives over the monthly close have been properly executed.

Lease Agreements

Buried inside many lengthy lease agreements are two items that can have a significant impact on an organization’s statement of financial position and statement of activities.

Accounting standards require that rent expense be recognized on a straight-line basis over the life of the lease agreement. Because most lease agreements include annual rent escalation clauses (and some include an initial period of free or reduced rent), the amount of rent paid does not equal the amount of expense recognized on a straight-line basis. Deferred rent represents the difference between the rent paid and the amount expensed for operating leases.

Many landlords include an allowance for tenant improvements as an incentive to the lessee. Often these costs are managed and paid for by the landlord, resulting in no transactions being recorded in the organization’s financial records. Accounting standards require that the financial impact of tenant improvement allowances be recorded in an organization’s statement of financial position as a leasehold-improvement asset and a corresponding deferred tenant-allowance liability. The asset will be amortized over the life of the lease and the liability recognized as a contra-expense over the life of the benefit obtained.

These accounting requirements are often overlooked by organizations because they are noncash transactions. However, the assets and liabilities of an organization may be materially affected by these clauses in lease agreements, which can affect financial ratios used in calculating, among other things, debt covenants.

Contract Reviews

An organization grants individuals differing levels of authority to enter into binding contracts on its behalf. For example, the director of fundraising for a museum enters into an agreement with a beverage company to exclusively offer only that company’s products in its restaurant. During the preparation of the organization’s Form 990, the agreement is reviewed by the tax preparer and the exclusive provider provision is discovered—which, unbeknownst to the director of fundraising, has now triggered taxable unrelated business income. In addition, because there were little costs incurred with the contract, nearly the entire amount of the fee is now taxable.

This is just one example of why is it is essential for all contracts to be reviewed by qualified individuals for potential financial and tax ramifications. Because the financial impact of a contract may not have been appropriately considered, individuals may unknowingly enter into agreements that are not beneficial to the organization. As a result, all contracts should be reviewed at a minimum by the chief financial officer, who may consult legal counsel or tax advisors for additional guidance.

Evaluating Significant Estimates

Most financial statements include at least one significant amount based upon management’s estimate. These typically include the allowance for uncollectible receivables and reserve for nonsalable inventory. The organization needs to have a documented procedure for evaluating and adjusting significant estimates. Throughout the year, management should be reviewing and adjusting these estimates based upon historical and prospective data.

For example, the allowance for doubtful accounts may include 50 percent of amounts past 90 days due based upon historical collection history, plus an amount for any additional items potentially uncollectable. An organization’s inventory-obsolescence reserve may include items for which sales were minimal during the year as well as items for which new updated editions are now available.

Because accounting estimates are subjective and based upon management’s evaluation of the account and transaction cycle, it is essential that the estimate process be well-documented, reasonable, and consistently applied.

Conclusion

Establishing the appropriate internal control structure at your organization to ensure that all transactions are identified and evaluated for financial ramifications is essential to eliminating surprises during the audit. Auditors should be proactively meeting with their clients throughout the year to update them on standards, events, and best practices in the industry.

Conversely, when questions arise during the year, organizations should consult their auditor early on in the process and not wait until year end to discuss significant matters. Consistent and timely communication between all parties, both internal and external, is a key element to successfully navigating your organization through its year-end audit.

Christian Spencer is a partner in Tate & Tryon’s audit and assurance services department and can be reached at cspencer@tatetryon.com.