Stafford's Accountant Blog

I don’t really know how to make this interesting. The best I can hope for  is that you are reading this because you want to know something about financial audits.

Let’s start with a definition. Most of us in the profession know what they mean by an audit in the same way that medics will understand what “Choledocholithiasis” means (gallstones to save you looking it up). But most lay people don’t.  Basically it is a fancy name for checking things. You might also come across the word “assurance” which is another fancy word for checking things. It is not what we do when we prepare accounts for a typical SME. SMEs do not usually need an audit unless their sales exceed £6.5m p.a. and, although we have a critical look through the client’s records when we are doing the accounts, we aren’t auditing them.

Auditing can be split into two types – those required by Act of Parliament (statutory) and other audits.

Statutory audits include audits under the Companies Act 2006 when sales are greater than £6.5m p.a. or other exemptions are not satisfied, and under the Charities Act 2011 where income exceeds £500,000. Incidentally, Charities are much more complicated in this regard than Companies. I won’t attempt to set out the requirements but have a look at http://www.charity-commission.gov.uk/Publications/cc15b.aspx if you are interested. These acts don’t dictate what auditors need to do and these are fleshed out in Audit Regulations and Auditing Standards.

Other audits include a whole set of audits including:

• Purely voluntary audits where the entity concerned thinks it would be a good idea;
• Audits imposed by outside investors in investment agreements (which often require a statutory audit;
• Audits required by the Memorandum and Articles of a company (rare except with quite old companies);
• Grant audits from UK/EC grant funders. These audits normally place specific requirements on the auditor to check, broadly speaking, that money has actually been spent on the project being funded and that the expenditure properly relates to the project and the types of expenditure being grant-aided;
• Internal audits where (usually a large organisation) conducts a self-examination of its own internal systems and procedures. It may have its own Internal Audit Department or may use an outside body. The nature of these audits varies widely;
• Audits instigated by HMRC under their statutory powers;
• Independent examinations for charities. These are a sort of hybrid as they are required when a charity has income over £25,000 and there are specific requirements but the examiner’s report is on the lines of “nothing has come to our attention to suggest that………” which is obviously much better from a professional negligence perspective than “these accounts give a true and fair view of……” which statutory audits require.

So what do auditors actually do? In a nutshell they do the following:

1. Plan what they are going to do;
2. Document the client’s accounting system;
3. Check the system operates as documented (not always required);
4. Check specific accounting transactions;
5. Check the printed accounts agree with the underlying records;
6. Check the accounts disclose everything they should.

But, you may say, testing everything is impossible, and you would be right. We get over this in two ways. Firstly we have a concept of materiality which broadly says that you ignore anything small. Secondly, having eliminated the small items, we only check some of the big items. This is called sampling. This cuts down the checking to a manageable size. However it clearly avoids about 99% of the transactions so is highly unlikely to unearth any small irregularities.

Audits are supposed to give (note cautious wording) ”reasonable assurance that the accounts are free from material misstatement… by fraud” but note that this is not a guarantee – more of an aspiration. Clearly this aspiration fell short in the cases of Barlow Clowes, Polly Peck, Enron etc. Realistically, discovering frauds of any size is very rare. I have only ever been on one audit where a fraud was discovered in 35 years of auditing.

Do audits have any real benefits? My own view is that it is not worth having a statutory audit if you don’t need one. This is because the amount of time the auditor spends on “peripheral” matters such as planning and documenting what they do and checking accounts disclosures etc reduces the time available for actually rootling about in the systems and transactions. However, agreeing with the auditor some sort of tailor-made specific report and specific areas to look at could well be helpful, particularly if the emphasis was on efficiency, system improvements and better controls.

Audits are also useful if you are checking a customer’s credit-worthiness. This is something that clients do not do often enough even though it’s very simple. Unfortunately, as most small companies don’t have an audit and don’t even have to file a Profit and Loss account at Companies House – just a Balance Sheet – it’s difficult to get any useful information. But if an audit has been conducted, anything less than a clean audit should raise eyebrows. Watch in particular for paragraphs headed:

1. “Basis for Qualified Opinion”,
2. “Basis for Adverse Opinion” or “Adverse Opinion on …”
3. “Disclaimer of Opinion on….”
4. “Qualified Opinion on other matter…..”
5. “Emphasis of matter”

1-4 normally mean the auditors think the accounts are wrong. 5 normally means there’s something significant which you need to be aware of (often related to future funding or lack of).

How much should you pay?

If you pay between £30 and £500 per month into a pension from age 21 to age 65 and increase those monthly contributions by 5% compound each year, the table below shows the sort of pension you might expect if growth in real terms (i.e. stripping out the effect of inflation) is either 2 or 3% and the rate of tax relief the payments attract is between 20% and 50%:

In reality, you will probably pay nothing until you have to and/or start panicking and the level of contributions is likely to go up in a non-linear way as promotions happen, mortgages are paid off and kids leave home. Rates of tax relief will also vary. But you can probably see that, to get a £30,000 pension at age 65, you will probably need to contribute an average over your working life of about £150 per month (i.e. the amount actually paid out of the bank) assuming you get a mixture of 20/40% relief on the contributions and that annuity rates stay at around current levels.

Who should you pay it to?

Advice on pension providers is tightly regulated so it is not possible to go into specifics. But it is true to say that the two main factors which will affect the value of your pension pot at retirement are charges applied to the fund and investment performance. Sometimes there is a link between the two but not always.

There is little chance that you will optimise your fund by personally selecting funds (unless you support the Random Walk theory) which postulates that a blindfolded monkey throwing darts at the FT financial pages would probably do as well as expert selection. Interestingly, this experiment is currently being replicated by the owners of Sophie the Shetland sheepdog in the US – tastefully called “Sophie’s choice”. We watch with interest.

For those of a conventional disposition, a good financial adviser is probably the way to go (unless you are in a large group scheme). Factors you should consider when selecting an adviser are:

• Have they been recommended by someone whose opinion you trust?
• How are they remunerated and is it clear what the costs will be?
• Do they seem thorough and efficient?
• Are they independent?
• Have they explained everything to your satisfaction including policy charges?
• How will they monitor your scheme after set up?
• What qualifications and experience do they have?

Alternatives to pensions

Some people, having had bad experience with advisers and/or investment returns, have been turned off pensions. This is a shame as a pension should in theory provide a better net return than an equivalent investment. This is because of the following:

• You get tax relief at your marginal rate on contributions made;
• The pension fund itself is not liable to taxation;
• You can take 25% of the fund out tax free when you reach retirement.

The main drawback is that you normally cannot get access to the whole fund and have to convert 75% of it into some sort of regular payment for life.

Other investments can sit easily alongside pension funding and a spread of risk is good. But most savings portfolios should contain a pensions element for the reasons set out above.

The principle is easy – the practice a little more difficult. As with any other choice, you need to establish some criteria and then apply each of those to the options available.

Some criteria may be deal-breakers i.e. if the criterion is not satisfied it’s a “No”. Others may be on a scale of 1-10 i.e. to what extent is the criterion satisfied? Others may be binary factors but not deal-breakers. Some may be more important than others. Some may be factors rather than criteria i.e. you might just want to hear the response to consider what you think of it.

Here is my suggestion for honing down the options. I have assumed that you are either a potential personal tax or small business client requiring a reasonable range of expertise:

Deal-breaking factors

Exclude those who:

• Do not have a recognised qualification (see my earlier blog on choosing accountants and hotels for details);
• Cannot demonstrate familiarity with any specialist factors which your business may have;
• Cannot deal with the range of services you require;
• Are one of the “Big 4” (they will be far too expensive);

Important factors

• Is there a partner or manager who is a Chartered Tax Adviser?
• Will you have a person who will be your primary point of contact?
• Have you met that person?
• Did you get on with them?
• Are their technical staff qualified (see above) or working towards a professional qualification?
• Do they have a proper website?

Things to consider

• How local are they?
• Have you read a draft “Terms of Business” letter?
• Do they charge extra for any ad hoc queries raised by letter, email or phone?
• Have you received a detailed and fully costed quotation?
• How much was it?
• Do they outsource any of their work e.g. to India?
• Do their offices appear smart and well-staffed?
• Have they been recommended by someone whose opinion you respect?
• How advanced are they from an IT point of view?
• How well was the person you met able to explain the services they would perform and clarify any tax and accounting issues which are likely to be relevant to you?
• How well did they handle any questions you had? Try asking them to explain things like:
  • What sort of business entity you should use and why?
  • How does VAT work?
  • How should you take money out of the business?
  • How do Working Tax Credits interact with business profits?
  • How do you determine whether someone can be treated as self-employed rather than employed?
  • Can you apportion income legally between working and non-working spouses or partners?
  • Were they willing to provide references from existing clients of a similar size or nature?
  • To what extent did you feel that they would be pro-active rather than re-active?
  • If they are in business on their own, what would happen if they were ill or on holiday? Also, were you satisfied that they could handle the work and that they were not too busy with other client commitments?
  • How efficient do you think they would be?
  • How many times did they say “that’s not a problem” when you queried something?

Decision

I suggest you exclude any candidates who do not pass the deal-breaker test. I would also think seriously about any candidates who did not pass the important factors test. Following that, maybe draw up a table for the things to consider, rank them in order of importance to you and analyse the extent to which each candidate satisfies the criteria. Then apply a bit of “gut feel” and off you go.