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Strategies for addressing pandemic-related audit risks

By Joseph Radigan, from Journal of Accountancy: Like professionals in nearly every business on the planet, auditors have suffered a tremendous disruption to their normal operations because of the coronavirus pandemic.

But the magnitude of the pandemic’s fallout will only start to become clear as engagement teams plan strategies for upcoming 2020 client reviews and audits and carry out fundamental procedures like audit sampling.

Lynford Graham, CPA, Ph.D., a consultant in Short Hills, N.J., is scheduled to lead the sessions “Audit Strategies for Better Efficiency” and “Audit Sampling — It’s Not Rocket Science” at the AICPA’s ENGAGE 2020 online conference in July. He explained that the lessons auditors have gained from working with clients through the years will mean very little in 2020.

“You may have to rip up the usual strategy this year and start fresh,” Graham said. “You’ve got to look at this company as it is in 2020.”

Most public company and some private company audits employ a controls-based strategy, which Graham said relies heavily on a client’s ability to maintain sufficient financial reporting controls throughout the year. It also has the benefit of saving the auditor from having to do an extensive amount of substantive testing at year end.

But such a controls-based strategy may not be possible in 2020.

“Were those controls really in operation throughout 2020?” Graham asked. “They might have been in January; they might be in December. But what about that middle period? Did some of those controls go by the wayside because those key people weren’t present and business processes changed?”

The likelihood that a client’s controls will be less reliable than in years past will also affect how the engagement team approaches its sampling of client accounts.

“The sample size that you used for your substantive test of revenue and tests of cost last year might have to be raised quite substantially if you’re not getting your leverage from your controls or if fraud risks are identified,” Graham said.

“If the operations were continuous, like in many prior periods, you could take a random sample from the entire population, and it would give you an answer with respect to the financial statements,” he said. “But this year you could have had very different operations.” Some lines of business may have begun the first couple of months of 2020 performing as they had throughout 2019, but the pandemic and lockdown began a disruption with an end date that’s still uncertain.

“What you might want to do is stratify your sample so that you more intensively sample the period that was abnormal,” Graham said. If business gets back to normal late in the year, he said, auditors may wish to sample the middle period more intensively and look at the beginning and the end of the year together.

The pandemic’s severe damage to the economy risks plunging many businesses into bankruptcy, and privately held businesses may face greater risks than public companies.

Graham estimated that in about 80% of bankruptcies, historically, auditors face the risk of litigation because the client’s creditors may accuse them of failing to identify the extent to which the client’s financial position deteriorated prior to the bankruptcy. If a client is acquired, the buying company may sue the auditor if, following the deal’s close, the buyer uncovers such weakness or finds errors in reporting in the newly acquired business that it determines it greatly overpaid. Because it’s all but certain that an unusually high surge of bankruptcies will mar the business environment for the remainder of 2020 and perhaps into 2021, Graham expects that lawsuits targeting auditors will also surge.

“That is going to be a dramatic change in the environment,” he said. In his view the unusually severe litigation risks facing the profession put a heightened urgency on carefully mapping out the strategy for each engagement and being especially thorough in obtaining the documents and documenting the evidence examined when performing basic procedures like sampling.

“You’ve got a very interesting year, where the traditional approach to auditing and the usual approach to risk assessment may not be the same,” Graham said.

The adoption of the guidance from FASB Accounting Standards Update No. 2014-09, Revenue From Contracts With Customers (Topic 606), provides a good example of the challenges to audit sampling procedures during the pandemic, Graham said.

“From litigation exposure and professional standards perspectives, you shouldn’t be issuing an opinion you can’t defend,” he said. “This kind of environment is going to put the risk on the auditor to know when you just haven’t got enough evidence, with assurance to say, ‘Yes. This company is as presented in the financial statements at this time.’”

The AICPA’s most comprehensive conference, ENGAGE 2020, is all digital. Sessions will be held July 20–24, covering topics including accounting and auditing, tax, technology, personal financial planning, and more. For more information, visit aicpaengage.com.

 Joseph Radigan is a financial writer based in New York. To comment on this article or to suggest an idea for another article, contact Ken Tysiac, the JofA’s editorial director, at Kenneth.Tysiac@aicpa-cima.com.

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