Accounting vs Auditing and Auditing within the IRS - Essay Example

? The Auditing Profession - Accounting vs. Auditing & the Auditing within the IRS The dynamic of international exchanges and complex accounting projects requiring extensive knowledge of evaluation and analysis brought to the light the need of a profession and of a comprehensive and credible information work, which would assure the employees that financial and economic indicators reflect with accuracy patrimonial realities. That’ how audit profession appeared. Accounting information users often confuse the notions of accounting, financial audit and financial control. The rich existing literature highlights the common source of these three concepts and the fine line between them. We mention the opinion of Richard Brown, cited by two world-class specialists (Mautz and Sharaf, 1961) indicating that audit has its roots in the past, only a little beyond the origins of accounting. Every time the society progress has made it necessary for a man to be entrusted with the property of another- to some extent, the need of a certain type of its loyalty control become obvious. The textbook definition included in the Report of the Committee on Basic Auditing Concepts of the American Accounting Association presents auditing as “a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interested users” (Media Wiley, 2003, p.4). To emphasize the essence of financial audit, its meaning and scope, we present the definition of Arens and Loebbecke, two high-class American specialists: “audit consists of gathering and evaluating evidences to determine and report the degree of compliance of reported with a series of predetermined criteria. The audit should be conducted by a competent and independent individual." (Arens&Loebbecke, 2003, p.11). Many of the indicated features are common to all forms of audit. There are various types of audit, such as operational, technical, ecological, but in the vast majority of cases, the term refers to the audit of financial statements. Table 1: Main features of various types of audits Type of audit Financial statement audit Compliance audit Audit report and internal control Operational audit Assertion about economic actions and operations Presentation of financial position, results of operations and cash flow Claims or data pertaining to adherence to policies, laws, regulations, so on. Adequacy of system of internal control over financial reporting Operational or performance data Established criteria GAAP Management’s policy or laws and regulations COSO criteria for evaluating internal controls Objectives set by management Communication of results Opinion of independent CPA Summary of findings or assurance regarding degree of compliance Opinion of independent CPA Summary of findings regarding efficiency and effectiveness observed Interested users Investors, creditors and others Management, board of directors and others Investors, creditors and others Management and board of directors Source: Media Wiley. Auditing and the Public Accounting Profession-Integrity of Financial reporting, 2003, p.7 Note: COSO=Committee of Sponsoring Organizations of the Treadway Commission; GAAP=Generally Accepted Accounting Principles; CPA=Certified Public Accountant. Table 1 summarizes main differences between various types of audit: financial statements audit, compliance audits, audit reports on internal control and operational audits. As presented, financial audit is an examination conducted by an independent, competent professional, in order to express a justified opinion on the validity and correct application of financial-accounting internal procedures established by managers and on the real, complete and accurate nature of a unit’s financial statements. Financial auditors analyze and compare accounting reports and other documents in terms of conformity with established standards and regulations such as GAAP and International Financial Reporting Standards (IFRS). The ambiguity of many financial statements users on audit and accounting is explained by the fact that most audit activities are strongly related to accounting data, and an auditor has to have good knowledge of accounting issues. Regarded as a complex informational system, accounting quantifies, analyzes and transmits (communicates) financial information about a certain structure, linking operations and decision makers. Despite the very thin border between accounting and financial audit, their scope is well-defined. Thus, accounting is the logical process of registering, classifying and converting all economic activities of an entity into monetary units, while financial audit deals with the examination of the workbook entries and the fairness of its transactions. So, the latter studies, completes and certifies data accuracy of accounting reports. Due to its functions, accounting information system is the main source for financial audits. Considering the importance of the data for all stakeholders, the objectives of financial audit are clearly shaped as follows: To improve the usage of accounting information; To ensure proper registration of all economic operations; To check and assure the accuracy of accounting information; Professional argument and the registration of economic activities according to the International Accounting Standards (IASs). The role of the financial audit is to review financial statements, providing both internal utility (to the unit management) and external utility (to stakeholders, investors, government institutions, clients, suppliers, creditors, banks and others), with the aim of protecting resources and ensuring information credibility. Figure 1: The accountant’s value chain Source: authorial calculation after Media Wiley. Auditing and the Public Accounting Profession-Integrity of Financial reporting, 2003 Figure 1 presents the accountant’s value chain. Accountants offer a large array of services that provide support for decision making bodies. The correct perception of this value chain could be of help in understanding the value of audit. Reliable information is vital for various decisions. In the absence of audits, outside players who use information provided by the management team may build their decisions on fake premises. The soundness of every step under information (in the value chain figure) depends upon the credibility of that data. The relevance of the information depends on the processing methods in terms of respecting accounting principles and rules imposed by the financial reporting system. Any auditor must be extremely familiar with all these notions. Audit is a practical activity which relies on knowledge and experience from different fields that allow the collection and interpretation of audit evidence. Accountant (chartered accountant) has to act according to accounting rules and principles while the auditor has to decide whether they are respected or not. As a short parenthesis, the auditor is a much respectable individual! For example, considering this feature in England he is the most important person after the Queen (guarantor of social stability), the Prime Minister (guarantor of political stability) being the guarantor of economic stability. To provide more arguments on the necessity and importance of audit we present a short story of 1993 when a major gold deposit was found in Indonesia leading to a spectacular increase of Bre-X Minerals Ltd price on Toronto Stock Exchange. The event was described as mining discovery of the century and triggered fierce battles for the right to exploit the gold. Soon after the discovery strange things began to happen: a fire burned all geologists’ records; the site manager was involved in an unfortunate accident; ore samples “dusted” with gold powder had been destroyed and became impossible to be studied. So, a new expertise was needed, which revealed only very small amounts of gold, leading to the collapse of Bre-X shareholder value by 90% (Starcea, 2009, p. 4). As suggested above, investors, banks, public require independent assurance on financial information and other elements and indicators of performance. Thus, audit appeared to responds to this need. Due to their technical knowledge, and their independence in most cases auditors advice management teams, making suggestions that enhance profitability and improve operational efficiency by reducing costs, the number of errors and potential fraud. Thus, the audit activity has an essential role in business, government and the US national economy (figure 2). As a profession, it offers the chance of a rewarding and challenging career in public accounting, industry and government (Media Wiley, 2003). Figure 2: Economic advantages versus limitations of an audit Source: authorial calculations In the US, auditors (CPAs) are members of the American Institute of Certified Public Accountants (AICPA), a private sector organization. Although the Securities and Exchange Commission (SEC) may issue accounting rules for listed companies, it relies on the Financial Accounting Standards Board (FASB), a designated independent organization that establishes accounting and reporting standards. FASB maintains a permanent direct connection with AICPA, issues guidance and closely involves in its development. Individuals that provide audit services for individuals and business structures are generally divided into three classes: 1. Independent auditors-mainly CPAs including both individuals and members of public accounting firms that provide specialized services to their clients (business structures non-profit entities, governmental bodies). Considering their education level, training and past experience, they are allowed to perform all types of audit. Auditor’s independence is vital for their customers, as they derive value from the fact that the auditor has a neutral attitude towards the client subject to verification. 2. Internal auditors are employees of the structure they audit. They provide independent, internal auditing within the company as a service to it. The aim of this form of auditing is to support the management team in the effective discharge of the responsibilities it is tasked with. Internal audit functions expand to all organizational levels. They provide operational audits and deal with compliance issues. A great number of internal auditors hold the certified internal auditor (CIA) credential; many other are also CPAs. The Institute of Internal Auditors (IIA), the international body of internal auditors has imposed practice standards in the field and also, a code of ethics. 3. Government auditors provide services for numerous local, state and federal government structures. The main federal agencies are the General Accounting Office (GAO), the Internal Revenue Service (IRS) and the Defense Contract Audit Agency (DCAA). The IRS agents review taxpayer’s returns for compliance with existing tax laws. The results of their audit are generally restricted to the IRS and the subject of verification. When preparing financial statements or performing audit services accountants and CPAs are governed by various professional standards, with a different design for public companies and for private bodies, as presented by figure 3. Figure 3: Standard-setting structures in the United States Source: authorial calculation after Financial Accounting Standards Board, American Institute of Certified Public Accountants and the US Government Accountability Office Since 1973, the Financial Accounting Standards Boards has been tasked with the establishment of standards for financial accounting that offer support for non-governmental bodies financial reporting. Their authoritative nature is officially recognized by the SEC and AICPA. The importance of the ten accounting principles derive from their role in ensuring proper functioning of the US economy, as best decisions heavily rely on credible, accurate and clear financial information. While recent years have witnessed large efforts to globally harmonize GAAP, a much quieter revolution marked the arena of generally accepted auditing standards, GAAS (Morris and Thomas, 2011, p.1). In the US, Auditing Standards Board of American Institute of Certified Public Accountants has created 10 auditing standards, grouped as general standards, standards of field work and standards of reporting. The International Standards of Auditing (ISAs) define a set of rules established by the International Auditing and Assurance Standards Board of the International Federation of Accountants. ISAs derivatives are widely used. The accounting standards used by the IRS are not governed by the FASB as in the case if financial accounting. Financial accounting is supported by GAAP, while the IRS has the Internal Revenue Code. In the case of a tax audit, the IRS or other state taxing agency analyses someone’s tax returns to verify id income, expenses and credits are reported with accuracy (Tax Resources Incorporated, 2012, p.1). A tax audit is about verifying individual, business structures and corporate bodies’ tax returns in terms of accuracy, self-evaluation of amounts to be paid, arrangements of colleting delinquent taxes and compliance with existing laws and requirements. Main taxes subject to an audit refer to personal, business and corporate income, licensing, fiduciary, withholding, realty transfer, motor fuel, gross receipt, cigarette and bankruptcy. In general, the IRS reviews the followings: Proper reporting of income from all sources; Proper registration of all receipts and proof of payments corresponding to all expenses claimed on the tax return; The existence of unreported income or expenses impossible to document; in such cases, the IRS adjusts the tax returns, adding interest and potential penalties. As an indirect consequence of the US financial crisis, the IRS displays aggressive behavior in terms of auditing individuals and business organizations. Tax audits do not have a random nature; they are justified by a whole plethora of reasons as indicated below: Mathematical adjustments- as in the case of any other process, not always the accuracy level is 100%, as there can be mismatches between names and social security numbers (SSN), filling status problems, wrong estimations and tax errors, late filing interest and penalties, or other issues. Thus, in order to overcome these drawbacks, the IRS computerized its activity. Income document matching. The IRS informatics system matches all forms linking the individual or the businesses’ name and SSN to the content of the tax return. In case of a mismatch, an audit will take place, preceded by a phone call, in-person meeting or simply an act including additional taxes, interest and penalties. Discriminant function system (DIF) scoring. Every tax return is scored by the IRS with a DIF number, based on a secret specific methodology they apply to identify income tax returns carrying the higher likelihood of tax change on audit. The Unreported Income DIF (UEDIF) score rates the return for the potential of unreported income (IRS, 2006, p. 1). The DIF score varies depending on the items, significant DIF values indicating which items will be audited by the IRS. Additional documentation requirements. This type of verification implies sending the IRS auditor mail documentation for certain tax return item/items such as proof of payments or receipts. To illustrate, let’s take the case of charitable contribution audit where copies of the receipts or copies of canceled checks from the beneficiary structures are needed. No contribution that cannot be proved will be allowed. Face-to face audits were the most popular in the last years. As a result of the pressures from the Congress in the context of the sub-prime crisis and the subsequent need to raise funds, the IRS has largely expanded its audit activity. The process debuts with a phone call to the targeted entity (individual or company) or a written notification. The calling strategy aims at getting volunteer information before the official meeting. The IRS will then review certain items and the results could lead to higher tax bill or even the verification of other tax years. National Research Program (NRP). It is a very uncomfortable form of audit, as it means a rigorous tax examination line by line. For example, if an individual claims a child as a dependent, he/she is required to provide all necessary documents, such as birth certificate or address (similar to the audit subject). As stated above, this type of audit has a really intrusive nature. Random. Being subject to an audit doesn’t necessarily mean that something is wrong or that tax returns are unfair. The decision of reviewing an entity’s tax return is based on a large array of methods; thus, the IRS can pick at random a tax return to audit. Financial standing. Sometimes, a tax audit is triggered by certain levels of life standard. Based on available statistical data and public records, an IRS auditor can analyze the dynamic of spending and wealth variations and identify unreported sources of income. The elements indicating such changes are related to credit reports, tax returns for all open years, currency operations, SEC filings, business license applications, 1099 information, motor vehicle records and many others. Due to the abusive features of these methods, in 1998 the US Congress imposed restrictions on their use. As a consequence, the IRS must reasonably justify all possible cases of unreported income and not consider financial status or economic reality as indicators of fraud based on simple assumptions. IRS Special Projects. Every year, the IRS presents a top of the most prominent tax scams, also known as the Dirty Dozen, and then uses this list to choose tax returns subject to future audit. The aim of an IRS tax return audit is to decide the taxpayers’ correct liability. A high quality audit examines the accuracy of provided information, ascertains the true meaning of existing tax laws and applies them to relevant facts (IRS, 2006 b, p. 1). In 2011, the IRS reviewed more than 1.58 million individual returns, up from 1.43 million in 2010; in 2012, the tax agency increased the number by nearly 11 percent (The Pappas Group, 2012 p.1). After analyzing accounting-auditing dichotomy we conclude by saying that audit is required especially to decide on internal control weaknesses, task that accounting is not responsible for, so that based on its findings and recommendations it improves operations control and respectively, the reliability of financial reporting. References 1. American Institute of Certified Public Accountants. (2011, January). Blue-Ribbon on Standard Setting for Private Companies. Retrieved from AICPA website http://www.aicpa.org/interestareas/frc/accountingfinancialreporting/pcfr/downloadabledocuments/blue_ribbon_panel_report.pdf 2. Arens A., & Loebbecke K. (2003). Audit: An Integrated Approach. Chisinau: Arc Publishing House. 3. Brown, R. (2004). A history of Accounting and Accountants. New York, NY: Cosimo Books Inc. 4. Financial Accounting Standards Board. (2012, April). Facts about FASB. Retrieved from FSAB website http://www.fasb.org/facts/ 5. Government Accountability Office. (1-219) Government Auditing Standards. 6. Internal Revenue Service (2006, January). The examination (Audit) Process. Retrieved from IRS website http://www.irs.gov/newsroom/article/0,,id=151888,00.html 7. Internal Revenue Service (2012, April). Statement of Principles. Retrieved from IRS website http://www.irs.gov/irm/part4/irm_04-035-001.html 8. Mautz, R.K., & Sharaf H.A. (1961). The Philosophy of Auditing Sarasota. FL: American Accounting Association 9. Media Wiley. (2003). Auditing and the Public Accounting Profession-Integrity of Financial reporting. Retrieved from PBS Online http://media.wiley.com/product_data/excerpt/71/EHEP0003/EHEP000371.pdf 10. Morris, T.J., & Thomas W. (2011). Clarified Auditing Standards: the Quiet Revolution. Journal of Accountancy 11. Starcea, D. (2009). Financial audit and a well-organized accounting. Annals of “Constantin Brancusi” University of Targu Jiu, Economics Series 1, 309-312. 12. Tax Resources Incorporated. (2012). What is Tax Audit? Retrieved from PBS Online http://www.taxaudit.com/what-is-a-tax-audit 13. The Pappas Group. (2012). IRS will audit more tax returns in 2011. Retrieved from PBS Online http://www.pappastax.com/index.php/2011/01/irs-will-audit-more-tax-returns-in-2011/ Read More