Discussion: Value of engaging Big 4 audit firm as auditor

It is known in the commercial world that the auditing industry for the world is dominated by Big 4 audit firms, namely: Deloitte, Ernst & Young, KPMG and Pricewaterhouse Coopers (PWC). The number of listed companies (including most of the blue chip corporates) are audited by Big 4. The audit fees charged by Big 4 are usually higher than other non-big 4 audit firms (i.e. there is a premium on Big 4's audit fee).

What are the reasons for Big 4 to command a premium on its audit fees? Have you thought about it? We encourage our readers to submit their answers to us, such that we can discuss the value of engaging a Big 4 as audit firm together.

You may leave a comment to the blog post or send the email to our account: myauditing@gmail.com

Dividend income from subsidiary, and its withholding tax

We receive questions from a reader, who just started to learn the principle of consolidation.

"The question was will dividend income from subsidiary remain in the Group consolidation account"

The basis principle of consolidation is to prepare a consolidated account that captures the transactions of a Group with extrenal party. Any transaction within the Group will not be captured in the consolidation account.

To answer his/ her question: the dividend income received from a subsidiary by the holding company relates to a transaction within the Group. As such, this transaction will be eliminated during the consolidation process. Hence, the dividend income from a subsidiary will not be captured in consolidated account. However, we would like to highlight that, the holding company often suffer witholding tax while the subsidiary remit dividend to holding company, who might be at different country.

The with holding tax sufferred is not eliminated, as it represents the amonut payable to local tax authority of the subsidiary.

PCAOB in tentative deal to observe China official auditor' inspections

Chicago Tribune reported that the a tentative agreement has been reached by PCAOB of U.S. to observe official auditor inspection in China.


(http://articles.chicagotribune.com/2012-09-21/business/sns-rt-us-usa-audit-watchdogbre88k1bi-20120921_1_audit-firms-pcaob-scandals-at-chinese-companies),

After the infamous Sino Tech Engergy Ltd incident, US investors are cautious in dealing with the trading of China-based companies listed on U.S. Exchanges. PCAOB announced that “We are working toward and have tentatively agreed on observational visits".

This is a move for PCAOB to observe the audit firms’ quality control over the auditing industry within China.



We, Accounting & Auditing blog, view this move positively. As the observation will allow PCAOB to develop understanding of the audit firms’ quality, high level understanding of audit procedures’, controls exercised by China relevant regulatory authority. Any difference in expectation may be communicated by PCAOB to China authority, in order to allow the China authority to close any gap.



In the long term, we expect close border listing to become more common and frequent, an overview by the authority from U.S. stock exchange may assist in clearing the obstacles / anxiousness the market may have towards the China-based company. We hope to hear more good progress in the future.

Critical review of Gross Margin Analysis

Dealing with gross margin analysis, academic often provide the following guidances for analyst / auditor in the approach on how to analyse:
- compare gross margin of a subject company to competitors within the industry
- compare gross margin of a subject company to prior period
- compare gross margin of a subject company to our expectations (i.e. increase in fuel costs would likely result in the decrease in the subject company's gross margin)

The above analysis is fundamental and provide insight for analyst / auditor of the subject Company. We, Accounting & Auditing blog, propose the auditor to critically review the component of gross margin and the movement within each key compoent, to reflect the gross margin of the Company factually and within reasonable expectation of a financial statement user.

Gross margin represents the difference between sales revenue and cost of goods sold. Sales revenue represents the revenue the Company generated after transferring the significant risk and rewards/ title of the goods. Cost of goods sold include all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. Costs of goods made by the business include material, labor, and allocated overhead.

Management may have incentive to change the classification of its cost component, such that the gross margin appears to be favorable. For instance, management of a manufacturing may decide to include freight inward as selling and distribution costs, while in fact, freight inwards is the cost incurred in bringing in raw materials for its production purpose. By excluding freight inward from being a component of cost of goods sold, the gross margin will appear to be higher.

As the auditor, it is recommended to review through the cost of goods sold component of our audit client, to critically review the reasonableness of the cost of goods solds. The analysis need to be supplemented by our understanding of the business and discussion with management. Engaging different client personnel from different departments/ operations assist in developing our understanding of the business better.

Gross margin analysis should not be limited to comparing to prior period, comparing to industry norm, as this is not sufficient to understand a business better. We, as the auditor, has the responsibility to re-assess what we have done in the past and critically review the existing account against the changing business environment to make sure that the financial statment reflect the financial affair of the audit client reasonably within the current business context.

International Standard on Auditing 540: Auditing Accounting Estimates

International Stanard on Auditing ("ISA") 540 discuss about the auditing of accounting estimates, including fair value accounting estimates and related disclosures. This is a crucial auditing standard for all auditors as auditing accounting estimates is not straight forward, involve critical review of assumptions and management's assessment, and the results have a significant impact on the financials of our audit client.

ISA 540 defines the natuer of accounting estimates as follows: Some financial statement items cannot be measured precisely, but can only be estimated.The nature and reliability of information available to management to suport the making of an accounting estimate varies widely, which thereby affects the degree of estimation uncertainty associated with accounting estimates. The degree of estimation uncertainty affects, in turn, the risks of material misstatement of accounting estimates, including their susceptibility to unintentional or intentional management bias.

To illustrate, while reviewing through the debtors' aging summary of your audit client, you noted a number of debtors has long outstanding debts overdue more than 120 days. Based on your understanding of the industry, the norm of the debtors' turnover is about 90 days. Management need to make an estimation on the provision for doubtful debts. The estimations based on a number of factors: repayment history of the particular customer, financial position of the customer, availability of repayment plan, etc. Auditor, need to carry out the review objectively to review for the reasonableness of management's estimation assessment.

Management may have incentive of not providing provision in order to make sure that their profitability appears to be favorable. As a result, a thorough review need to be carried out.

ISA 540 also mentions that the measurement objective for certain accounting estimates if to forecast the out come of one or more transactions, events or conditions giving rise to the need for the accounting estimate. For other accounting estimates, including many fair value accounting estimates, the measurement objective is different, and is expressed in terms of the value of a current transaction or financial statement item based on conditions prevalent at the measurement date.

What is accounting?

Some non-business friends of mine came to me and ask me: what is accounting?

Accounting is a system/ mechanic used to record (i.e. account) transactions of a business. To illustrate, an owner of a small-business-enterprise records its daily revenue information. At the end of every period (e.g. end of every month, end of every year), the accounting information is accumulated and summarised in a report, i.e. balance sheet statement, income statement, cash flow statement.

Management can determine business decision based on balance sheet statement/ income statement. The financial statements prepared reflect the financial state of affairs and performance of a business. Financial statement users make decisions based on the financil statements

There is a systematic method to account for the transactions to ensure consistencies in recording the transactions. Consistency allowed the readers of accounting records to make useful comparison to understand the changes of a business between the comparative period.

Understanding accounting / financial statements is crucial in understanding a business crucially. It is important for every single investor to appreciate the accounting.

What do you do when you noted overprovision/underprovision for prior years' tax

While reviewing through financial statement or tax schedule, you may note overprovision/ underprovision for prior years' tax. What will you do as an auditor?

First let us understand, what will trigger the accounting entries for over / underprovision for tax:

The over / under provision maybe resulted from:
- tax correspondences (i.e. notice of assessment) from tax authority showing a revised tax payable
- tax agent / client a computation error in prior year tax computation
- tax agent/ client become aware of new evidences which may suggest that prior tax computation need to be revised
- clarification of new ruling being published recently
- etc

It is important for an auditor to understand the nature of overprovision/ underprovision. Why?

By understanding the nature of overprovision/ underprovision, we can cross-check to current year tax computation to make sure that the basis of computation has been rectified such that current year tax computation is in line with appropriate ruling/ basis. For instance, during the year, tax authority may disagree with claiming professional fee as deductible expense. As such, it will result in underprovision in respect of prior year tax. In current year tax computation, management should deem the same nature of professional fee to be non-deductible expense. This will prevent the underprovision of tax in the future.

In short, it is important to understand the nature of any over/underprovision of tax, and check that the basis of current year tax computation has been updated such that it is in accordance with latest tax ruling.

Accounting for intangible assets - Self-generated intangible assets

Recently, while browing through the financial article, we noticed one interesting article from www.investopedia.com relating to intangible assets. We have extracted some paragraphs as below:

"Any business professor will tell you that the value of companies has been shifting markedly from tangible assets, "bricks and mortar", to intangible assets like intellectual capital. These invisible assets are the key drivers of shareholder value in the knowledge economy, but accounting rules do not acknowledge this shift in the valuation of companies. Statements prepared under generally accepted accounting principles do not record these assets. Left in the dark, investors must rely largely on guesswork to judge the accuracy of a company's value.
But although companies' percentage of intangible assets has increased, accounting rules have not kept pace. For instance, if the R&D efforts of a pharmaceuticals company create a new drug that passes clinical trials, the value of that development is not found in the financial statements. It doesn't show up until sales are actually made, which could be several years down the road. Or consider the value of an e-commerce retailer. Arguably, almost all of its value comes from software development, copyrights and its user base. While the market reacts immediately to clinical trial results or online retailers' customer churn, these assets slip through financial statements.

As a result, there is a serious disconnect between what happens in capital markets and what accounting systems reflect. Accounting value is based on the historical costs of equipment and inventory, whereas market value comes from expectations about a company's future cash flow, which comes in large part from intangibles such as R&D efforts, patents and good ol' workforce "know-how". "

Our audit client may have invested research & development costs, payroll costs in developing intangible assets, e.g. new drugs, software, new machines. The invention may subsequently lead the Company to apply for patents, which is essentially the intangible assets of the Company. According to IFRS, internally generated goodwill should not be recognised on the balance sheet of the Company. Some of the readers may wonder why this asset should not be recognised on the balance sheet of the Company.

Let us answer this question by giving you a scenario by assuming intangible assets can be recognised. The Company would capitalise the costs incurred as an intangible assets, i.e.

Dr. Intangible Assets
Cr. Costs (i.e. R&D costs, payroll costs)

By capitalising the intangible assets, the Company will be able to reduce the costs and increase the profitability. There's a incentive for certain Company to capitalise intangible assets as much as possible, in order to reduce the costs incurred, even for certain costs that may not yiled economic benefits to the Company.

Sometimes, it is hard to measure the real economic benefit of an intangible assets. A Company should not recognise intangible assets if it is not econmical benificial to the Company. This is the issue with the recognition. Also, for the measurement, how should intangible assets be measured. Some might argue that, it should be the full amount of costs incurred. However, what if the full amonut of costs is not 100% beneficial to the Company? Do we still recognise the full amount?

It will be a challenge for the accountant, auditor, and even general invenstor to understand the nature or amount of the intangible assets being recognised on the balance sheet. Hence, in order to protect financial statement user, self generated intangible assets should not be recognised. However, this amount can be disclosed in the financial statement for financial statement user to understand the Company better.

Guarantee of inter-company's loans

It is common for our audit client to provide corporate guarantee to a bank in favour of related companies for the loan drawn down by the related companies. Generally, your audit client may guarantee timely repayment of interest and guarantee to repay amount due should the related company default in repaying.

A bank may ask for guarantee, if:
- the borrower is not in financially sound position; or
- the loan amount is substantial to the borrower perspective; or
- the borrower is trying to ask for a discount on its interest rate

This guarantee represents a potential / contingent exposure to our audit client. This has to be disclosed in the financial statement of our audit client. The disclosure should, at a minimal, include:
- the nature of the guarantee;
- the amount guaranteed; and
- contingent exposure as of balance sheet date (i.e. the amount guaranteed maybe US$100mil on a facility, while the outstanding loan amount drawn down by related company is US$80mil as of balance sheet date).

This disclosure helps to inform the financial statement user on the contingent libility the Company has, and this could be a key concern for some of the financial statement users.