Magazine article The CPA Journal

Five Important Properties of Accounting Numbers

Magazine article The CPA Journal

Five Important Properties of Accounting Numbers

Article excerpt

Auditors work with numbers practically every day. There are five interesting properties of accounting numbers that are directly relevant to the day-to-day work of most auditors.

Large Numbers Are Important, Small Numbers Are Not Everyone who works with numbers ends up being distracted, at least occasionally, by insignificant items that have captured their time and attention. To be sure, experience helps in judging whether an item is significant or not. However, unless an auditor makes a concerted effort to stay focused on what is important, she inevitably becomes distracted by minutiae and the myriad exceptions produced by an imperfect world. As a result, the auditor wastes not only her own time and energy, but also the time and energy of client officials and audit staff personnel that interact with her.

Here are a few pointers for developing insight into relative magnitudes when working with numerical data. First, be mindful that Pareto's "20/80 rule" (i.e., 20% of the items account for 80% of the total) fits most heterogeneous economic populations reasonably well. Second, the "largest order of magnitude rule" is an informal technique to avoid insignificant details. Under this rule, the focus is only on items greater than one-tenth the size of the largest item in the population. Third, data residing on computer-accessible files frequently can be graphed or sorted to provide useful insights into relative magnitudes. In the final analysis, however, there is no substitute for keeping perspective, priorities, and purpose firmly fixed in mind when working with numerical data. Perfectionism and the tendency to be distracted by insignificant detail extract a huge cost in auditing.

Noise Tends to Cancel out, Bias Does Not Noise is a statistical term referring to effects of random errors, which have a cumulative expected value of zero. Bias does not have an expected value of zero, but rather a positive or negative value, depending upon intent. When accounting data have been developed in an unbiased manner, income effects of individual misstatements tend to offset one another, especially in large, multidivisional companies. However, when income has been biased via a series of individual actions and judgments, detected misstatements will tend in the same direction.

At the conclusion of an audit, an auditor may not know which detected misstatements reflect random noise and which, if any, reflect systematic bias. Nonetheless, if she suspects that detected misstatements reflect bias, she may be more inclined to propose adjustments than if she believed otherwise. Client officials normally do not attempt to conceal noise (which has an expected effect on income of zero), but would be expected to attempt to conceal bias (which typically has an effect on income). Hence, if the aggregated effect of detected misstatements is anywhere close to materiality thresholds, an auditor would be prudently concerned about the possibility that further undetected bias would cause the financial statements to be materially misstated.

Editors Note: Under Lee Sers proposal in this month's CPA Journal, all but inconsequential adjustments would have to be recorded That would not, however, eliminate the need to consider whether undetected bias exists.

An Estimate Is No License to Be Sloppy. Accounting information based upon objective facts is usually developed with reasonable care. However, there is a tendency for a noticeable degree of imprecision and lack of analytical rigor to creep into calculations involving accounting estimates. …

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