My Writing > Managing Risk

20 Jun 2005

Managing Risk

Eileen Reppenhagen, QuickBooks ProAdvisor

The cost of insurance for the business of accounting and tax preparation is increasing. Practice insurers say that an increasing number of claims are a result of errors and omissions on tax returns.

Sometimes it’s the simplest assumptions that get us into the most trouble. The following six case studies will illustrate when the basic assumption one should have been able to go on was, in fact, not the case. In each case, I’ll set the stage, highlight the basic assumption, tell you my story and share procedures I resolved to use as a result of my findings.

  1. Unbalanced Balance Sheet

    Scenario: New client with financial statements prepared by previous accountant.
    Assumption: Double underlines means it adds up.
    Story: The opening balance equity didn’t agree to the previous accountant’s figures when I entered the opening balances into my accounting software. It was out $10,000.
    Procedure: I requested past financial statements, general ledgers and journal entries, as well as corporate tax returns, in order to analyze when it went out of balance and exactly why it was out of balance.
    Findings: Three years earlier, there was a debit to receivables without a credit to revenue. It was a one sided journal entry, the kind that plagued accountants prior to software that automatically records a double entry. These financial statements had been prepared using Word from a handwritten spreadsheet.
    Result: The unrecorded sale increased income and income taxes payable. A voluntary disclosure saved the client from penalties on unreported income.
    Resolve: Use accounting software like QuickBooks to prepare financial reports. Add up everything anyone else gives you. Check that the opening balance agrees to the ending balance and that the balance sheet balances. Check that the income statement and any dividends agree to the change from the prior year’s retained earnings and the current year’s retained earnings.

  2. Phantom Dividends

    Scenario: Take over of a new corporate client. It was a compilation engagement. Comparative balance sheets were not prepared by the previous accountant.
    Assumption: Retained earnings ending balance will be next year’s opening balance.
    Story: I was checking for dividends paid tax free to calculate the Capital Dividends Account balance because the client asked if there were any tax free dividends available to be paid out.
    Procedure: I was doing this by constructing a continuity schedule of changes in retained earnings.
    Findings: The balance in retained earnings decreased and shareholder loan balance increased from one year to the next. $30,000 disappeared from retained earnings and appeared as an increase in the shareholder loan. The balance sheet still balanced. $30,000 just slid from equity to liability without a journal entry between year ends. Unless you did a continuity of retained earnings or shareholder loan, I doubt if you would notice. CRA certainly did not notice. Back then they were not checking for continuity between the years. But, I am sure you noticed this year that GIFI statements are now comparative.
    Result: The $30,000 shareholder loan payable was paid out to shareholder without any tax consequences.
    Resolve: Start and continue a running reconciliation of retained earnings since incorporation for all corporate clients. Keep it in a permanent file to update each year. Have a column to compare the income statement to reported income on the T2S(1). Have a column to compare taxable and non taxable dividends paid with the declarations of dividends payable and CDA elections in the corporate minute book.

  3. The Non-Materiality of One Dollar

    Scenario: I was a 4th year student in a large accounting department. It was my job to prepare the corporate holding company financial statements and to consolidate them with the operating companies.
    Assumption: Materiality is about how large the number is that you are looking at.
    Story: There was a $1.00 bank transfer into the bank account in the previous month. When asked, my supervisor said, don’t worry about it, just book it as interest income, it’s only a dollar so it isn’t material.
    Procedure: I prepared the consolidated financial statements and presented them to the VP Finance.
    Finding: He asked me why there was no accounting for the disposition of the 35% ownership in a multi-million dollar company. He pointed to the corner of his office. In the corner was a banker’s box full of legal binders.
    Result: It turned out the $1.00 was the net result of a large transaction. The transaction was very material and had a huge impact on the balance sheet and the income statement. It took me several days to read the box of documents, record the transactions and calculate the tax consequences.
    Resolved: I’ve never looked at a $1.00 bank transfer the same way again or assumed that just because a number is small that it is not material.

  4. Zero Account Balances

    Scenario: The client had been preparing their own financial statements. The company had grown to a size where it became necessary to hire an accountant because the owner no longer had the time to prepare the records.
    Assumption: All sales would be recorded as sales.
    Story: The owner brings in his records in an accounting software format. There are very few account balances on the balance sheet.
    Procedure: This is an owner manager and I know that they can be asked to produce their personal bank statements in an IVI audit. I ask the owner for his personal bank statements. I do a quick scan of the personal bank statements and just out of curiosity add up the deposits to his personal bank account and compare them to the salaries recorded as expense on the income statement.
    Finding: There is $50,000 more deposited to the personal bank account of the owner than paid out by the company in expenses. On closer examination of the adding machine tape of the deposits, I see a deposit for $50,000. The bank statement in July of the previous year shows a $50,000 deposit. Where did it come from? I check the company bank account.
    -The company has recorded a payment to the shareholder for $50,000. Just a minute here, the opening shareholder loan balance was only a few hundred dollars. Is there a dividend recorded? No, there isn’t. -What's recorded is an increase in the shareholder loan balance, along with an increase in accounts receivable. How did this happen?
    -A $50,000 sale is recorded as a debit to accounts receivable and the credit is coded to shareholder loan.
    -What happened next? The customer pays the company. Increase bank, decrease accounts receivable.
    Result: The receivable account is now zero. The bank account has a $50,000 balance and the books show that the shareholder is owed $50,000. The company pays $50,000 to the shareholder, reducing the shareholder loan account. You guessed it, not only is accounts receivable zero, the shareholder account balance is now zero and the bank account is also zero. It’s like the sale never happened.
    Resolve: Never skip analysis of a zero balance account. Analyze all accounts with transactions by scanning the general ledger and prepare working papers for all accounts with transactions even if the opening and closing balances are zero. Scan personal bank, credit card and investment statements for deposits in excess of reported income. Look for deposits for items other than salary and dividends, and RRSP withdrawals. Check for unusual changes in non-registered investments or debts.

  5. Unreported Transactions

    Scenario: New personal tax client.
    Assumptions: Capital gains and losses were recorded for non registered investments such as stocks, bonds and mutual funds traded in previous years. RRSP contributions claimed for all contributions each year.
    Story: I requested that the client provide the broker statements and mutual fund annual reports in order to calculate ACB of investments from the client.
    Procedure: I input the transactions into Quicken to calculate ACB of current holdings and compared income reported by the broker T5’s and mutual fund T3’s for reinvested dividends to my accounting. I compared the RRSP contributions to the amounts claimed the previous year.
    Finding: Calculations of capital gains from prior years, when compared to prior years’ tax returns, exposed unclaimed capital transactions for 10 years. Voluntary disclosure limited the client’s liability for penalties on unreported income. RRSP contributions each year in January and February were not claimed. The contribution slips were filed in with the broker statements and never made it to the previous accountant.
    Result: Unclaimed capital losses and unclaimed RRSP contributions helped to offset liability for unreported capital gains of prior years.
    Resolve: All clients are required to provide investment statements for all investments including non registered and registered RRSP and RRIF accounts. Reconcile investment transactions to prior years’ tax returns for all clients. Results include claims of capital losses for clients who never claimed losses in past years. Losses can offset capital gains in the future because capital losses carry forward forever.

  6. Too Much Tax

    Scenario: Who doesn’t have little old ladies who complain about how much tax they pay? This one claims her friend has similar income and investments and pays half the tax.
    Assumption: Little old ladies always complain about paying too much tax. Brokers’ slips like T3’s and T5’s for investment income must be correct.
    Story: Staff keyed all investment transactions into Quicken to test against T5 and T3 slips. Based on the investment income reports generated, I called the client to ask what happened to the additional $100,000. Client said “I don’t have another $100,000 dear, that’s what I have been trying to tell you”.
    Procedure: I went back and looked carefully at all the documents. Then I called the broker and the bank to get their help to figure out what I was looking at because it did not make sense. There was about $5,000 more in income per year than there was investment. Hence my question on the whereabouts of the other $100,000.
    Finding: The broker had recorded all of the disbursements received by the client from a bank for a special type of investment that included a return of capital and income payment each month. The broker’s accounting department included the total of these disbursements in interest income on the T5. In addition, the bank had prepared a T3 for income from same investment, including interest income, not including the return of capital. To correct the situation, the broker reduced the T5 for the total of the return of capital and income, not just for one year, but for all years involved.
    Result: Client received thousands of dollars in tax refunds due to the overstatement of income on her T5’s. The brokerage apologized and lost the client anyway, as she no longer trusted them or her old accountant.
    Resolve: Always check that T5’s and T3’s agree to income calculated from investment statements using investment accounting software. Start and maintain records for clients’ adjusted cost base on an annual basis. Compare all changes to cost including capital gains, reinvested dividends, broker fees, dividends and interest, deposits and withdrawals to the net change in the cost base of the portfolio. Watch for return of capital and adjust the cost base where necessary from T3 slips. Brokers and mutual fund companies don’t provide this information during the year; it comes from the T3 slips that are mailed by March 31 each year.

These six cases have taught me to…

  • Keep an open mind, don’t make assumptions without checking that they hold true;
  • Be disciplined, examine client documents and comparisons to prior years’ tax returns;
  • Be curious, trust my instincts and listen to what my clients are saying.




Eileen Reppenhagen is the originator and contributing author of Section 800 of the CGA Canada Public Practice Manual "Future Oriented Financial Information" (1999), and a participant in CGA Canada's Video: Taking Care of Business (2000). She may be contacted by telephone: 1 604 943.7414





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