Expectation Gap

So I mentioned this thing called the expectation gap in auditing. As you may have guessed it is the gap between what the client and/or public in general expect from an audit and what the auditors are delivering.

Auditors must work hard to narrow the gap as much as possible, so I'll do what I can by explaining what it is that the auditors provide.

Auditors do NOT prepare the financial statements of their clients. The clients themselves do that. The auditors come in and examine the financial statements that have been prepared, checking to make sure the accounting standards (e.g. Generally accepted accounting principles -- GAAP) have been applied properly and that everything is fairly presented.

The second part of an auditors job is to provide an opinion (unqualified, qualified, adverse, and I can't even recall the 4th one because it is rarely even used -- you will generally see unqualified or qualified opinions) on the statements. If everything looks great and any potential issues were cleared up (adjusted) with management, then an unqualified opinion will be issued (as weird as it sounds, this is the best opinion a company can hope for).

Notice, though, that the auditor does NOT go through every single transaction and balance to ensure they are 100% correct and free of error. They use sampling methods to test them. This means that the auditors do NOT provide 100% assurance (i.e. they are not providing insurance on the financial health of the company). There will be some small percentage of misstatements that are not caught by the auditors.

So, does that mean if I'm an investor and I invest in the company based on the audited financial statements and lose money due to the misstatement then I can sue the auditor for negligence? Well, it depends. It depends if they followed GAAS (generally accepted auditing standards) or not. If the auditor followed GAAS, then they provide reasonable assurance that the statements are fairly presented and have sufficiently done their job. If the auditor failed to comply with GAAS, then an investor could sue them!

This is a good place to explain the difference between business failure and audit failure. Business failure is where a business fails to make it's debt payments and could result in bankruptcy. Audit failure, on the other hand, is the failure of the auditor to comply with GAAS. They are NOT the same. As was explained above, business failure could occur while there was no failure in audit.

So do we want 100% assurance from the auditors? It would sure be nice, but it just means that it will cost the company more money in audit fees. More assurance = more work for the auditor = higher fees. The level of assurance that is currently provided is sufficient enough that investors can have confidence in it and make informed decisions based on the audited financial statements. It's currently cost-effective.

Tax advantages of long term investing

I'd like to discuss the beauty that is called capital gains tax (it's beautiful relative to regular taxes anyway). What's so great about it? Well you are only taxed on HALF of your capital gains.

The basic math:
$1000 income from working (say 30% tax rate) = $300 tax bill ($1000*30%)
$1000 from capital gains (same 30% tax rate) = $150 tax bill ((1/2)*$1000*30%)

When you're investing for the long term, the majority of your wealth creation comes from capital gains. As a result you get to enjoy the very advantageous capital gains tax. Since it's long term you also don't pay the tax for a few years either. Deferred taxes at an advantageous rate? I'll take 3!

Check out this video showing the legendary Warren Buffett (he's probably my hero with Wolverine or something coming in a close second) talking about how he pays a lower % tax rate than his receptionist:



(I'm sort of technically challenged so I can't quite figure out how to insert a YouTube video here .. if anyone wants to let me know in a comment that would be greatly appreciated!!)

EDIT: You guys rock! Thanks for the help getting this video posted!!

Net Income for Which Purpose?

I'd like to make a brief post to point out an important difference between income for accounting purposes and income for tax purposes. In 99.99% of cases there is a difference between the income that companies report to their shareholders and the income they report for tax purposes.

Some of these differences are permanent while others are temporary. This means that at some point in the future, temporary difference will reverse while permanent differences will never reverse.

I'll outline a common example for each to clear things up a bit.

Temporary difference:
The amount of depreciation that a company claims in any given year is almost certain to be different under tax and accounting approaches. For tax purposes, a company may use a declining balance method at a prescribed rate depending on the type of asset (e.g. business vehicles are assigned to Class 10 and decline at 30% per year). On the other hand, under the generally accepted accounting principles (GAAP) which are used for accounting purposes, a company is likely to use a straight line amortization schedule (i.e. the depreciation reported on an asset is basically a set amount over its economic useful life).

The result of this is that in early years an asset is going to depreciated faster for tax purposes, which means that it will reverse in later years when the depreciation for accounting purposes will be higher. This leads to future income tax liabilities or assets to be reported on the balance sheet!

Permanent difference:
Meals & entertainment. Under GAAP, these expenses are fully deducted from income. For tax purposes, only 50% of these expenses can be deducted from income. The idea is that you can deduct the cost of entertaining clients (1/2 the bill), but cannot deduct your own meal (the other 1/2 of the bill)!