What Is an Auditor?

An auditor is a person authorized to review and verify the accuracy of financial records and ensure that companies comply with tax laws. They protect businesses from fraud, point out discrepancies in accounting methods and, on occasion, work on a consultancy basis, helping organizations to spot ways to boost operational efficiency. Auditors work in various capacities within different industries.

Understanding an Auditor

Auditors assess financial operations and ensure that organizations are run efficiently. They are tasked with tracking cash flow from beginning to end and verifying that an organization’s funds are properly accounted for.

In the case of public companies, the main duty of an auditor is to determine whether financial statements follow generally accepted accounting principles (GAAP). To meet this requirement, auditors inspect accounting data, financial records, and operational aspects of a business and take detailed notes on each step of the process, known as an audit trail.

Once complete, the auditor’s findings are presented in a report that appears as a preface in financial statements. Separate, private reports may also be issued to company management and regulatory authorities as well.

The Securities and Exchange Commission (SEC) demands that the books of all public companies are regularly examined by external, independent auditors, in compliance with official auditing procedures. Official procedures are established by the International Auditing and Assurance Standards Board (IAASB), a committee of the International Federation of Accountants (IFAC).

Unqualified Opinion vs. Qualified Opinion

Auditor reports are usually accompanied by an unqualified opinion. These statements confirm that the company’s financial statements conform to GAAP, without providing judgment or an interpretation.

When an auditor is unable to give an unqualified opinion, they will issue a qualified opinion, a statement suggesting that the information provided is limited in scope and/or the company being audited has not maintained GAAP accounting principles.

Auditors assure potential investors that a company’s finances are in order and accurate, as well as provide a clear picture of a company’s worth to help investors make informed decisions.

Types of Auditors

• Internal auditors are hired by organizations to provide in-house, independent, and objective evaluations of financial and operational business activities, including corporate governance. They report their findings, including tips on how to better run the business, back to senior management.
• External auditors usually work in conjunction with government agencies. They are tasked with providing an objective, public opinion concerning the organization’s financial statements and whether they fairly and accurately represent the organization’s financial position.
• Government auditors maintain and examine records of government agencies and of private businesses or individuals performing activities subject to government regulations or taxation. Auditors employed through the government ensure revenues are received and spent according to laws and regulations. They detect embezzlement and fraud, analyze agency accounting controls, and evaluate risk management.
• Forensic auditors specialize in crime and are used by law enforcement organizations.

Auditor Qualifications

External auditors working for public accounting firms require a Certified Public Accountant (CPA) license, a professional certification awarded by the American Institute of Certified Public Accountants. In addition to this certification, these auditors also need to obtain state CPA certification. Requirements vary, although most states do demand a CPA designation and two years of professional work experience in public accounting.

Qualifications for internal auditors are less rigorous. Internal auditors are encouraged to get CPA accreditation, although it is not always mandatory. Instead, a bachelor’s degree in subjects such as finance and other business disciplines, together with appropriate experience and skills, are often acceptable.

Special Considerations

Auditors are not responsible for transactions that occur after the date of their reports. Moreover, they are not necessarily required to detect all instances of fraud or financial misrepresentation; that responsibility primarily lies with an organization’s management team.

Audits are mainly designed to determine whether a company’s financial statements are “reasonably stated.” In other words, this means that audits do not always cover enough ground to identify cases of fraud. In short, a clean audit offers no guarantee that an organization’s accounting is completely above board.

What Is the Average Cost Basis Method?

The average cost basis method is a system of calculating the value of mutual fund positions held in a taxable account to determine the profit or loss for tax reporting. Cost basis represents the initial value of a security or mutual fund that an investor owns.

The average cost is then compared with the price at which the fund shares were sold to determine the gains or losses for tax reporting. The average cost basis is one of many methods that the Internal Revenue Service (IRS) allows investors to use to arrive at the cost of their mutual fund holdings.

Understanding the Average Cost Basis Method

The average cost basis method is commonly used by investors for mutual fund tax reporting. A cost basis method is reported with the brokerage firm where the assets are held. The average cost is calculated by dividing the total amount in dollars invested in a mutual fund position by the number of shares owned. For example, an investor that has $10,000 in an investment and owns 500 shares would have an average cost basis of $20 ($10,000 / 500).

Types of Cost Basis Methods

Although many brokerage firms default to the average cost basis method for mutual funds, there are other methods available.

FIFO

The first in, first out (FIFO) method means that when shares are sold, you must sell the first ones that you acquired first when calculating gains and losses. For example, let’s say an investor owned 50 shares and purchased 20 in January while purchasing 30 shares in April. If the investor sold 30 shares, the 20 in January must be used, and the remaining ten shares sold would come from the second lot purchased in April. Since both the January and April purchases would have been executed at different prices, the tax gain or loss would be impacted by the initial purchase prices in each period.

Also, if an investor has had an investment for more than one year, it would be considered a long-term investment. The IRS applies a lower capital gains tax to long-term investments versus short-term investments, which are securities or funds acquired in less than one year. As a result, the FIFO method would result in lower taxes paid if the investor had sold positions that were more than a year old.

LIFO

The last in first out (LIFO) method is when an investor can sell the most recent shares acquired first followed by the previously acquired shares. The LIFO method works best if an investor wants to hold onto the initial shares purchased, which might be at a lower price relative to the current market price.

High-Cost and Low-Cost Methods

The high-cost method allows investors to sell the shares that have the highest initial purchase price. In other words, the shares that were the most expensive to buy get sold first. A high-cost method is designed to provide investors with the lowest capital gains tax owed. For example, an investor might have a large gain from an investment, but doesn’t want to realize that gain yet, but needs money.

Having a higher cost means the difference between the initial price and the market price, when sold, will result in the smallest gain. Investors might also use the high-cost method if they want to take a capital loss, from a tax standpoint, to offset other gains or income.

Conversely, the low-cost method allows investors to sell the lowest-priced shares first. In other words, the cheapest shares you purchased get sold first. The low-cost method might be chosen if an investor wants to realize a capital gain on an investment.

Choosing a Cost-Basis Method

Once a cost basis method has been chosen for a specific mutual fund, it must remain in effect. Brokerage firms will provide investors with appropriate annual tax documentation on mutual fund sales based on their cost basis method elections.

Investors should consult a tax advisor or financial planner if they are uncertain about the cost basis method that will minimize their tax bill for substantial mutual fund holdings in taxable accounts. The average cost basis method may not always be the optimal method from a taxation point of view. Please note that the cost basis only becomes important if the holdings are in a taxable account, and the investor is considering a partial sale of the holdings.

Specific Identification Method

The specific identification method (also known as specific share identification) allows the investor to choose which shares are sold in order to optimize the tax treatment. For example, let’s say an investor purchases 20 shares in January and 20 shares in February. If the investor later sells 10 shares, they can choose to sell 5 shares from the January lot and 5 shares from the February lot.

Example of Cost Basis Comparisons

Cost basis comparisons can be an important consideration. Let’s say that an investor made the following consecutive fund purchases in a taxable account:

• 1,000 shares at $30 for a total of $30,000
• 1,000 shares at $10 for a total of $10,000
• 1,500 shares at $8 for a total of $12,000

The total amount invested equals $52,000, and the average cost basis is calculated by dividing $52,000 by 3,500 shares. The average cost is $14.86 per share.

Suppose the investor then sells 1,000 shares of the fund at $25 per share. The investor would have a capital gain of $10,140 using the average cost basis method. The gain or loss using average cost basis would be as follows:

• ($25 – $14.86) x 1,000 shares = $10,140.

Results can vary depending on the cost-basis method chosen for tax purposes:

• First in first out: ($25 – $30) x 1,000 shares = – $5,000
• Last in first out: ($25 – $8) x 1,000 = $17,000
• High cost: ($25 – $30) x 1,000 shares = – $5,000
• Low cost: ($25 – $8) x 1,000 = $17,000

From strictly a tax standpoint, the investor would be better off selecting the FIFO method or the high-cost method to calculate the cost basis before selling the shares. These methods would result in no tax on the loss. However, with the average cost basis method, the investor must pay a capital gains tax on the $10,140 in earnings.

Of course, if the investor sold the 1,000 shares using the FIFO method, there’s no guarantee that when the remaining shares are sold that $25 will be the selling price. The stock price could decrease, wiping out most of the capital gains and an opportunity to realize a capital gain would have been lost. As a result, investors must weigh the choice as to whether to take the gain today and pay the capital gains taxes or try to reduce their taxes and risk losing any unrealized gains on their remaining investment.

What Is an Alternative Depreciation System (ADS)?

An alternative depreciation system (ADS) is one of the methods the Internal Revenue Service (IRS) requires taxpayers to use to determine the depreciation allowed on business assets. An ADS has a depreciation schedule with a longer recovery period that generally better mirrors the asset’s income streams than declining balance depreciation. If the taxpayer elects to use an alternative depreciation system, they must apply it to all property of the same class placed in service during the same year.

Understanding when to use ADS is important for business owners because accurately calculating depreciation expenses can help lower business taxes. However, the IRS rules regarding ADS can be complex. For this reason, many business owners opt to hire a tax professional to ensure they take as much depreciation expense as the IRS allows.

Understanding Alternative Depreciation System (ADS)

Depreciation is an accounting method that allows businesses to spread out the cost of a physical asset over a specified number of years, which is known as the useful life of the asset. The useful life of an asset is an estimate of the number of years a company will use that asset to help generate revenue. The IRS allows businesses to depreciate many kinds of business assets, including computers and peripherals; office furniture, fixtures, and equipment; automobiles; and manufacturing equipment.

Taxpayers who elect to use the alternative depreciation system feel that the alternative schedule will allow for a better match of depreciation deductions against income than the recovery period under the general depreciation system. While the ADS method extends the number of years an asset can be depreciated, it also decreases the annual depreciation cost. The depreciation amount is set at an equal amount each year with the exception of the first and last years, which are generally lower because they do not include a full twelve months.

Alternative Depreciation System (ADS) vs. General Depreciation System (GDS)

For property placed in service after 1986, the IRS requires that taxpayers use the Modified Accelerated Cost Recovery System (MACRS) to depreciate property. There are two methods that fall under the MACRS: the general depreciation system (GDS) and the alternative depreciation system (ADS).

The alternative depreciation system offers depreciation over a longer period of time than the general depreciation system, which is a declining balance method. The general depreciation system is often used by companies to depreciate assets that tend to become obsolete quickly and are replaced with newer versions on a fairly frequent basis. Computers and phone equipment are examples of this.

The general depreciation system allows companies to accelerate the asset’s depreciation rate by recording a larger depreciation amount during the early years of an asset’s useful life and smaller amounts in later years. The general depreciation system is more commonly used than the alternative depreciation system.

Special Considerations

The tax implications of calculating depreciation can affect a company’s profitability. For this reason, business owners need to carefully consider the pros and cons of ADS versus GDS. Since the alternative depreciation system offers depreciation over a longer course of time, the yearly deductions for depreciation are smaller than with the other method. Taxpayers who choose the alternative depreciation system schedule must use this schedule for all property of the same class that was placed in service during the taxable year.

However, taxpayers may elect the alternative depreciation system schedule for real estate on a property-by-property basis. The alternative depreciation system recovery schedule is listed in IRS Publication 946.

What Is the Amortization of Intangibles?

Amortization of intangibles, also simply known as amortization, is the process of expensing the cost of an intangible asset over the projected life of the asset for tax or accounting purposes. Intangible assets, such as patents and trademarks, are amortized into an expense account called amortization. Tangible assets are instead written off through depreciation. The amortization process for corporate accounting purposes may differ from the amount of amortization used for tax purposes.

Understanding the Amortization of Intangibles

For tax purposes, the cost basis of an intangible asset is amortized over a specific number of years, regardless of the actual useful life of the asset (as most intangibles don’t have a set useful life). The Internal Revenue Service (IRS) allows intangibles to be amortized over a 15-year period if it’s one of the ones included in Section 197.

Intangible assets are non-physical assets that can be assigned an economic value. Intellectual property (IP) is considered to be an intangible asset and is a broad term that encompasses most intangible assets. Most IP is covered under Section 197. Examples of these Section 197 intangible assets include patents, goodwill, trademarks, and trade and franchise names.

Not all IP is amortized over the 15-year period set by the IRS, however. There are certain exclusions, such as software acquired in a transaction that is readily available for purchase by the general public, subject to a nonexclusive license, and has not been substantially modified. In those cases and select others, the intangibles are amortized under Section 167.

Special Considerations

When a parent company purchases a subsidiary company and pays more than the fair market value (FMV) of the subsidiary’s net assets, the amount over fair market value is posted to goodwill (an intangible asset). IP is initially posted as an asset on the firm’s balance sheet when it is purchased.

IP can also be internally generated by a company’s own research and development (R&D) efforts. For instance, a company may win a patent for a newly developed process, which has some value. That value, in turn, increases the value of the company and so must be recorded appropriately.

In either case, the process of amortization allows the company to write off annually a part of the value of that intangible asset according to a defined schedule.

Amortization vs. Depreciation

Assets are used by businesses to generate revenue and produce income. Over a period of time, the costs related to the assets are moved into an expense account as the useful life of the asset dwindles. By expensing the cost of the asset over a period of time, the company is complying with GAAP, which requires the matching of revenue with the expense incurred to generate the revenue.

Tangible assets are expensed using depreciation, and intangible assets are expensed through amortization. Depreciation generally includes a salvage value for the physical asset—the value that the asset can be sold for at the end of its useful life. Amortization doesn’t take into account a salvage value.

Types of Amortization

For accounting (financial statement) purposes, a company can choose from six amortization methods: straight line, declining balance, annuity, bullet, balloon, and negative amortization. There are only four depreciation methods that can be used for accounting purposes: straight line, declining balance, sum-of-the-years’ digits, and units of production.

For tax purposes, there are two options for amortization of intangibles that the IRS allows. These are straight line and the income forecast method. The income forecast method can be used instead of the straight-line method if the asset is: motion picture films, videotapes, sound recordings, copyrights, books, or patents. For depreciation of physical assets, the IRS only allows the Modified Accelerated Cost Recovery System (MACRS).

Example of Amortization

Assume, for example, that a construction company buys a $32,000 truck to contractor work, and that the truck has a useful life of eight years. The annual depreciation expense on a straight-line basis is the $32,000 cost basis minus the expected salvage value—in this case, $4,000—divided by eight years. The annual deprecation for the truck would be $3,500 per year, or ($32,000 – $4,000) ÷ 8.

On the other hand, assume that a corporation pays $300,000 for a patent that allows the firm exclusive rights over the intellectual property for 30 years. The firm’s accounting department posts a $10,000 amortization expense each year for 30 years.

Both the truck and the patent are used to generate revenue and profit over a particular number of years. Since the truck is a physical asset, depreciation is used, and since the rights are intangible, amortization is used.