Key takeaways
- A large number of adjustments shows that the accounting process cannot catch errors on its own. Fix the cause.
- A management letter is a task list that must be prioritised, with an owner and a closing date for each item.
- Before sending figures to the bank, test the effect of the adjustments on the Covenant.
The auditor sends several adjustments, followed by a management letter with more than ten points. The accounting team rushes to book the adjustments and files the documents away. The following year the same issues return, until a bank or investor asks to see the documents and the owner discovers that the same issues have repeated for three years.
Adjustments are like the marks an examiner makes on a driving test. If you passed only by patching things up on the day without practising your driving, the same marks will come back next year. Aiming for no adjustments at all this year is a good goal in terms of direction, but it is not always realistic, because some adjustments arise from the interpretation of standards or from information that emerges later. What matters is that adjustments decrease and do not repeat.
Reading the types of issue correctly
| Term | Meaning | What to do |
|---|---|---|
| Audit Adjustment | Entries that correct figures in the financial statements | Find the cause and fix the process |
| Uncorrected Misstatement | Differences found but not yet adjusted by management | Review the reasoning, as they may accumulate across years |
| Deficiency | A control cannot prevent or detect errors in time | Identify the owner and the remediation plan |
| Significant Deficiency | A deficiency significant enough to be communicated in writing to those charged with governance, under TSA 265 | Directors should follow it up directly |
"Material Weakness" is a term commonly found in the regulatory context of some countries, whereas auditing standards based on ISA 265 use the Significant Deficiency framework. Whichever term the auditor uses, ask which level in the standard it refers to.
Example: an adjustment hits a Covenant
Hypothetical example: profit before tax before adjustments of THB 32 million, EBITDA of THB 48 million, debt service of THB 30 million, and a hypothetical minimum DSCR Covenant of 1.30x. For simplicity, assume DSCR is calculated from EBITDA and that every adjustment affects EBITDA.
| Adjustment | Effect on profit (THB million) | Cause |
|---|---|---|
| Revenue cut-off error across periods | (4.2) | Used the document issue date, not the date control transferred |
| Incomplete expense accruals | (1.8) | No report of goods received not invoiced |
| Allowance for obsolete inventory | (2.5) | No aging report |
| Repair and maintenance costs recorded as assets | (1.5) | No capitalisation criteria |
| Long-term debt reclassified as current | 0.0 | No effect on profit, but affects liquidity |
| Total | (10.0) | A 31.25% reduction in profit before tax |
Profit before tax falls to THB 22 million and EBITDA falls from THB 48 million to THB 38 million. DSCR drops from 1.60x to 1.27x, below the hypothetical threshold of 1.30x. If the company sees this figure during the year-end close, it still has time to talk to the bank. If it sees it only when submitting the financial statements, its options are far fewer.
Prioritising the management letter
| Order | Characteristics | Deadline |
|---|---|---|
| A | Affects cash, fraud, tax or bank conditions | Immediately, and report to the directors |
| B | Causes a material adjustment, or repeats from the prior year | Before the next quarter-end close |
| C | Update documents and policies | Within the financial year |
For each point, you must be able to answer who owns it, which process will be fixed, how you will test that the fix really works, and when the auditor will be informed. Management's response should match what is actually done, rather than replying "noted and will act" to every point.
Auditors must maintain their independence, so they should not design or carry out, on the company's behalf, the systems they have to audit, and should not be pressured to avoid adjustments. If you disagree with any point, discuss it using documents and the relevant standards.
From adjustments to root causes
Fixing at the end of the pipeline means correcting the figure and stopping there. Fixing at the source means asking why the existing process did not catch the item before the auditor saw it. Keep asking, layer by layer, until you reach a point that can really be fixed. For example, cross-period revenue arises because staff record revenue by the document issue date, since the system holds no delivery date and nobody compares end-of-month delivery documents with revenue. The answer is therefore not to instruct staff to be more careful, but to add delivery date data and add a cut-off test at every month-end.
An issue attributed to staff error usually has not yet reached the root cause, because when people change, the same error comes back. Record causes in categories that can be reviewed retrospectively, such as incomplete data, no policy, no reviewer, system unable to support, or the team not having enough time. After two or three years, the owner will see exactly where money should go: systems, people or training.
Before the auditor comes in, the accounting team should close the internal trial balance and answer for themselves the questions the auditor will ask: whether revenue at the start and end of the period is in the right period, whether the various allowances have a calculation basis, and whether unusual items are documented. The time spent on this reduces follow-up fixes during the rush to close the books. Banks and investors who read several years of financial statements will also see more consistency in the figures.
Next steps
- Build a three-year table of adjustments, grouped by cause, and see which ones repeat.
- Ask for the full management letter and have the directors or owner read it themselves.
- Rank the points A, B and C, with an owner and a closing date for each.
- Run a pre-audit before year-end on cut-off, accruals and inventory.
- Test the expected effect of the adjustments on the Covenant before submitting the financial statements.
- Report progress every quarter until the issues are closed.