CHAPTER 27 COMPLETING THE AUDIT AND POST-AUDIT RESPONSIBILITIES I Review Questions Many of the revenue and expense accounts are not material in relation to the financial statements and may be combined with other accounts in the financial statements These accounts can be audited through analytical procedures Such procedures compare the account balance to related balance sheet accounts, to sales, to industry averages or to a multiple-year trend to ascertain whether any unusual fluctuations are present Unusual or unexpected items would have to be investigated and material items vouched to supporting documents The primary purpose of the client representation letter is to impress upon management its ultimate responsibility for the adequacy of the financial statements and related disclosures With respect to receivables, such letters typically state that all receivables are valid and include proper amounts; also stated is the amount written off in the past year and the current provision for uncollectibles In connection with inventories, the client represents that the peso amount of inventories reflects physical quantities determined by a count and priced by a stated accounting method The client also represents that provision has been made by the company for all obsolete and damaged inventory In regard to minutes, the client represents that all minutes of meetings of stockholders, directors, and executive committees which have been transmitted to the auditor are complete and authentic records for the period under audit (including the subsequent period) The client letter of representation should state whether any events occurred subsequent to the date of the financial statements that, in the client’s opinion, require adjustment or disclosure in the statements In addition to the attorney’s letter, other procedures that are used to gather evidence regarding contingencies include: • • • • • Standard bank confirmation Inquiry of client management Reading of the minutes of the board of directors Vouching to purchase and sales contracts Vouching to lease agreements, confirmation with lessor or lessee 27-2 Solutions Manual - Assurance Principles, Professional Ethics… There are two types of subsequent events: The first type consists of those events that provide additional evidence with respect to conditions that existed at the date of the balance sheet and affect the estimates inherent in the process of preparing financial statements The use of the evidence requires an adjustment to the financial statements The second type consists of those events that provide evidence with respect to conditions that did not exist at the date of the balance sheet being reported on but arose subsequent to that date These events should not result in an adjustment of the financial statements However, disclosure may be required to prevent the financial statements from being misleading In some cases, pro forma financial statements may be required to ensure adequate disclosure The purpose of dual dating is twofold: (1) To provide a means of inserting important information in the financial statements even when learned after field work is complete, while at the same time (2) to inform users that the auditor takes full responsibility for subsequent events only up to the end of the field work and for the specifically identified later event, but does not take responsibility for other events which may have occurred after the end of field work and before the date of the specifically identified subsequent event Loss contingencies from litigation, claims, and assessments can be accrued or disclosed, depending on the event’s likelihood When a loss contingency involves an unasserted claim or assessment, disclosure is not required if no evidence exists that the assertion of a claim is probable When an unasserted claim probably will be asserted and an unfavorable outcome is a reasonable possibility, disclosure is required When a loss contingency is likely and the amount can be estimated, the contingency should be accrued When substantial doubt exists about the ability of an entity to continue in operation for a year following the financial statements, an auditor should add a paragraph calling attention to the fact that the statements have been prepared assuming that the entity will continue as a going concern If an auditor fails to modify the report, however, and an entity ceases to exist as a going concern within one year following the date of the audit, this does not in itself indicate inadequate performance by the auditor Management’s refusal to sign a representation letter would typically result in a disclaimer of opinion because audit evidence was restricted by management At the completion of the audit, an auditor must reconsider materiality and determine an amount for materiality to be used in evaluating the estimated errors in the financial statements Also, an auditor should reconsider the audit risk Completing the Audit and Post-Audit Responsibilities 27-3 As errors are found during the audit, the auditor generally shares them with the client, and the client makes adjusting entries for material errors If the client refuses to correct a material error, the auditor must consider the materiality of the combined known errors and likely errors Known errors are individual errors specifically identified by an auditor, whereas likely errors are an auditor’s best estimate of other errors based on a projection of errors detected during sampling An auditor should compare projected error to materiality, both on an account level and in the aggregate 10 A financial statement disclosure checklist is a checklist an auditor uses to review the financial statements to check that all necessary disclosures have been included In contrast, the auditor uses an engagement checklist to determine that all auditing procedures have been performed 11 “Subsequent events” are material events that occur after the balance sheet date but before the end of field work (and thus, before the audit report date) that require disclosure in the financial statements and related notes Auditors (and management) are responsible for gathering evidence on these subsequent events and evaluating the proposed disclosure “Subsequent discovery of facts existing at the audit report date” is knowledge gained after the audit report is issued about an event or condition that existed at the audit report date Auditors have no responsibility to search for these facts (as they for subsequent events); however, once brought to the auditors’ attention, their responsibility is to determine if the financial statements (and thus their report) are misstated and take appropriate action 12 The actions the partner should take if the client consents to disclose the information (which existed at the audit report date and materially impacts the financial statements) is to determine the method and timing of disclosure The actions the partner should take if the client refuses to make disclosure are: • Notify the client that the auditors’ report must no longer be associated with the financial statements • Notify regulatory authorities that the auditors’ report should no longer be relied upon • Notify users known to be relying on the financial statements that the auditors’ report should no longer be relied upon Such notification may be to the SEC and the stock exchanges 13 Once auditors have reported on audited financial statements, they have no responsibility to carry out a retroactive review of their work However, postissuance review may be made in connection with a firm’s internal quality control monitoring program, peer review or otherwise, and the omission of an auditing procedure may be discovered 27-4 Solutions Manual - Assurance Principles, Professional Ethics… If an omitted procedure is found, the auditors should consult legal counsel and take the following actions: • Assess the importance of the omitted procedure to the present ability to support the previously expressed opinion • Determine if there are persons currently relying or likely to rely on their report • If the omitted procedure impairs present ability to support the previously expressed opinion, the omitted procedure should be applied or alternative procedures applied that would provide a satisfactory basis for the opinion • If, as a result of subsequent application of the omitted procedure or alternative procedures, the auditors become aware of facts that existed at the date of their report, they should refer to page 927 (Subsequent Discovery of Facts Existing at the Date of the Auditor’s Report) for guidance 14 In a “cold review,” a partner not otherwise associated with an engagement will take the report (in draft copy) and all working papers and review the entire engagement with a fresh start The purpose of the review is to obtain the unbiased view of a professional expert who is not committed to a particular engagement or its problems It is performed to aid in maintaining high standards of professional practice 15 A management letter is an extra audit service Auditors write to the management their recommendations about control, tax matters, operating efficiencies, and other consulting subjects to impress on managers the benefits of audits in addition to “just an audit.” The letter also serves to promote and sell CPAs’ consulting services 16 A good management letter can show the client some profit potential, and the CPA may be hired to the consulting work 17 When the auditor learns of information existing at the date of a previously issued audit report, that it, if known, would have altered the audit opinion, the following steps are in order: a Determine whether the information is reliable and whether the facts existed at the date of the audit report; b Request the client to make necessary disclosure to persons known to be relying on the statements; c If the client refuses, the auditor has a duty to notify those known to be relying on the audit report that such reliance is no longer justified (notifying board of directors, SEC, and stock exchange usually satisfies this requirement) 18 An auditor should investigate the new information as soon as practicable When an auditor determines that the information is reliable, that the facts existed at the Completing the Audit and Post-Audit Responsibilities 27-5 date of the report, and that the nature of the information and its effect on the financial statements are such that the report would have been affected, the auditor should consider whether persons are relying on the report If the auditor must take steps to prevent future reliance on the report, the preferred resolution is for the client to issue revised financial statements and the auditor to issue a revised report, unless the issuance of statements for a subsequent period is imminent When the effect on the financial statements of the subsequently discovered information cannot be determined without a prolonged investigation, the client should notify persons who are known to be relying on or who are likely to rely on the financial statements and the related report The client’s notification should state that (1) the statements should not be relied on and (2) revised financial statements and auditor’s report will be reissued on completion of an investigation If applicable, the client should discuss the matter with the Securities and Exchange Commission, stock exchanges, and appropriate regulatory agencies 19 If the client refuses to disclose the newly discovered facts, the auditor should consult with his or her attorney and notify each member of the board of directors of such refusal and of the fact that, in the absence of such disclosure, the auditor will take steps to prevent future reliance on the audit report These steps may include • notifying the client that the audit report must no longer be associated with the financial statements • notifying the appropriate regulatory agencies that the audit report should no longer be relied on • notifying each person known to the auditor to be relying on the financial statements that the audit report should no longer be relied on If such notification is impracticable, the auditor may request a regulatory agency having jurisdiction over the client to take whatever steps it deems appropriate 20 When an auditor concludes that an auditing procedure considered necessary at the time of the audit was omitted, auditing standards require the auditor to assess the importance of the omitted procedure to his or her present ability to support the previously expressed opinion An auditor may review the working papers and discuss the matter with other engagement personnel to evaluate whether other applied procedures compensate for the omitted procedure If the auditor concludes that omission of the procedure impairs his or her present ability to support the previously expressed opinion, and if persons are currently relying on or are likely to rely on the report, the auditor should promptly undertake to apply the omitted procedure or alternative procedures that would provide a satisfactory basis for the opinion If the auditor is unable to so, he or she should consult a lawyer to determine the proper course of action 27-6 Solutions Manual - Assurance Principles, Professional Ethics… When performing the omitted procedures supports the opinion that was previously released, the auditor has no further responsibility However, if while performing the procedures the auditor becomes aware that facts regarding the financial statements existed at the date of the report that would have affected the report had he or she had been aware of them, the auditor should follow notification procedures to prevent further reliance on the report II Multiple Choice Questions 10 11 c b a c d b d d d c d 12 13 14 15 16 17 18 19 20 21 22 b c a b b b c a b d a 23 24 25 26 27 28 29 30 31 32 33 a c a a b a a c d c a III Comprehensive Cases Case a (1) The objectives of the engagement letter are to: a b c Make sure that the CPA and his client are in agreement about the nature of the engagement Inform the client about the scope of the CPA’s work and what may be expected to result Provide a written record of the responsibilities assumed by the CPA and those retained by the client (This understanding protects both the CPA and his client) (2) The CPA usually prepares the engagement letter as a follow-up to a verbal understanding that he and his client have reached It is desirable that the client endorse and return an approved copy of the engagement letter to the CPA It also is acceptable for the client to prepare his own letter summarizing his understanding of the nature of the engagement (3) Preferably, the engagement letter should be sent at the beginning of the engagement so that misunderstandings, if any, can be remedied (4) Obviously, the engagement letter will be most useful in clarifying misunderstanding on a first engagement But it is desirable that the letter be renewed periodically Client personnel or the nature of the engagement may change, and the resubmission of the letter gives both Completing the Audit and Post-Audit Responsibilities 27-7 parties an opportunity to review the circumstances Accordingly, for recurring examinations of financial statements, it is appropriate to prepare an engagement letter at the start of each examination For other continuing engagements, the engagement letter also should be updated periodically – probably on a yearly basis b (1) The objectives of the client’s representation letter are to: confirm oral representations given to the auditors, indicate and document the appropriateness of such representations, and reduce the possibility of misunderstandings (2) The client’s representation letter should be prepared by the auditors (to ensure all items are included) and signed by members of management whom the auditors believe are responsible for and knowledgeable about matters covered by the representations Normally, the chief executive officer and chief financial officer should sign (3) The client’s representation letter should be obtained at the end of the audit work and should be dated as of the date of the auditors’ report (the date of the end of field work) (4) The client’s representation letter should be prepared for each examination as the representations apply to one period’s financial statements The items that need representation will change from one period or another, as will the people who should sign the letter c (1) The CPAs should obtain an engagement letter when performing accounting services involving unaudited financial statements, such as in a compilation or review engagement The engagement letter is probably more important in unaudited engagements that in audited engagements because as there is more likelihood of misunderstanding The engagement letter should include: a description of the nature and limitations of the services to be performed, a description of the report, a statement that the engagement cannot be relied upon to disclose errors, irregularities or illegal acts, and that the CPAs will inform the client of any matters that come to their attention (2) The CPAs are not required to obtain a client’s representation letter when performing engagements involving unaudited financial statements However, the CPAs may wish to obtain such a letter Case a A subsequent event is an event or transaction that occurs subsequent to the balance sheet date but prior to the issuance of the financial statements and 27-8 Solutions Manual - Assurance Principles, Professional Ethics… auditor’s report that has a material effect on the financial statements and therefore requires adjustment or disclosure in the financial statements b The occurrence of subsequent events that provide additional evidence regarding conditions that existed at the date of the balance sheet and affect the estimates inherent in the process of preparing financial statements necessitate financial statement adjustment Those events that provide evidence regarding conditions that did not exist at the date of the balance sheet being reported on but arose subsequent to that date ordinarily would not result in adjustment of the financial statements Some of these latter events, however, may be such that disclosure of them is required to keep the financial statements from being misleading Occasionally such an event may be so significant that disclosure can best be made by supplementing the historical financial statements with pro forma financial data giving effect to the event as if it had occurred on the balance sheet date c The specific procedures that should be performed in order to ascertain the occurrence of subsequent events are these: • Read the latest available interim financial statements, compare them with the financial statements being reported upon, and make any other comparisons considered appropriate in the circumstances Inquire of officers and other executives having responsibility for financial and accounting matters whether the interim statements have been prepared on the same basis as that used for the statements under examination • Inquire of and discuss with officers and other executives having responsibility for financial and accounting matters (limited, where appropriate, to major locations) regarding: a b c d • Whether any substantial contingent liabilities or commitments existed at the date of the balance sheet being reported on or at the date of inquiry Whether there was any significant change in the capital stock, long-term debt, or working capital to the date of inquiry The current status of items in the financial statements being reported on that were accounted for on the basis of tentative, preliminary, or inconclusive data Whether any unusual adjustments have been made during the period from the balance sheet date to the date of inquiry Read the available minutes of meetings of stockholders, directors, and appropriate committees; inquire about matters dealt with at meetings for which minutes are not available Completing the Audit and Post-Audit Responsibilities Case a 27-9 • Obtain from the client’s legal counsel a description and evaluation of any litigation, impending litigation, claims, and contingent liabilities (of which counsel has knowledge) that existed at the date of the balance sheet being reported on, together with a description and evaluation of any additional matters of such nature that have come to counsel’s attention up to the date the information is furnished • Obtain letter of representation, dated as of the date of the auditor’s report, from appropriate officials (generally the chief executive officer and chief financial officer) regarding whether any events occurred subsequent to the date of the financial statements being reported on by the independent auditor that, in the officer’s opinion, would require adjustment or disclosure in these statements • Make such additional inquiries or perform such procedures as considered necessary and appropriate to dispose of questions that arise in carrying out the foregoing procedures, inquiries, and discussions (1) A contingent liability is an existing condition situation, or set of circumstances, involving uncertainty as to a possible loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur The business enterprise must have already sustained an event which exposed it to a loss but all aspects of the event have not yet been concluded The ultimate effect of the event will not be known with certainty until the occurrence of some future event which will conclude the transaction and resolve the current contingency (2) A loss contingency should be accrued only if the information available prior to issuance of the financial statements indicates that it is probable that a liability has been incurred at the date of the financial statements, and the amount of the loss can be reasonably estimated A loss contingency should be disclosed in a footnote when it is probable that a liability has been incurred but the amount cannot be estimated A loss contingency for which it is only reasonably possible that a liability has been incurred and for which no amount can be estimated should be disclosed in a footnote Where the probability that a liability has been incurred is remote, no disclosure is required b Subsequent events may provide new and important information about known or unknown contingency losses as of the balance sheet date The 27-10 Solutions Manual - Assurance Principles, Professional Ethics… subsequent event may very well modify the circumstances surrounding the contingent loss thereby changing the reporting method from no disclosure to footnote disclosure or accrual For example, a contingent loss may have been recorded as a footnote disclosure because, at the balance sheet date, the company had only a reasonable possibility that a loss may be incurred A subsequent event occurs which in the accountants’ judgment makes it probable that a contingent liability has been incurred The contingent liability will now have to be accrued in the financial statements (provided an amount can be estimated) Case Other matters that J Cee’s representation letter should specifically confirm include whether or not – a b c d e f g h i j k l Management acknowledges responsibility for the fair presentation in the financial statements of financial position, results of operations, and cash flows in conformity with generally accepted accounting principles (or other comprehensive basis of accounting) All material transactions have been properly reflected in the financial statements There are other material liabilities or gain or loss contingencies that are required to be accrued or disclosed The company has satisfactory title to all owned assets, and whether there are liens or encumbrances on such assets or any pledging of assets There are related party transactions or related amounts receivable or payable that have not been properly disclosed in the financial statements The company has complied with all aspects of contractual agreements that would have a material effect on the financial statements in the event of noncompliance Events have occurred subsequent to the balance sheet date that would require adjustment to or disclosure in, the financial statements The accountant has been advised of all actions taken at meetings of stockholders, board of directors, and committees of the board of directors (or other similar bodies) that may affect the financial statements Management is aware of irregularities that could have a material effect on the financial statements or that involve management or employees who have significant roles in the system of internal control All financial records and data were made available Provision, when material, has been made to reduce excess or obsolete inventories to their estimated net realizable value Provision has been made for any material loss to be sustained in the fulfillment of, or from inability to fulfill, any sales commitments Completing the Audit and Post-Audit Responsibilities 27-11 m Provision has been made for any material loss to be sustained as a result of purchase commitments for inventory quantities in excess of normal requirements or at prices in excess of the prevailing market prices Case The auditor’s search for subsequent events is an important set of auditing procedures because certain events, occurring after the balance sheet date, may have a significant impact on the audited financial statements Litigation in progress at the balance sheet date, for example, may be settled following the balance sheet date, but prior to completion of the audit field work If the litigation is decided to the detriment of the client, and if the judgment against the client is material and not subject to appeal, an audit adjustment recognizing the loss is in order Only by communicating with the client’s legal counsel near the end of audit field work, concerning the current status of litigation, will the auditor become aware of the settlement Otherwise, a material loss pertaining to the year under audit will be incorrectly omitted from the income statement A Type I subsequent event (like the one described above) provides further evidence of conditions that existed at the balance sheet date, and, if the related amounts are material, may require adjustment of the financial statements Type II subsequent events provide evidence of conditions which did not exist at the balance sheet date, and, therefore, not require adjustment, but may require footnote disclosure, if considered material The following procedures assist the auditor in locating subsequent events: a Obtaining a letter from the client’s legal counsel – Added information concerning litigation pending at the balance sheet date may provide a basis for an audit adjustment recognizing a loss contingency or a footnote describing uncertainty b Reading the minutes of directors’ meetings held subsequent to the balance sheet date may reveal the following subsequent events: c Approval of bonus applicable to year under audit (Type I) Decision to dispose of a segment (Type II) Approval of restructuring agreement (Type II) Approval of major recapitalization plan (Type II) Reading the latest interim financial statements may disclose events such as the following: Major adjustments correcting for prior year’s earnings inflation (e.g., reversal of fabricated revenue through abnormal sales returns entries) (Type I) Major uninsured casualty loss occurring after the balance sheet date (Type II) Reappearance of officers’ loans purported to have been paid or collected prior to the balance sheet date (Type I) 27-12 Solutions Manual - Assurance Principles, Professional Ethics… Case (1) If an omitted procedure is found, the auditors should consult legal counsel and take the following actions: • • • • Assess the importance of the omitted procedure to the present ability to support the previously expressed opinion Determine if there are persons currently relying or likely to rely on their report If the omitted procedure impairs present ability to support the previously expressed opinion, the omitted procedure should be applied or alternative procedures applied that would provide a satisfactory basis for the opinion If as a result of subsequent application of the omitted procedure or alternative procedures, the auditors become aware of facts that existed at the date of their report, they should refer to page 927 (Subsequent Discovery of Facts Existing at the Date of the Auditor’s Report) for guidance (2) If after reevaluating the scope of the examination and reviewing the completed audit workpapers, procedures were found that tend to compensate for the omitted procedure, the omitted procedure would not have to be performed The auditors should document their decision and their support for this decision (3) If in subsequently applying the omitted procedure, the auditors become aware of material new information that should have been disclosed in the financial statements, they should follow the provisions of auditing standards (refer to page 927 – subsequent discovery of a fact existing at the date of the auditor’s report) Case a The following accounting changes require a fourth paragraph explaining the lack of inconsistency, given the change: b Change in accounting principle; Change in reporting entity; Correction of an error in principle; Change in principle inseparable from change in estimate To be in conformity with GAAP, management must demonstrate that the new principle is preferable to the old The auditor, therefore, must establish preferability in evaluating whether the change is justified If preferability cannot be established, the auditor should render an “except for” Completing the Audit and Post-Audit Responsibilities 27-13 qualification on the basis that the financial statements contain a departure from GAAP Case d The management representation letter documents management’s acknowledgment of responsibility for the assertions made in the financial statements Typically, one of management’s assertions is a statement that all material transactions have been recorded properly This statement relates to the completeness and valuation categories of management assertions i The audit inquiry letter to legal counsel seeks to confirm with the client’s lawyer assertions furnished by management about pending or threatened litigation, unasserted claims and assessments, and other contingencies d The management representation letter documents management’s acknowledgement of responsibility for the assertions made in the financial statements One of management’s assertions may be that a provision has been made for any material loss to be sustained in the fulfillment of, or from the inability to fulfill, any sales commitments This statement relates to the valuation and presentation and disclosure categories of management assertions c The audit engagement letter documents the contract between the client and the auditor This documentation also includes the basis of fees for services to be provided c The audit engagement letter documents the contract between the client and the auditor The letter should indicate the objective of the engagement d Management’s assertions, as documented in the management representation letter, often deny the existence of any irregularities, such as those caused by employees, that may cause the financial statements to be materially misstated b The successor auditor should make specific and reasonable inquiries of the predecessor auditor regarding matters that the successor believes will assist him or her in determining whether to accept the engagement The inquiries should include specific questions regarding, among other things, facts that might bear on the integrity of management a The partner’s engagement review program is designed to confirm that the audit was conducted in accordance with GAAS This review program is also designed to identify any problems that may have arisen during the audit, such as differences of opinion between an auditor and a specialist or other consultant e The standard financial institution confirmation request asks the institution to confirm the accounts and account balances of the client The 27-14 Solutions Manual - Assurance Principles, Professional Ethics… form also allows the institution to include exceptions to management’s assertions, such as the existence of an undisclosed outstanding loan 10 c The auditor’s engagement letter outlines the auditor’s expectations of management, including compliance with requests for written representations 11 d Management assertions, as documented in the management representation letter, often deny the existence of any plans or intentions to materially alter the financial statements 12 g An additional paragraph may be added to the otherwise unmodified audit report to emphasize a matter, for example, significant transactions with related parties 13 f Any serious difficulty encountered in completing the audit, such as management’s delays in providing information, should be communicated to the audit committee 14 j Accounts receivable confirmations seek to confirm account balances with a client’s debtors and customers This excerpt is from a negative confirmation, which requests a reply from a debtor or customer only if a discrepancy exists 15 g Substantial doubt on the part of an auditor about an entity’s ability to continue as a going concern is presented in an explanatory paragraph of the auditor’s report  ... monitoring program, peer review or otherwise, and the omission of an auditing procedure may be discovered 27-4 Solutions Manual - Assurance Principles, Professional Ethics… If an omitted procedure... prepared by the auditors (to ensure all items are included) and signed by members of management whom the auditors believe are responsible for and knowledgeable about matters covered by the representations... sheet date The 27-10 Solutions Manual - Assurance Principles, Professional Ethics… subsequent event may very well modify the circumstances surrounding the contingent loss thereby changing the reporting