Chapter 15

Completing the Audit

Assessing the Quality of the Audit

Analytical review Required by GAAS Do company results make sense in relation to

industry and economic trends?Concurring partner review Independent review by experienced auditor who is

not part of audit team Sarbanes/Oxley Act requires for audits of public

companiesPartner rotation Sarbanes/Oxley Act requires new audit engagement

and concurring review partner every 5 years Does not apply to CPA firms with less than 10

partners and 5 public company audit clients

Other Considerations in the Final Review Stage of the Audit: Contingencies

Contingent losses that are both probable and reasonably estimated should be accrued and disclosed

Contingent losses that are reasonably possible, and remote contingencies disclosed because of common practice, should be disclosed in the notes to the financial statements

Contingencies include: Collectibility of receivables and loans Product warranty liability Litigation, claims, and assessments Threat of expropriation of assets in a foreign country Guarantees of debts of others Purchase and sale commitments Agreements to repurchase receivables that have been sold Obligations of banks under standby letters of credit

Discuss Contingencies

Responsibilities Management is responsible for identifying,

evaluating, and accounting for contingencies Auditor is responsible for determining client has

properly identified, accounted for, and disclosed material contingencies

Sources of Evidence Primary sources include management and client's

legal counsel Additional sources include corporate minutes,

contracts, correspondence from government agencies, and bank confirmations

What is the letter of audit inquiry?

Primary source of corroborative evidence concerning litigation, claims, and assessments is the client's legal counsel

Letter of inquiry should include Management's list that describes and evaluates its

contingencies A request that the attorney furnish auditor with the

following: Comment on the completeness of management's list and

evaluations For each contingency,

Description of the matter, progress to date, and action client intends to take

Evaluation of the likelihood of unfavorable outcome and estimate of potential loss, if possible

Any limitations on the attorney's response

The letter of inquiry is good for establishing completeness of potential liabilities and providing factual information about contingencies

However, because audit workpapers are not privileged, attorney responses will be less than forthcoming about the likelihood of unfavorable outcomes, and the estimated amount of any potential losses

An attorney's refusal to provide the requested information is a scope limitation sufficient to preclude issuing an unqualified opinion

What is the letter of audit inquiry? (Continued)

Review Adequacy of Disclosures

Third standard of reporting states "Informative disclosures in the financial statements are to be regarded as reasonably adequate unless otherwise stated in the report."

Auditor must be sure that:Disclosed events and transactions occurred

and pertain to the clientAll disclosures that should be included are

includedDisclosures are understandable to usersDisclosures are accurate

Explain Management Representations

Management Certification of Financial Statements Sarbanes/Oxley Act requires CEO and CFO to certify

financial statements are fairly presented in accordance with GAAP

Auditor should review management's processes for certification

Management Representation Letter Reminds management of its responsibility for the

financial statements Confirms significant oral responses made by

management Reduces possibility of misunderstandings between

management and auditor

Letter is prepared by auditor on client letterhead, addressed to the auditor, and normally signed by CEO and CFO

Letter is dated as of the audit report date (end of fieldwork)

Because management representations are not strong evidence, the auditor should perform procedures to corroborate the information in the letter

Management's failure to provide this letter is a scope limitation sufficient to preclude issuance of unqualified opinion

Explain Management Representations (Continued)

What is the management comment letter?

Auditors often notice things that might make the client more profitable

Many of these observations related to control deficiencies or operational matters

The observations are included in a management comment letter typically delivered to the Board of Directors with the audit report

Management letter is not required, but does add value to the audit

What is the going concern issue?

Auditor is required to evaluate client's ability to remain a going concern for a period not to exceed one year from the balance sheet date

Indicators of potential going concern problems include Negative trends in key financial areas like cash flow,

sales, profits Internal matters, such as loss of key personnel, and

outdated facilities and/or products External matters, such as new legislation, loss of

significant customer or supplier, uninsured casualty loss

Other matters, such as loan default, inability to pay dividends, attempted debt restructuring

If there is substantial doubt about ability of client to remain a going concern, auditor should

Discuss the situation with management Assess management's plan to overcome problems Consider the effects on the financial statements

Auditor should evaluate the adequacy of financial statement disclosure

Disclosures might include conditions causing the going concern doubt and management's plan to overcome the problem

Consider the effects on the audit report Add explanatory paragraph to the unqualified audit report Disclaim opinion Issue qualified opinion if disclosure is not adequate

What is the going concern issue? (Continued)

Management estimates provide opportunities for the entity to "manage" or even manipulate earnings. The auditor provides reasonable assurance that - Management has information system to develop estimates material to the financial statements

Estimates are reasonable Estimates are presented per GAAPIn evaluating management estimates, the auditor

concentrates on key factors and assumptions that are Significant to the accounting estimate Sensitive to variations Deviations from historical patterns Susceptible to misstatement Inconsistent with current economic trends

Discuss Review of Significant Estimates

Comment on Communicating with the Audit Committee

Items the auditor should discuss with the audit committee include Auditor's responsibility under GAAS Management judgments and accounting estimates Audit adjustments Uncorrected misstatements Accounting policies and alternative treatments Major accounting and reporting disagreements with

management Difficulties encountered in performing the audit Copies of significant communications between auditor and

management Management's discussion with other CPA firms Significant fraud or illegal acts Significant deficiencies in internal control Any independence issues Any other significant matters

What are subsequent events?

Subsequent events occur after the balance sheet date. Audit procedures used to identify subsequent events include:

Read minutes of meetings of the board of directors, stockholders, and other authoritative groups held after year-end

Read interim financial statements; investigate significant changes

Inquire of management about Significant changes in noted in interim statements Significant contingent liabilities Significant changes in working capital, debt, or owners' equity Status of any tentative items Unusual accounting adjustments made after balance sheet date

Inquire of management and legal counsel about subsequent events

Obtain management representation letter

Subsequent Events

How an auditor handles a subsequent event depends on two things:

Whether the subsequent event provides evidence about conditions that existed at the balance sheet date (type 1), or conditions arising after the balance sheet date (type 2)

When the subsequent event occurred: during fieldwork, after fieldwork but before the audit report has been issued, or after the audit report has been issued

What are the types of subsequent events?

Type 1 subsequent events provide evidence about conditions that existed at the balance sheet date

The financial statement numbers should be adjusted to reflect this information; footnote disclosure may also be necessary

Examples of type 1 subsequent events: Major customer files for bankruptcy during

subsequent period, its deteriorating financial condition existed prior to the balance sheet date

Lawsuit settled for different amount than accrual Stock dividend or split during the subsequent period Sale of inventory below carrying value when loss

occurred during the subsequent period

Type 2 subsequent events provide evidence about conditions that did not exist at the balance sheet date

The financial statement numbers should not be adjusted for these events, but they should be considered for disclosure

Examples of type 2 subsequent events: Uninsured casualty loss that occurs after the balance sheet

date Significant lawsuit initiated for incident occurring after the

balance sheet date Significant loss due to natural disaster occurring after the

balance sheet date Major decisions made during the subsequent period such as

decision to merge, discontinue a line of business, or issue new securities

Material change in value of investment securities after the balance sheet date

What are the types of subsequent events?

Subsequent Events

If subsequent event occurs after end of fieldwork but before audit report is issued, auditor must decide whether to single or dual date the audit report

Single dateDate of subsequent event is the audit report dateAuditor must make sure there are no other

subsequent events prior to report date

Dual dateUse dates of end of fieldwork and subsequent

event

Subsequent discovery of facts existing at the date of the auditor's report

Auditor must determineReliability of new informationWhether the event had occurred by the

audit report dateWhether users are likely to still be

relying on the financial statementsWhether the audit report would have

been affected had the facts been known

Subsequent discovery of facts existing at the date of the auditor's report

If the auditor decides further reliance on the financial statements and audit report is not appropriate, client is advised to make appropriate and timely disclosure of these new facts

Appropriate actions: Revise financial statements and audit report Revision and explanation reflected in subsequent period

financial statements If revision will take extended period, notify users that

statements and audit report should no longer be relied onIf client will not cooperate, auditor should Notify client and regulatory agency that the audit report

should no longer be associated with the financial statements

Notify known users that the audit report should no longer be relied on