Chapter 15

Completing the Audit

Copyright © 2010 South-Western/Cengage Learning

Audit Opinion Formulation Process

LO 1 Going-Concern Assumption

• 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– Internal matters, such as loss of key personnel, and outdated facilities and/or products

Going-Concern Assumption (continued)

– 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

– Significant changes in the competitive market and the competitiveness of the client’s products

• 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

Going-Concern Assumption (continued)

– 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

LO 2 Evaluating 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

Evaluating Management Representations (continued)

– 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

Evaluating Management Representations (continued)

• 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

LO 3 Summarizing and Resolving Possible Adjustments

• Uncorrected misstatements detected during the audit should be summarized and evaluated

• Management and the auditor must decide which possible adjustments will be “booked” (corrected) and which will be “waived” (left uncorrected)

• If internal control material weaknesses are identified:

Summarizing and Resolving Possible Adjustments (continued)

– Guidance in the PCAOB’s Auditing Standard No. 5 must be applied to assure that users receive proper notification

LO 4 Reviewing Contingencies

• Contingent losses that are probable, reasonably estimated, and remote 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

Reviewing Contingencies (continued)

• Contingencies include:– Threat of expropriation of assets in a foreign country

– Litigation, claims, and assessments

– Guarantees of debts of others

– Obligations of banks under standby letters of credit

– Agreements to repurchase receivables that have been sold

– Purchase and sale commitments

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

Contingencies (continued)

– Additional sources include corporate minutes, contracts, correspondence from government agencies, and bank confirmations

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 – Identification of the company, its subsidiaries, and

the date of the audit– Management's list that describes and evaluates its

contingencies

Letter of Audit Inquiry (continued)

– 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

Letter of Audit Inquiry (continued)

• 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

LO 5 Review of Significant Estimates

• Management estimates provide opportunities for the entity to "manage" or even manipulate earnings

• Companies may underestimate liabilities or impairment of asset values to achieve reported earning goals

• The auditor provides reasonable assurance that – Management has information system to develop estimates

material to the financial statements

– Estimates are reasonable

Review of Significant Estimates (continued)

– Estimates are presented per GAAP

• In 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 and bias

– Inconsistent with current economic trends

LO 6 Evaluating Adequacy of Disclosures

• Third standard of reporting states "When informative disclosures are not reasonably adequate, the auditor must note that fact in the auditor’s report."

• Disclosures can be made either on the face of the financial statements and/or in the notes to the statements

• Auditor must be sure that:

Evaluating Adequacy of Disclosures (continued)

– Disclosed events and transactions occurred and pertain to the entity

– All disclosures that should be included are included

– Disclosures are understandable to users– Disclosures are accurate

LO 7 Performing Analytical Review

• Analytical procedures are required in both planning phase and the final review phase

• Audit team analyzes the data from an overall business perspective

• Analytical review for Revenues and Expenses– Ratio analysis, common-size analysis, and analysis

of the dollar and percentage changes is useful for confirming audit work

Performing Analytical Review (continued)

– Analytical procedures should include the relationship of income statement changes to pertinent balance sheet accounts

LO 8 Engagement Quality Review

• Concurring partner review– Independent review by experienced auditor who is not part

of audit team

– Sarbanes/Oxley Act requires for audits of public companies

• Review process include:– Discussing significant matters related to the financial

statements and internal controls

– Evaluating judgments about materiality

– Reviewing the engagement team’s evaluation

Engagement Quality Review (continued)

– Reviewing the related audit documentation to determine its sufficiency

– Reading the financial statements, management’s report on internal control, and auditor’s report

– Confirming with the lead audit partner that there are no significant unresolved matters

– Determining if appropriate consultations have taken place on difficult or contentious matters

– Evaluating whether the auditor documentation supports the conclusions

Engagement Quality Review (continued)

• Partner 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• Documentation of an engagement quality review

include:– Who performed the engagement quality review– Documents reviewed by the quality engagement reviewer– Significant discussions held by the engagement quality

reviewer– Date the engagement quality reviewer

LO 9 Communicating with Management via the Management 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

Communicating with Management via the Management Letter (continued)

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

LO 10 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

Communicating with the Audit Committee (continued)

– 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

LO 11 Assessing Subsequent Events

• Subsequent events occur after the balance sheet date. These events require special audit attention:– Review of events occurring after the client’s balance sheet

date but prior to issuance of the audit report– Subsequent discovery of facts existing at the date of the

auditor’s report but not discovered during the audit– Consideration of omitted audit procedures that come to

attention after the auditor’s report has been issued

Types of Subsequent Events• Type 1 subsequent events provide evidence about

conditions that existed at the balance sheet date

Assessing Subsequent Events (continued)

• 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

Assessing Subsequent Events (continued)

– A sale of inventory below carrying value provides evidence that the net realizable value was less than cost at year end

• 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

Assessing Subsequent Events (continued)

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

– Material change occurs in the value of investment securities

• Audit procedures used to identify subsequent events include:

Assessing Subsequent Events (continued)

– 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

Assessing Subsequent Events (continued)

• 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 date

• Use the date of this event as the date of the audit report

– Dual date• using the dates of the original audit report and the date of the event,

to disclose the work done only on that event after the original audit report date

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

• Auditor must determine

– Reliability of new information

– Whether the event had occurred by the audit report date

– Whether users are likely to still be relying on the financial

statements

– Whether 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 (continued)

• 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 on

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

• If 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

• Causes of restatements:– PCAOB inspection reports uncovered material weaknesses – SEC financial review identifying practice issues that it

concludes merit better accounting

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

– Failures in the accounting system that allowed misstatements