McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved

Chapter 17

Completing the Engagement

17-2

Auditors’ Responsibilities When Completing Audits

Completing Field Work

Evaluating the Findings

Communicating with Client

Postaudit Responsibilities

17-3

Completing Field Work

Review for Contingent Liabilities

Subsequent events (post balance sheet) review.

Obtain evidence concerning litigation, claims, and assessments.

Obtain client representation letter.

Perform analytical procedures as part of overall (final) review.

17-4

Review for Contingent LiabilitiesA contingent liability is defined as an existing condition, situation, or set of circumstances

involving uncertainty as to possible loss to an entity that will ultimately be resolved when some future

event occurs or fails to occur.

A contingent liability is defined as an existing condition, situation, or set of circumstances

involving uncertainty as to possible loss to an entity that will ultimately be resolved when some future

event occurs or fails to occur.

Probable: The future event is likely to occur.

Reasonably Possible: The chances of the future event occurring is more than remote but less than probable.

Remote: The chance of the future event occurring is slight.

Probable: The future event is likely to occur.

Reasonably Possible: The chances of the future event occurring is more than remote but less than probable.

Remote: The chance of the future event occurring is slight.

Examples

• Pending or threatened litigation;

• Actual or possible claims and assessments;

• Income tax disputes;

• Product warranties or defects;

• Guarantees of obligations to others;

• Agreements to repurchase receivables that have been sold.

Examples

• Pending or threatened litigation;

• Actual or possible claims and assessments;

• Income tax disputes;

• Product warranties or defects;

• Guarantees of obligations to others;

• Agreements to repurchase receivables that have been sold.

LO# 1

17-5

Audit Procedures for Identifying Contingent Liabilities

Read minutes of meetings of the board of directors, committees of the board,

and stockholders.

Review contracts, loan agreements, leases, and

correspondence from government agencies.

Confirm or otherwise document guarantees and

letters of credit.

Inspect other documents for possible guarantees.

Review income tax liability, tax returns, and IRS agents’

reports.

LO# 2

17-6

Audit Procedures for Identifying Contingent Liabilities

Inquiry and discussion with management about its policies and

procedures for identifying, evaluating, and accounting for

contingent liabilities.

Examine documents in the entity’s records such as correspondence and invoices from attorneys for pending or threatened lawsuits.

Obtain a legal letter that describes and evaluates any litigation, claims,

or assessments.

Obtain written representation from management that all litigation,

asserted and unasserted claims, and assessments have been

disclosed in accordance with FASB No. 5.

Specific Audit Procedures Conducted Near Completion of Audit

LO# 2

17-7

Commitments

Long-term commitments are usually identified through inquiry of client personnel during the audit of the revenue and purchasing processes.

In most cases, such commitments are disclosed in a footnote to the financial statements.

Long-term contracts to purchase raw materials or sell their products at a fixed price.

Long-term contracts to purchase raw materials or sell their products at a fixed price.

To obtain a favorable pricing arrangement.

To obtain a favorable pricing arrangement.

To secure the availability of raw

materials.

To secure the availability of raw

materials.

LO# 4

17-8

Subsequent Events

Events or Transactions That

Occur after the balance-sheet date, but prior to the issuance of the financial statements and the auditors report,

Have such a material effect on the financial statements, that the require adjustment to or disclosure in the statements.

17-9

Review for Subsequent Events for Audit of Financial Statements

Balance Sheet Date

Type I Event

Affects estimates that are part of

financial statements.

Type II Event

Conditions did not exist at the balance sheet

date.

Require adjustment of the financial statements.

Require disclosure and possibly pro forma

financial statements.

LO# 5

17-10

Review of Subsequent Events for Audit of Financial Statements

LO# 5

17-11

Type I Subsequent Events

Provide additional evidence with respect to conditions that existed at the balance-sheet date and affect estimates inherent in the process of preparing financial statements.

Because Type 1 subsequent events provide evidence with respect to material changes in estimates in the financial statements as of year-end, these events require adjustment to the financial statements as of year-end.

17-12

Examples of Type I

Subsequent Events A loss, that was not fully provided for, on an uncollectible

accounts receivable as a result of a customer's deteriorating financial condition that lead to bankruptcy subsequent to the balance-sheet date.

Settlement of litigation for an amount that is greater that the related liability recorded in the accounts if the condition that gave rise to the litigation occurred prior to the balance-sheet date.

Sale of inventory after year-end at a net realizable value that is materially below he book value at the balance-sheet date if the quality of the inventory at the date of sale is similar to its quality at year-end.

17-13

Type II Subsequent Events

Provide evidence with respect to conditions that arose subsequent to the balance-sheet date.

Although Type II subsequent event do not require adjustment to the financial statements as of year-end, they usually require disclosure in the financial statements to keep them from being misleading.

17-14

Examples of Type IISubsequent Events

Sale of a bond or capital stock issue.

Purchase of a business.

Settlement of litigation when the event giving rise to the claim occurred after the balance-sheet date.

Loss of plant or inventories as a result of fire, flood, earthquake, or other major casualty.

Losses on receivables resulting from conditions (such as a customer's major casualty) arising subsequent to the balance-sheet date.

17-15

Objectives of Auditing Procedures

Performed in Subsequent Period

Determine whether proper cutoffs have been made by the client,

Search for material unrecorded liabilities at year-end, and

Identify the occurrence of subsequent events that may require adjustment to or disclosure in the financial statements as of year-end.

17-16

Audit Procedures for Subsequent Events

Inquire of Management

Read Interim Financial

StatementsExamine the

Books of Original Entry

Examples of audit procedures

Read Minutes of Meetings

Inquire of Legal Counsel

Obtain Management

Representation Letter

LO# 7

17-17

Procedures an Auditor Performs to Identify Occurrence of Subsequent

Events1. Read the latest available interim financial statements and compare

them with the financial statements being reported on.

2. Inquire of and discuss with officers and other executives having responsibility for financial and accounting matters as to:

Whether any substantial contingent liabilities existed at the balance sheet date or at the date of inquiry (the latter date is usually at or near the completion of fieldwork).

Whether there were any significant changes in capital stock, long-term debt, or working capital between the balance sheet date and the date of inquiry.

Whether any unusual adjustments have been made between the balance-sheet date and the date of inquiry.

The current status of items in the financial statements that were accounted for on the basis of tentative, preliminary, or inconclusive data.

17-18

Procedures an Auditor Performs to Identify Occurrence of Subsequent

Events

Read the available minutes of stockholders, directors, and appropriate committees through the completion of fieldwork. If minutes are not available, inquire about matters dealt with at such meetings.

Inquire of client's legal counsel concerning litigation, claims, and assessments.

Obtain a letter of representation as to whether any material subsequent events occurred between the balance-sheet date and the completion of field work.

17-19

Procedures an Auditor Performs to Identify Occurrence of Subsequent

Events

Scan the general journal between year-end and the completion of field work for any unusual adjusting entries that might indicate the occurrence of subsequent events.

Make additional inquiries or perform such procedures as necessary and appropriate to dispose of questions that arise in carrying out procedures in 1 through 6 above.

17-20

Dual DatingWhen a subsequent event is recorded or disclosed in the financial statements after completion of the field work but before the issuance of the financial statements, the

auditor must consider the following options for dating of the auditor’s report:

(1) “Dual date” the report (limits liability)

(2) Use the date of the subsequent event.

LO# 6

17-21

Dating the Auditor’s Report

The auditor’s responsibility for performing procedures to identify subsequent events normally terminates with the last day of field work.

For example, if the auditor completes the field work on Feb. 7, 2007, he/she would date his/her report Feb. 7, 2007.

17-22

Auditor’s Responsibility for Subsequent Events Occurring after

the Last Day of Field Work but Prior to the Issuance of the Auditor’s Report

Should the auditor, however, learn a possible material subsequent event that occurs after he/she leaves the field (e.g., Feb. 7, 2007) but before he/she issues the auditor’s report and audited financial statements (Feb. 15, 2007), the auditor would have to return to the client’s offices (i.e., the field) to determine whether the subsequent event requires adjustment to or disclosure in the financial statements that were audited.

17-23

Dating Auditor’s Report When a Subsequent Event Occurs after Last Day

of Field Work but Prior to Issuance of Auditor’s Report

Dating his/her report as of the date of the subsequent event that occurred after leaving the field but prior to issuing the audit report and the audited financial statements (e.g., Feb. 11, 2007).

Dual-dating his/her report

17-24

Dating Auditor’s Report as of Date of Subsequent Event That Occurred after

Last Day of Field Work but Prior to Issuance of Auditor’s Report

Auditor would have to search for any other subsequent events that may have occurred between the date of leaving the field (e.g., February 7, 2007) and the date of this latest subsequent event (e.g., February 11, 2007).

17-25

Example of Dual-dating an Audit Report

February 7, 2007, except for Note X as to which the date is February 11, 2007

The first date refers to the date when the auditor originally completed the fieldwork; the second date refers to the date of the subsequent event that occurred between the completion of field work and the issuance of the auditor’s report and audited financial statements.

Thus, the auditor’s responsibility for events occurring subsequent to the completion of field work is limited to the specific event referenced by the second (latter) date.

17-26

Review of Subsequent Events for Audit of Internal Control over Financial

Reporting

Auditors of public companies are responsible to report on any changes in internal control that

might affect financial reporting between the end of the reporting period and the date of the

auditor’s report.

LO# 7

17-27

Responsibilities of Lawyer, Client, and CPA for LCAs

17-28

Legal LettersA letter of audit inquiry (a legal letter) sent to the client’s attorneys is the primary means of obtaining or corroborating information about

litigation, claims, and assessments.

LO# 3

17-29

Litigation, Claims, and Assessments Management represents the primary source of information to be

reported about litigation, claims, and assessments

Inquire of and discuss with management its policies and procedures for identifying, evaluating, and accounting for litigation, claims, and assessments.

Obtain from management a description and evaluation of litigation, claims, and assessments.

Examine documents in the client's possession concerning litigation, claims, and assessments, including correspondence and invoices from lawyers.

Obtain assurance from management, ordinarily in writing, that it has disclosed all unasserted claims that the lawyer has advised them are probable.

17-30

Obtain from Management a Description and Evaluation of

Litigation, Claims, and Assessments That

Existed at the balance sheet date.

Occurred during the period from the balance sheet date to the date the information is furnished.

17-31

Litigation, Claims, and Assessments

A letter of audit inquiry to the client's lawyer is the auditor's primary means of obtaining corroboration of the information furnished by management concerning litigation, claims, and assessments.

17-32

Matters That Should Be Covered in Letter of Audit Inquiry

Identification of the company, including subsidiaries, and the date of the examination.

A list prepared by management (or a request by management that the lawyer prepare a list) that describes and evaluates pending or threatened litigation, claims, and assessments with respect to which the lawyer has been engaged. The lawyer is requested to furnish the above information or comment on those matters as to which his/her views may differ from those stated by management.

A list prepared by management that describes and evaluates unasserted claims and assessments that management considers to be probable of assertion, which, if asserted, has a reasonable possibility of an unfavorable outcome.

17-33

A Lawyer May Appropriately

Limit His/Her Response to

Matters in which he or she has given substantive attention in the form of legal consultation or representation.

Matters that are material, individually or collectively, to the financial statements.

Parts A & B above are not considered to be a limitation on the scope of the auditor's examination.

17-34

Example of Legal LetterLO# 3

17-35

Lawyer's Refusal to Furnish Information Requested by

Letter of Audit Inquiry

Would be a scope limitation sufficient to preclude an unqualified opinion.

Evidential matter obtained from the client's inside legal counsel is not a substitute for information outside legal counsel refuses to furnish.

17-36

Client Representation Letter The auditor is required to obtain written representations

from management as a part of an examination made in accordance with GAAS. The representations are in the form of a letter, which usually is referred to as a management representation letter.

During the course of an audit, management makes many representations to the auditor, both oral and written. Such representations from management:

Are part of the evidential matter the auditor obtains.

Are not a substitute for the application of auditing procedures necessary to provide a reasonable basis for an expression of an opinion on the financial statements.

17-37

Written Representations

Ordinarily document or confirm oral representations given to the auditor by management.

Indicate and document the continuing appropriateness of management’s representations.

Reduce the possibility of misunderstanding concerning matters that are the subject of representations.

Complement other auditor procedures by corroborating the information discovered in performing these procedures.

Obtain evidence concerning management’s future plans and intentions, such as refinancing of debt or discontinuing a line of business.

17-38

Matters Typically Included in Representation Letter (see Exhibit 17-3)

Management's acknowledgment of its responsibility for the fairness of the presentations in the financial statements. [Materiality limits do not apply]

Availability of financial records and related data. [Materiality limits do not apply]

Completeness and availability of all minutes of meetings of stockholders, directors, and committees of directors. [Materiality limits do not apply]

Absence of material errors in the financial statements and material unrecorded transactions.

17-39

Matters Typically Included in Representation Letter (see Exhibit 17-3)

Information concerning related party transactions and related receivables/payables.

Noncompliance with aspects of contractual agreements that may affect the financial statements.

Information concerning subsequent events.

Irregularities involving management or employees. [Materiality limits do not apply]

Communications from regulatory agencies concerning non-compliance with, or deficiencies in, financial reporting practices.

17-40

Matters Typically Included in Representation Letter (see Exhibit 17-3)

Plans or intentions that may affect the carrying value or classification of assets or liabilities.

Disclosure of compensating balance or other arrangements involving restrictions on cash balances, and disclosure of lines-of-credit or similar arrangements.

Reduction of excess or obsolete inventories to net realizable value.

Losses from sales commitments.

Satisfactory title to assets, liens on assets, and assets pledged as collateral.

17-41

Matters Typically Included in Representation Letter (see Exhibit 17-3)

Agreements to repurchase assets previously sold.

Losses from purchase commitments for inventory quantities in excess of normal requirements or at prices in excess of market.

Management acknowledges that it (SAS No. 89):

1. Has considered the financial statement misstatements brought to its attention by the auditor, and

2. Has concluded that any uncorrected misstatements are not material, both individually and in the aggregate.

17-42

Matters Typically Included in Representation Letter (see Exhibit 17-3)

A summary of uncorrected misstatements should be included or attached to the representation letter (SAS No. 89).

Management's representations may be limited to matters that are considered material, individually or collectively, to the financial statements. However, such limitations do not apply to A, B, C, and H in Part IV above, since these representations are not directly related to amounts.

If the auditor is reporting on consolidated financial statements, the written representations obtained from the parent company's management should specify that the representations apply to the consolidated financial statements, as well as to the separate financial statements of the parent.

17-43

17-44

17-45

17-46

Management Representation Letter

Should be dated as of the date of the auditor's report (i.e., the last day of field work)

Should be signed by members of management whom the auditor believes are responsible for and knowledgeable, directly or through others, about the matters covered in the representation. Those members of management who usually those who sign the letter of representation are the chief executive officer (CEO) and chief financial officer (CFO).

17-47

Management Representation Letter

Management's refusal to furnish written representations constitutes a limitation of the scope of the examination and is sufficient to preclude an unqualified opinion.

17-48

Final Evidential Evaluation Processes

Perform final analytical procedures.

Evaluate entity’s ability to continue as a going

concern.

Obtain a representation letter.

Review working papers.

Final assessment of audit results.

Evaluation of financial statement presentation

and disclosure.

Obtain an independent review of the engagement.

LO# 8

17-49

Perform Final Analytical ProceduresAs Part of Overall Review

Required by GAAS.

The auditor would consider:

the adequacy of evidence gathered in response to unusual or unexpected balances previously identified by analytical procedures.

unusual or unexpected balances or relationships that were not previously identified.

17-50

Perform Final Analytical Procedures As Part of Overall Review

Partner or manager usually conducts final analytical review.

Apply procedures to critical audit areas.

Procedures should be based on financial statements after all audit adjustments and reclassifications completed.

Consider going concern assumption with analytical procedures and other inquiries.

17-51

Evaluate the Findings

Goal is to determine: type of opinion to render; and

whether audit was in accordance with GAAS.

Obtain client approval of adjusting entries and disclosures.

Management has primary responsibility for fair presentation of financial statements.

Auditor proposes adjusting entries and notes to the financial statements and management decides whether to accept them.

17-52

Make Final Review of Waived Adjustments

Summarize all misstatements not yet adjusted by client (Exhibit 17-4).

Adjustments not made represent either: immaterial misstatement, or

management’s unwillingness to make adjustment.

Determine whether aggregate effect of waived adjustments is material to any component of financial statements by comparing to materiality thresholds.

17-53

Make Technical Review ofFinancial Statements

Some firms use checklists that address form and content of basic financial statements and disclosures.

Many firms have personnel that specialize in technical review.

SEC clients may warrant more attention because of reporting requirements.

17-54

Estimating Likely MisstatementsLO# 8

17-55

Make Technical Review ofFinancial Statements

Some firms use checklists that address form and content of basic financial statements and disclosures.

Many firms have personnel that specialize in technical review.

SEC clients may warrant more attention because of reporting requirements.

17-56

Archiving and RetentionSarbanes-Oxley Act and PCAOB’s Documentation Standard

• Requires audit firms to archive their public-company audit files for retention within 45 days following the time the auditor grants permission to use the auditor’s report in connection with the issuance of the company’s financial statements.

• Retain audit documentation for 7 years from the date of completion of the engagement, as indicated by the date of the auditor’s report, unless a longer period of time is required by law.

• Retain all documents that “form the basis of the audit or review.”

• Include in the audit file for significant matters any document created, sent, or received, including documents that are inconsistent with a final conclusion.

LO# 8

17-57

Going-Concern ConsiderationsLO# 9

17-58

Going-Concern ConsiderationsLO# 9

17-59

Going-Concern ConsiderationsLO# 9

17-60

Communications with Audit Committee and Management

Auditors are required to communicate certain matters related to the conduct of the audit to those individuals responsible for oversight of the financial reporting process (1) when entities have an audit committee or

similar group, and (2) for all SEC engagements.

Auditor’s responsibility under GAAS.

Significant accounting policies.

Management judgments and accounting

estimates.

Significant audit adjustments.

Auditor’s judgments about the quality of the entity’s

accounting principles.

Disagreements with management.

Consultation with other accountants.

Major issues discussed with management before the auditor was retained.

Difficulties encountered during the

audit.

Fraud involving senior management and fraud that causes material misstatement of the financial

statements.

LO# 10

17-61

COMMUNICATION WITH AUDIT COMMITTEES

AU 380

Requires that the auditor ensure that the audit committee (or those who have responsibility for oversight) receives additional information regarding the scope and results of the audit that may assist the audit committee in overseeing the financial reporting and disclosure process for which is responsible.

Though AU 380 does not require communications with management, it does not preclude communications with management who may, in the auditor's judgment, benefit from such communications.

17-62

Matters to Be Communicated to Audit Committee

The auditor should determine that the audit committee is informed about significant accounting policies and changes in those policies or in their application.

The auditor should determine that the audit committee is informed about:

1. the process used by management in formulating particularly sensitive accounting estimates, and

2. about the basis for the auditor's conclusions regarding the reasonableness of those estimates.

17-63

Matters to Be Communicated to Audit Committee

The auditor should inform the audit committee about adjustments (actual or proposed) arising from the audit that could, in his or her judgment, have a significant effect on the client's financial reporting process.

A proposed audit adjustment, whether recorded or not, is a proposed correction of the financial statements that would not have been detected except though the auditing procedures performed, even though the auditor has concluded that the adjustments are not material to the current financial statements.

17-64

Matters to Be Communicated to Audit Committee

The auditor should inform the audit committee about uncorrected misstatements brought to management’s attention by the auditor that were determined by management to be immaterial, both individually and in the aggregate.

The presentation to the audit committee should be similar to the summary of uncorrected misstatements that was included or attached to the representation letter. (SAS No. 89)

17-65

Matters to Be Communicated to Audit Committee

The auditor of an SEC client should discuss with the audit committee the auditor’s judgments about the quality, not just the acceptability, of the company’s accounting principles as applied in its financial reporting (SAS No. 90).

1. The standard (i.e., SAS No. 90) states that “the discussion should be ‘open and frank’ and generally include such matters as the consistency of the accounting policies and their application, and the clarity and completeness of the financial statements.

2. The discussion should also include items that have a significant impact on the representational faithfulness, verifiability, and neutrality of the accounting information included in the financial statements.”

17-66

Matters to Be Communicated to Audit Committee

The auditor should discuss with the audit committee his or her responsibility for other information in documents containing audited financial statements, any procedures performed, and the results.

The auditor should discuss with the audit committee any

disagreements with management, whether or not satisfactorily resolved, about matters that could be significant to the client's financial statements or in the auditor's report.

In part E above, disagreements do not include differences of opinion on incomplete facts or preliminary information that are later resolved.

In cases where management has decided to consult with other auditors about auditing and accounting matters, the auditor should discuss with the audit committee his or her views about significant matters that were the subject of such consultation.

17-67

Matters to Be Communicated to Audit Committee

The auditor should discuss with the audit committee any major issues that were discussed with management in connection with the initial hiring or retention of the auditor, including any discussions regarding the application of accounting principles and auditing standards.

17-68

Matters to Be Communicated to Audit Committee

The auditor should inform the audit committee of any serious difficulty he or she encountered with management related to the performance of the audit. This may include:

1. Any unreasonable delays by management in permitting the audit to commence.

2. Any delays in providing the auditor with needed information.

3. Whether the timetable set by management was unreasonable.

17-69

Matters to Be Communicated to Audit Committee

If significant to the conduct of the audit, the auditor should inform the audit committee of the unavailability of client personnel and the failure by client personnel to complete client-prepared schedules on a timely basis.

17-70

Final Working Paper Review by Engagement Partner

Make sure that work is accurate and thorough.

Make sure that subordinates’ judgments were reasonable (i.e., unbiased). Review work of less experienced personnel.

Ensure that audit completed in accordance with terms in engagement letter.

All significant issues (accounting, reporting, auditing) raised during the audit have been resolved.

Working papers support opinion.

GAAS and firm’s quality control standards have been met.

17-71

Second Partner Review,

Independent Review, Cold Review

Required on SEC engagements.

To obtain an objective review.

17-72

Subsequent Discovery of Facts Existing at the Date of the Auditor’s Report

Notify the client that the auditor’s report must no

longer be associated with the financial statements.

Notify the client that the auditor’s report must no

longer be associated with the financial statements.

Notify any regulatory agency having jurisdiction

over the client that the auditor’s report can no longer be relied upon.

Notify any regulatory agency having jurisdiction

over the client that the auditor’s report can no longer be relied upon.

Notify each person known to the auditor to be relying

on the financial statements.

Notify each person known to the auditor to be relying

on the financial statements.

LO# 11

17-73

Management Letter

Includes recommendations to management not included in required communication to audit committee.

Recommendations usually relate to improving efficiency and effectiveness of operations.

Demonstrates auditor’s continuing interest in the client.

May also allow the accounting firm to provide additional services, such as consulting.

17-74

Management Letter

Example of items included in management letters include:

Internal control matters not considered to be reportable conditions for non-public companies and not significant weaknesses for public companies.

Management of resources such as cash, inventory, investments.

Tax-related matters.

17-75

Management Letter

17-76

Management Letter

17-77

End of Chapter 17