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CHAPTER 11

CHAPTER 11

Completing the Audit

LEARNING OBJECTIVES

Review

CheckpointsExercises, Problems, and Simulations

1.Describe the approach used to examine major revenue and expense accounts.

1, 2, 3, 4

2.Explain the use of the attorney letter during the completion of the audit.

5, 6, 751, 52, 54 (partial), 59, 60

3.Identify why the auditor obtains management representations and list the key components of management representations.

8, 9, 10, 1147, 48, 49, 50

4.Identify the final steps in the completion of an audit.

12, 13, 14, 15, 16

5.Identify the two major categories of subsequent events and describe the proper handling of these events by the auditor.

17, 18, 19, 2053, 54 (partial), 55, 56

6.Identify the auditors responsibility when, after the issuance of the audit reports, the auditor discovers (1) facts that may have existed at the date of the auditors reports or (2) omitted audit procedures.

21, 22, 2357, 58

7. Summarize important communications made by the auditor following completion of the audit and issuance of the auditors reports.

24, 2561

SOLUTIONS FOR REVIEW CHECKPOINTS

11.1 The four primary time periods in an audit examination and the tasks and activities that fall within each time period are:

1. Between the beginning of the year and end of year: Interim tests of controls and substantive procedures.

2. Between the end of the year and the last day of fieldwork: (1) roll-forward work; (2) examination of revenue and expense accounts; (3) attorney letters; (4) management representations; (5) adjusting journal entries; (6) audit documentation review.

3. Between the last day of fieldwork and issuance of reports: subsequent events.

4. Following issuance of the reports: (1) subsequent discovery of facts; (2) omitted audit procedures; (3) management letters; (4) audit committee communications.

Revenue and Expense AccountBalance Sheet AccountTransaction Cycle

Sales revenue and sales returnsReceivablesRevenue/Collection

Dividend and interest revenueReceivables, InvestmentsFinance/Investment

Gain or loss on asset disposalsProperty, plant and equipment

Receivables

InvestmentsProduction

Finance/Investment

Cost of goods soldInventoriesAcquisition/Expenditure

Interest expenseLiabilitiesAcquisition/Expenditure

Finance/Investment

11.2 In addition to work with the related balance sheet accounts and transaction cycles, the auditor (1) uses analytical procedures to examine the revenue and expense accounts and (2) scans revenue and expense accounts for large and unusual entries.

11.3 Miscellaneous, other, and clearing accounts may represent adjustments made by the client to meet analysts earnings expectations (or earnings management).

11.4 a.The responsibilities of client management are to (1) respond to the auditors inquiries regarding litigation, claims, and assessments; (2) provide the auditor with a listing, description, and evaluation of litigation, claims, and assessments; and, (3) send letter to attorney (attorney letter) that includes information related to litigation, claims, and assessments.

b.The responsibilities of the auditor are to (1) inquire of client regarding the existence of litigation, claims, and assessments; (2) perform various audit procedures regarding litigation, claims, and assessments; and, (3) initiate the request to the client for the attorney letter.

c.The responsibilities of the attorney are to respond to the auditor regarding the clients description of litigation, claims, and assessments.

11.5 Attorney letters ordinarily contain the following information:

A listing of pending or threatened litigation, claims, or assessments.

A description of each item, including the nature of the case and management responses or intended responses to the case.

An evaluation of the likelihood of an unfavorable outcome.

An estimate of the range of potential loss.

11.6 In addition to attorney letters, the auditor would ordinarily perform the following with respect to litigation, claims, and assessments:

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

Examine documents in the clients possession regarding litigation, claims, and assessments, including correspondence and invoices from attorneys.

Obtain assurance from management that it has disclosed all material unasserted claims the attorney has advised them of probable litigation.

Read minutes of meetings of stockholders, directors, and appropriate committees.

Read contracts, loan agreements, leases, and correspondence from taxing or other governmental agencies.

Obtain information concerning guarantees from bank confirmations.

Review the legal expense account and cash disbursements records and invoices related to legal services.

11.7 The purpose of management representations is to impress upon management its primary responsibility for establishing and maintaining effective internal control over financial reporting and for the fairness of the financial statements. In addition, management representations may establish an auditors defense if a question of management integrity arises later.

The following representations must appear in all management representations:

1. Managements acknowledgement of its responsibility for the fair presentation of financial statements in conformity with U.S. generally accepted accounting principles.

2. Availability of all financial records and related data and completeness of the minutes of meetings of stockholders, directors, and important committees.

3. Managements acknowledgement of its responsibility for the design and implementation of programs and controls to prevent and detect fraud.

4. Disclosure of all significant deficiencies in internal control.

5. Information concerning fraud involving management, employees who have significant roles in internal control, or cases where the fraud could have a material effect on the financial statements.

11.8 If the company is subject to the requirements of AS 2, the auditor should obtain the following management representations related to internal control over financial reporting:

Management has performed an assessment of the effectiveness of internal control over financial reporting based on criteria (for example, criteria established in Internal Control Integrated Framework issued by the Committee on Sponsoring Organizations of the Treadway Commission, or COSO criteria).

Managements conclusion with respect to the effectiveness of its internal control over financial reporting at year-end.

No control deficiencies communicated to the audit committee from prior engagements have not been properly resolved.

There are no subsequent changes in internal control over financial reporting or other factors that may significantly affect internal control over financial reporting.

11.9 These communications are obtained near the end of fieldwork and dated on or near the audit report date to ensure that the most current information has been considered and evaluated by the auditor.

11.10 If the client refuses to furnish management representations, the auditor may either qualify or disclaim an opinion, as with other scope limitations. However, because of the importance of this communication, the auditor should be very skeptical if the client refuses to furnish management representations.

11.11 Adjusting entries and note disclosures are labeled proposed because it is ultimately the clients responsibility to adjust the financial statements for these items.

11.12 A waived adjustment is a proposed adjustment the auditors decide not to insist that the client make because it does not have a material effect on the financial statements. Auditors are required to communicate all adjustments and misstatements detected during the audit to the clients audit committee, regardless of the materiality of these adjustments to the clients financial statements.

11.13 1.Upon completion, the audit documentation is reviewed by an audit supervisor and, sometimes, audit manager. The purpose of this review is to ensure that all appropriate steps in the audit program were performed, the referencing among audit documentation is clear, and the explanations contained in the audit documentation are understandable.

2. Once this initial review has been completed, the audit manager and audit partner review the audit documentation to ensure that the overall scope of the audit is appropriate and determine whether the overall conclusions in the audit documentation are sufficient to provide support for the opinion on the financial statements.

3. Finally, the audit documentation is reviewed by a partner who has not been involved with the audit (known as a reviewing partner). The purpose of this review is to ensure that the quality of audit work and reporting is consistent with the firms quality standards.

11.14 A second partner review is a review of audit documentation by a partner who is not involved with the audit. The purpose of this review is to ensure that the quality of the work and reporting is in keeping with the quality standards of the firm.

11.15 Some of the benefits of audit documentation review are:

To ensure the audit is conducted in accordance with generally accepted auditing standards.

To provide the firm with an opportunity to evaluate the overall quality of the firms audit practice.

To provide an important component of the evaluation of staff accountants.

To allow the firm to adhere to the first standard of fieldwork (that the work is adequately planned and assistants, if any, are properly supervised).

11.16 A subsequent event is an event occurring between the balance sheet date and the last day of fieldwork.

11.17 Procedures performed during the subsequent period include:

Reading the latest interim financial statements and comparing them with the financial statements being reported upon.

Inquiring of officers and other executives having responsibility for financial and reporting matters about contingent liabilities or commitments; significant changes in capital stock, long-term debt, or working capital since the balance sheet date; and unusual adjustments since the last balance sheet date.

Reading minutes of meetings of shareholders, directors, and appropriate committees.

Obtaining an attorney letter from any legal counsel engaged by the client.

Obtaining management representations.

11.18 A Type I subsequent event provides new information about a condition that existed at the balance sheet date. Because the condition existed at the balance sheet date, a Type I subsequent event requires adjustment of amounts already included in the clients financial statements.

A Type II subsequent event involves occurrences that had both their cause and manifestation after the balance sheet date. These events should be disclosed in the financial statements and, for particularly significant subsequent events, pro forma financial statements should be prepared (these statements present the entire financial statements as if the event had occurred on the balance sheet date).

11.19 Dual dating an audit report provides a means of inserting important information in the financial statements and footnote disclosures learned by the auditor after the last day of fieldwork. A significant advantage of dual dating the report is that the auditors liability for events after the last day of fieldwork is limited to the event specifically identified in the report date.

11.20 A subsequent event is an event occurring between the balance sheet date and last day of fieldwork. Depending upon the type of subsequent event, the auditor will either adjust the financial statements or disclose the subsequent event in the financial statements

A subsequent discovery of facts occurs when the auditor learns of events that existed at the balance sheet date following the issuance of the reports. The auditor should require the client to disclose the facts and their impact on the financial statements to persons relying on the financial statements if certain conditions exist.

11.21 If the client consents to the disclosure, the auditor should take actions to ensure that persons who are continuing to rely on the financial statements and auditors reports are properly notified of the facts.

If the client refuses to make the appropriate disclosures, the auditor should notify each member of the board of directors that they will be notifying regulatory agencies having jurisdiction over the client (such as the Securities and Exchange Commission) as well as other persons who are relying on the reports.

11.22 If an omitted procedure is found, the following courses of action would be taken:

1. Verify that (1) the omitted procedure is important in supporting the auditors opinion and (2) individuals are currently relying on the clients financial statements and reports.

2. If both of the above conditions exist, the auditor should perform the omitted procedure or alternative procedures. If both do not exist, no further action is necessary.

3. If performing the omitted or alternative procedures allow the auditor to support the previously-expressed opinion, no further action is necessary. However, if they do not, the auditor should formally withdraw the original reports, issue revised reports, and inform persons currently relying on the financial statements.

11.23 The auditor should communicate the following information to the audit committee:

The auditors responsibility under generally accepted auditing standards.

Initial selection of and changes in significant accounting policies.

Methods used to account for significant, unusual transactions and transactions in a controversial or emerging area with a lack of authoritative guidance or consensus.

Management judgments and accounting estimates.

Audit adjustments as well as uncorrected misstatements.

The auditors judgment about the quality of the clients accounting principles.

The auditors responsibility for other information in documents containing the financial statements.

Alternative accounting treatments permissible within generally accepted accounting principles.

Disagreements with management.

Consultation with other accountants.

Issues discussed with management in conjunction with the initial or recurring retention of the auditor.

Difficulties encountered in dealing with management in the performance of the audit.

11.24 Management letters contain a summary of recommendations to allow the client to improve the effectiveness and efficiency of its operations. They are not required by generally accepted auditing standards.

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS

11.26a. IncorrectInterest income is related to the examination of notes receivable.

b.CorrectInterest expense can be calculated from the notes payable information and is examined in conjunction with that information

c.IncorrectNotes payable are not related to goodwill amortization.

d.IncorrectNotes payable are not directly related to royalty revenue.

11.27 a.IncorrectManagement representations do not shift responsibility to auditors for the financial statements.

b.IncorrectManagement representations should not substitute for other evidence sources.

c.IncorrectManagement makes assertions directly in the financial statements and not as part of the management representations.

d.CorrectThis responsibility is explicitly included in the management representations.

11.28 Note to Instructor: Since this question asks students to identify which audit procedure is not used to obtain evidence about contingencies, the response labeled correct is not used to obtain evidence about contingencies and those labeled incorrect are used to obtain evidence about contingencies.

a.CorrectScanning expenses is unlikely to reveal any information about a contingency.

b.IncorrectAttorneys letters can provide information about contingencies.

c.IncorrectMinutes of board of directors meetings can provide information about contingencies.

d.IncorrectSales contracts can provide information about right of return that may need to be disclosed as a contingency.

11.29a.IncorrectThe issuance of stock occurred after December 31.

b.IncorrectThe injury related to the lawsuit was sustained after December 31.

c.CorrectSince an estimate had been made as of December 31, the event giving rise to the lawsuit had occurred, and the settlement introduced new information about the actual amount of the liability at December 31.

d.Incorrect The storm occurred after December 31.

11.30a.IncorrectThe report date is the last day of fieldwork, not the balance sheet date.

b.CorrectThe report date is the last day of fieldwork and the dual date is the date related to the specific event.

c.IncorrectThe report date is the last day of fieldwork, not the balance sheet date.

d.IncorrectThe report date is the last day of fieldwork, not the date of the subsequent event.

11.31a.IncorrectSee (d) below.

b.IncorrectSee (d) below.

c.IncorrectSee (d) below.

d.CorrectUnder the 1933 Securities Act, the auditors responsibility extends to the effective date of the registration statement.

11.32a.CorrectSubsequent discovery of facts refers to knowledge obtained after the issuance of the audit reports.

b.IncorrectSee (a) above. These types of events are referred to as subsequent events.

c.IncorrectSee (a) above. These types of events are referred to as subsequent events.

d.IncorrectSee (a) above. These types of events do not require any special audit consideration.

11.33a.IncorrectManagement representations are required under generally accepted auditing standards.

b.IncorrectAttorney letters are required under generally accepted auditing standards.

c.CorrectManagement letters, while helpful, are not required under generally accepted auditing standards.

d.IncorrectEngagement letters are required under generally accepted auditing standards.

11.34 Note to Instructor: Since this question asks students to identify which party would not participate in writing the management letter, the response labeled correct would not participate in writing the management letter and those labeled incorrect would participate in writing the management letter.

a.CorrectThe clients attorneys would not ordinarily participate in drafting the management letter, as this letter is concerned with helpful suggestions to increase the effectiveness and efficiency of the clients operations.

b.IncorrectThe clients accounting and production managers would provide information about current practices for the management letter.

c.IncorrectThe audit firms team would play a major role in drafting the management letter based on their observations during the audit examination.

d.IncorrectThe audit firms consulting and tax experts would participate in drafting the management letter, as they are in position to identify possible efficiencies and income tax savings..

11.35.a.IncorrectAn engagement letter would be secured prior to the commencement of the audit examination.

b.IncorrectTests of controls would be performed prior to the end of the year under audit.

c.IncorrectA review for subsequent events would be performed after year-end but prior to the end of fieldwork.

d.CorrectManagement representations would be obtained on the last day of fieldwork.

11.36a.Incorrect Discovery of a subsequent event occurs after issuance of the auditors report on the companys financial statements.

b.Incorrect Dual dating the audit report occurs following the last day of fieldwork.

c.Incorrect The management letter is prepared and presented to the client following the conclusion of the audit examination.

d.CorrectThe review of audit documentation occurs after the balance sheet date but before the last day of fieldwork.

11.37Note to Instructor: Since this question asks students to identify which procedure is least likely to be performed, the response labeled correct would not be performed and those labeled incorrect would be performed. .

a.IncorrectAnalytical procedures would be used in conjunction with the examination of revenue and expense accounts.

b.CorrectThe auditor would typically sample and investigate individual transactions in the examination of the related balance sheet accounts, but not revenue and expense accounts.

c.Incorrect The auditor would consider evidence obtained in the examination of related balance sheet accounts in the audit of revenue and expense accounts (see b above).

d.Incorrect The auditor would scan revenue and expense accounts for large and unusual debit and credit entries.

11.38a.IncorrectThis statement would typically be included in management representations and not an attorney letter.

b.Incorrect While this statement is related to communication with attorneys, it would not be appropriate for the attorney to directly inform the auditor of omitted unasserted claims or assessments.

c.Incorrect This statement would ordinarily be included in a management letter and not an attorney letter.

d.CorrectThe attorney letter would request that the attorney furnish this information to the auditor.

11.39a.Incorrect Prior to performing the omitted procedure or an alternative procedure, the auditor would determine that the omitted procedure is important in supporting the opinion on the companys financial statements.

b.Incorrect Prior to notifying the board of directors and regulatory agencies who are currently relying on the auditors reports, the auditor would determine that the omitted procedure is important in supporting the opinion on the companys financial statements.

c.CorrectThis is the initial course of action that would be taken upon the discovery of an omitted audit procedure.

d.Incorrect A quality assurance review may reveal the omission of an audit procedure, but would not be performed in response to an omitted procedure.

11.40Note to Instructor: Since this question asks students to identify which statement is not true with respect to management representations, the response labeled correct would not be true and those labeled incorrect would be true. .

a.CorrectThe failure of management to furnish representations would result in either a qualified opinion or a disclaimer of opinion.

b.Incorrect Management representations do address disclosure of significant deficiencies in internal control, regardless of materiality.

c.Incorrect Management representations are used by the auditor to corroborate information received from the client and its employees.

d.Incorrect Management representations are dated the same date as the auditors reports (the last day of fieldwork).11.41a.IncorrectManagement representations are dated as of the last day of fieldwork (in this case, March 24, year 2), not the date of completion of the financial statements.

b.IncorrectManagement representations are dated as of the last day of fieldwork (in this case, March 24, year 2), not the date that fieldwork began.

c.CorrectManagement representations are dated as of the last day of fieldwork (in this case, March 24, year 2).

d.IncorrectManagement representations are dated as of the last day of fieldwork (in this case, March 24, year 2), not the date that the audit reports are completed.

11.42a.IncorrectA charge to a notes receivable would relate to a transaction that has occurred in a prior period, not current period.

b.IncorrectA charge to a notes receivable would relate to a transaction that has occurred in a prior period, not current period.

c.IncorrectA charge would indicate that any obligation has been settled, not incurred.

d.CorrectThe entry may represent the establishment of a receivable from a party for whom the client has guaranteed a debt. The payment of the debt upon default of the party would be recognized in the accounts by a debit to notes receivable and a credit to cash.

11.43a.CorrectComparing interim financial statements with the financial statements being audited would identify potential subsequent events.

b.IncorrectSecond request confirmations would provide evidence regarding the valuation of accounts receivable balances but would not provide evidence regarding subsequent events.

c.IncorrectCommunicating material weaknesses in internal control would provide the client with the opportunity to improve its internal control but would not provide evidence regarding subsequent events.

d.IncorrectReviewing the cutoff bank statement would verify the valuation of cash but would not provide evidence regarding subsequent events.

11.44a.IncorrectThis procedure would provide evidence about the valuation of these transactions, but not subsequent events.

b.CorrectThis procedure may provide information about sales and repurchases of the companys stock.

c.IncorrectThis procedure would be used to search for unrecorded accounts payable at year-end, but not the occurrence of subsequent events.

d.IncorrectThis procedure would provide evidence about the valuation of cash and potential guarantees of debt, but not subsequent events.

11.45a.IncorrectWhile the attorney letter will ask for corroboration of managements information regarding the probable outcome of litigation, claims, and assessments, management is the primary source of this information.

b.CorrectThe attorney letter requests the attorneys to corroborate information furnished from management.

c.IncorrectHistorical experiences are not included in an attorney letter.

d.IncorrectA description and evaluation of litigation, claims, and assessments is obtained from the client; the attorney is asked to corroborate this information (see b above).

11.46a.CorrectThe attorneys response should be limited to matters in which they have given substantive attention.

b.IncorrectThe attorney should comment on matters of which they are aware that were not disclosed by the entity.

c.IncorrectThe attorney should not limit their response to matters in which the entity has historical experience.

d.IncorrectThe attorney should also comment upon unasserted claims as well as asserted claims and pending or threatened litigation.

SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS

11.47Management Representations

a. Auditors are required to obtain management representations in all audits conducted under generally accepted auditing standards.

b. The purpose of obtaining management representations is to impress upon management its primary responsibility for the financial statements. In addition, management representations may establish an auditors defense if a question of management integrity subsequently arises.

c. Management representations should be addressed to the auditor and dated as of the date of the auditors reports (last day of fieldwork).

d. Management representations should be signed by members of management whom the auditor believes are responsible and knowledgeable about matters covered by the representations (usually the chief executive officer, chief financial officer, treasurer, or controller). Their refusal to sign the representations would constitute a scope limitation that would preclude the issuance of an unqualified opinion.

e. Obtaining management representations does not relieve the auditor from their responsibility for planning and performing the audit. As a result, the auditor must still perform all usual procedures to corroborate representations made by management.

11.48 Management Representations OmissionsOther matters that should be confirmed in management representations include:

1. Management acknowledgement of its responsibility for the fair presentation in the financial statements in conformity with U.S. generally accepted accounting principles (or other comprehensive basis of accounting).

2. Availability of all financial records and related data and completeness of the minutes of meetings of stockholders, directors, and important committees.

3. Managements acknowledgement of its responsibility for the design and implementation of programs and controls to detect fraud.

4. Managements disclosure of all significant deficiencies in internal control.

5. Information concerning fraud involving management, employees who have significant roles in internal control, or cases where the fraud could have a material effect on the financial statements.

In addition to the above, which are required without limitation based on materiality, the following matters should be confirmed in Molars management representations:

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

Related party transactions or related amounts receivable or payable that may need to be 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.

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.

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.

11.49Management Representations

1. Appropriate.2. Inappropriate. While management representations address fraud involving management and employees who have significant roles in internal control, they do not indicate that no frauds that could have a material effect exist. Managements assessment of internal control over financial reporting will not provide management with a basis for a statement of this nature.3. Appropriate.4. Inappropriate. The description and evaluation of contingencies would accompany the attorney letter sent to the clients attorney. While management representations indicate that management is unaware of unasserted claims or assessments that are required to be disclosed in accordance with Statement of Financial Accounting Standards No. 5, they would not list contingencies in which attorneys have participated.5. Inappropriate. While management representations will indicate that all deficiencies in the design or operation of internal control have been disclosed to the auditor, they will not state that no such deficiencies exist, even in cases where no deficiencies are noted.6. Inappropriate. Management letter comments are merely advisory to management, and no action is required to be taken on these comments. Accordingly, reference to action on previous management letter comments is not appropriate.7. Inappropriate. Managements assessment of internal control over financial reporting will not provide such a high level of assurance to management; as a result, a reference of this nature in management representations is not appropriate.8. Appropriate.11.50Management Representations

1. Included in management representations regardless of materiality.

2. Not included in management representations. (This would accompany an attorney letter sent from the client to their attorneys.)

3. Not included in management representations. (This would be included in a management letter prepared by the auditor to the client.)

4. Included in management representations regardless of materiality.

5. Included in management representations, if material.

6. Included in management representations regardless of materiality.

7. Included in management representations regardless of materiality.

8. Not included in management representations. (This would be communicated to the clients audit committee.)

9. Included in management representations, if material.

10. Not included in management representations. (Management representations indicate that management believes the effects of uncorrected misstatements are immaterial to the financial statements but management representations should not express an opinion on the financial statements.)

11.51 Client Request for Attorney Letter

Note to Instructor: The categories of Major and Other deficiencies are the authors judgment. Students should be able to identify the Major deficiencies, while the Other deficiencies may be a bit more difficult to identify.

MAJOR DEFICIENCIES:

1. A description of the progress of each case to date is omitted.

2. An evaluation of the likelihood of an unfavorable outcome of each case is omitted.

3. An estimate, if one can be made, of the amount or range of potential loss of each case is omitted.

4. The various other pending or threatened litigation on which Young was consulted is not identified and included.

5. The unasserted claims and assessments probable of assertion that have a reasonable possibility of an unfavorable outcome are not identified.

6. Materiality (or the limits of materiality) is not addressed.

7. The reference to a limitation on Youngs response due to confidentiality is inappropriate.

8. Young is not requested to include matters that existed after December 31, 2006, up to the date of Youngs response.

9. There is no inquiry about any unpaid or unbilled charges, services, and disbursements.

OTHER DEFICIENCIES:

10. The action that Consolidated intends to take concerning each suit (for example, to contest the matter vigorously, to seek an out-of-court settlement, or to appeal an adverse decision) is omitted.

11. Consolidateds understanding of Youngs responsibility to advise Consolidated concerning the disclosure of unasserted possible claims or assessments is omitted.

12. Young is not requested to identify the nature of and reasons for any limited response.

13. The date by which Youngs response is needed is not indicated.

14. The reference to Youngs response possibly being quoted or referred to in the financial statements is inappropriate.

15. Ambiguous terminology such as slight and some chance is included where remote and possible are more appropriate.

11.52Attorney Letters

Inquire of management regarding litigation, claims, and assessments.

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

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

Obtain assurance from management that it has disclosed all material unasserted claims the lawyer has advised them are likely to be litigated.

Read minutes of meetings of stockholders, directors, and appropriate committees.

Read contracts, loan agreements, leases, and correspondence from taxing or other governmental agencies.

Obtain information concerning guarantees from bank confirmations.

Review the legal expense account and cash disbursements records and invoices related to legal services.

a. Jaworskis responsibilities with respect to litigation, claims, and assessments are to perform the procedures noted in (a) above and initiate the request to the client for the attorney letter.

Fulbrights responsibilities with respect to litigation, claims, and assessments are to respond to auditors inquiries regarding litigation, claims, and assessments; provide the auditor with a listing, description, and evaluation of litigation, claims, and assessments; and send a letter to the attorney that includes information related to litigation, claims, and assessments.

Vinsons responsibilities with respect to litigation, claims, and assessments are to respond to the auditor regarding Fulbrights description of litigation, claims, and assessments.b. 1.The auditor initiates the request for the client to send the attorney letter.

2. The attorney letter, along with a listing of litigation, claims, and assessments, is sent to each attorney who has devoted attention to legal matters on behalf of the client.

3. The attorneys will respond directly to the auditor on the information contained in the attorney letter.

c. The following information is typically included in an attorney letter (prepared from the clients perspective):

A listing of pending or threatened litigation, claims, or assessments.

A description of each item, including the nature of the case and management responses or intended responses to the case.

An evaluation of the likelihood of an unfavorable outcome.

An estimate of the range of potential loss.

11.53Subsequent Events

a.A subsequent event is an event or transaction that occurs after the balance sheet date but prior to the issuance of the auditors reports and the companys financial statements. Auditors are responsible for subsequent events from the balance sheet date to the last day of fieldwork.

b.Procedures that Michael can perform to assist him in identifying subsequent events include:

Reading the latest interim financial statements and comparing them with the financial statements being reported upon.

Inquiring of officers and other executives having responsibility for financial and reporting matters about contingent liabilities or commitments; significant changes in capital stock, long-term debt, or working capital since the balance sheet date; and unusual adjustments since the last balance sheet date.

Reading minutes of meetings of shareholders, directors, and appropriate committees.

Obtaining an attorney letter from any legal counsel engaged by the client.

Obtaining management representations.

c.The two type of subsequent events are:

Type I subsequent events provide new information about a condition that existed at the balance sheet date. Because the condition existed at the balance sheet date, a Type I subsequent event requires adjustment of amounts included in the financial statements.

Type II subsequent events involve occurrences that had both their cause and manifestation after the balance sheet date. These events should be disclosed in the financial statements and, for particularly significant subsequent events, pro forma financial statements should be prepared (these statements present the entire financial statements as if the event had occurred on the balance sheet date).

d.1.Michael could evaluate the disclosure of this event without additional considerations, since he became aware of the transaction prior to the last day of fieldwork.

2.Michael could evaluate the disclosure of this event, since his reports (and the financial statements) have not been issued. However, since he became aware of the subsequent event following the last day of fieldwork, he would ordinarily dual date the audit report to limit his responsibility beyond the last day of fieldwork to the disclosure related to the subsequent event.

3.This situation would reflect a subsequent discovery of facts, since Michael became aware of the transaction after the issuance of the audit reports. Michael should request that Dallas Companys management disclose the facts and their impact on the financial statements to persons relying on the financial statements if the following conditions exist: (a) the facts are reliable and existed at the report date; (2) the facts affect the financial statements and auditors reports; and, (c) persons are continuing to rely on the financial statements and auditors reports.

e.Because the announced acquisition of San Antonio Company did not exist at the report date, Michael has no responsibility with respect to this acquisition in the 2006 audit.

11.54Audit Simulation: Subsequent Events and Contingent Liabilities

a.1.A subsequent event is an event or transaction that occurs after the balance sheet date but prior to the issuance of the auditors reports and financial statements (AU 560.01).

2.The two types of subsequent events are (AU 560.03 AU 560.05):

A Type I subsequent event provides new information about a condition that existed at the balance sheet date. Because the condition existed at the balance sheet date, a Type I subsequent event requires adjustment of amounts included in the financial statements.

A Type II subsequent event involves occurrences that had both their cause and manifestation after the balance sheet date. These events should be disclosed in the financial statements and, for particularly significant subsequent events, pro forma financial statements should be prepared (these statements present the entire financial statements as if the event had occurred on the balance sheet date).

3.Procedures performed to ascertain the occurrence of subsequent events include (AU 560.12):

Reading the latest interim financial statements and comparing them with the financial statements being reported upon.

Inquiring of officers and other executives having responsibility for financial and reporting matters about contingent liabilities or commitments; significant changes in capital stock, long-term debt, or working capital since the balance sheet date; and unusual adjustments since the last balance sheet date.

Reading minutes of meetings of shareholders, directors, and appropriate committees.

Obtaining an attorney letter from any legal counsel engaged by the client.

Obtaining management representations.

b.1.A contingent liability is an existing condition, situation, or set of circumstances involving uncertainty as to a possible loss that will ultimately be resolved when one or more future events occur or fail to occur (AU 337B.01).

2.A loss contingency should be accrued only if 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 (AU 337B.08).

A loss contingency should be disclosed in a note 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 note. Where the probability that a liability has been incurred is remote, no disclosure is required (337B.08).

11.54Audit Simulation: Subsequent Events and Contingent Liabilities (Continued)

c.Subsequent events may provide new and important information about known or unknown loss contingencies as of the balance sheet date. The subsequent event may very well modify the circumstances surrounding the contingent loss thereby changing the reporting method from no disclosure to note disclosure or accrual. For example, a contingent loss may have been recorded as a note disclosure because, at the balance sheet date, the company had only a reasonable possibility that a loss may be incurred. If a subsequent event occurs which (in the accountants judgment) makes it probable that a liability has been incurred, the contingent liability will now have to be accrued in the financial statements (assuming that an amount can be estimated).

11.55 Subsequent Events Proceduresa. The purpose of a review for subsequent events is to determine whether there have been any material transactions or events occurring between the year-end and the last day of fieldwork that have a significant effect on the financial statements and may require adjustment to or disclosure in the financial statements. While the review for subsequent events normally ends as of the last day of fieldwork (February 20), the auditor is responsible for any information of which they become aware until the delivery of the audit reports (March 12).

b. The following procedures would be performed to identify subsequent events:

Reading the latest interim financial statements and comparing them with the financial statements being reported upon.

Inquiring of officers and other executives having responsibility for financial and reporting matters about contingent liabilities or commitments; significant changes in capital stock, long-term debt, or working capital since the balance sheet date; and unusual adjustments since the last balance sheet date.

Reading minutes of meetings of shareholders, directors, and appropriate committees.

Obtaining an attorney letter from any legal counsel engaged by the client.

Obtaining management representations.

11.56 Subsequent EventsCases1.a.This would have come to the auditors attention through inquiries of client officers and key personnel, review of the minutes of the meetings of the board of directors and stockholders, or through local news media.

b.The details of the construction of the express highway would need to be disclosed in the footnotes to the financial statements.

2.a.It is improbable that the auditor would learn the source of the $25,000 unless it were revealed in a discussion with the President or his personal accountant, or unless the auditor prepared the Presidents personal income tax return.

b.Disclosing the loan in the balance sheet as a loan from an officer would be sufficient. The source of the funds would not be disclosed because it is the officers personal business and has no effect upon Olars financial statements.

3.a.The additional liability for the ore shipment would have been revealed to the auditor through scanning of January transactions. The regular examination of transactions and related documents such as purchase contracts would have caused him to note the item for subsequent follow-up to determine the final liability. In addition, the management representations might have mentioned the potential liability.

b.The liability would not require separate disclosure; however, the inventory and accounts payable balances would need to be adjusted by amount of the additional charge, $9,064 [[$20,600 x (0.72/0.50)] - $20,600 = $9,064].

4.a.The auditor might learn of the agreement to purchase the treasurers stock ownership through his inquiries of management and legal counsel, examination of the minutes of the meetings of the board of directors and stockholders and subsequent reading of the agreement. The physical absence of the treasurer might from Olars headquarters also arouse the CPAs curiosity.

b.The details of the agreement would be disclosed in the footnotes to the financial statements because the use of company cash for the repurchase of stock and the change in the amount of stock hold by stockholders might have a significant impact on subsequent years financial statements. Usually, a management change, such as the treasurers resignation, does not require disclosure in the financial statements. The details underlying the separation (personal disagreements and divorce) need not be disclosed.

5.a.The auditor would learn of the reduced sales and of the strike through inquiries of management, review of financial statements for January, scanning transactions, and general observations during the engagement.

b.Disclosure should be made in the footnotes to the financial statements of these conditions and the facts available at to date of the reports.

11.57 Subsequent Discovery of FactsThe manner in which Faultless treated the discovery of facts after the issuance of his reports is inappropriate. Once the chief executive of Hopkirk refused to make proper disclosure, Faultless should have notified the Board of Directors of the need to disclose the facts to persons who are known to be relying on the financial statements. If the Board then agreed to such disclosure, Faultless and Hopkirk would issue a revised set of financial statements and audit reports or provided other notification as appropriate. If the Board refused to make such disclosure, Faultless should (1) notify Hopkirk that the audit reports must not be associated with the financial statements, (2) notify the appropriate regulatory agencies that the reports cannot be relied upon, and (3) notify users or the SEC that the reports cannot be relied upon.Significantly, Faultless probably increased its potential liability for three reasons. First, the auditors appear to have released confidential information. In this regard, auditors are warned to consult attorneys prior to releasing information that may be governed by state statutes. Second, Hopkirk may continue to issue the reports with the financial statements, increasing the auditors potential liability to third parties. Third, by not notifying the SEC and other regulatory agencies, Faultless may not only increase their potential liability to third parties, but also risk potential censure by the SEC.

11.58 Omitted Audit Procedures

a.1.If it is discovered that an important audit procedure was omitted, 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 any persons are currently relying or likely to rely on their reports.

If the omitted procedure impairs the auditors 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 formally withdraw the original reports, issue revised reports, and inform persons currently relying on the financial statements.

2. If after reviewing the audit documentation auditors determined that procedures were performed that 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 the auditors become aware of material new information that should have been disclosed in the financial statements, they should follow the guidelines for subsequent discovery of facts, which require that they request the client to disclose necessary information to persons known to be relying on the financial statements and auditors reports. If the client refuses to do so, the auditor should notify each member of the board of directors that they will be notifying regulatory agencies having jurisdiction over the client (such as the Securities and Exchange Commission) as well as other persons who are relying on the reports.

11.58Omitted Audit Procedures (Continued)

b.Case 1:You should document the decision that the specific procedures considered omitted by the internal inspection reviewers were not considered necessary in the valuation of Wildcats inventory. You should cite the specific performed procedures that you feel compensate for the procedure the reviewers thought necessary.

Case 2:You should immediately notify the partners of Arthur Hurdman that the December 31 financial statements of Top Stove are not correct. They should consult legal counsel and notify the client and ask the client to disclose to users that the financial statements are in error. The financial statements should be corrected as soon as possible and reissued with Arthur Hurdmans reports.

11.59 Attorney Letter Responsesa. The four responses were based on AU 9337, as are these solutions.

1. This response is too vague for adequate information. More evidence would be required to support the claim that the plaintiffs will have serious problems establishing Omegas liability.

2. According to AU 9337, this means remote likelihood of material loss.

3. According to AU 9337, this means remote likelihood of material loss.

4. Meritorious does not mean strong or adequate. The phrases reasonable chance, adequate defense, less than the damages claimed all indicate potential issues. More information is needed.

b. Plaintiffs counsel would probably assert the merits of the plaintiffs case, suggesting that the auditors client (defendant) will certainly lose large damages. However, it is important to note that auditors would not obtain representations from the plaintiffs regarding the outcome of litigation against a client.

11.60 Accounting for a ContingencyAttorney Letter Informationa. Both of these amounts should be considered with some skepticism. While MALDEF may indeed seek $250,000 from the city, this amount does not necessarily represent the amount of damages that will be paid (and the amount at which the liability might be settled). The fact that the attorney letter indicates that the damages could be between $30,000 and $175,000 provides some evidence that a negative outcome may occur but does not provide any reliable information as to the amount of that outcome.

b. The financial statements should disclose the verdict and mention the possibility of a monetary settlement. If this litigation had commenced prior to December 31, 2006 (which is highly likely), it would be treated as a Type I subsequent event and include the most current information as to the status of the case. If the litigation commenced following December 31, 2006, it would be treated as a Type II subsequent event and disclosed in the financial statements. However, it does not appear that any basis exists for including dollar amounts in the disclosure.

11.61Kaplan CPA Exam Simulation: Audit Committee Communications

Required

A significant deficiency in internal control over financial reporting that is not a material weakness.Yes

An uncorrected misstatement that management deems to be immaterial.

Yes

Specific fieldwork procedures where internal auditors were utilized.

No

Specific issues for which the auditors consulted another accountant.No (however, managements consultation with other accountants must be communicated to the audit committee).

An auditors responsibility under generally accepted auditing standards.

Yes

A list of all audit adjustments.No (only significant adjustments are communicated)

Disagreements with management that were resolved to the auditors satisfaction.Yes (all disagreements must be communicated, regardless of whether they were resolved)

Time delays and ill-timed vacations that made completion of the audit difficult.Yes (any difficulties in performing the audit must be communicated)

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2007

12-22Solutions ManualMcGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2007

Auditing and Assurance Services, Louwers et al., 2/e11-23