CHAPTER 11 Completing the Audit LEARNING OBJECTIVES Review Checkpoints Exercises, Problems, and Simulations Describe the approach used to examine major revenue and expense accounts 1, 2, 3, Explain the use of the attorney letter during the completion of the audit 5, 6, 51, 52, 54 (partial), 59, 60 Identify why the auditor obtains management representations and list the key components of management representations 8, 9, 10, 11 47, 48, 49, 50 Identify the final steps in the completion of an audit 12, 13, 14, 15, 16 Identify the two major categories of subsequent events and describe the proper handling of these events by the auditor 17, 18, 19, 20 53, 54 (partial), 55, 56 Identify the auditor’s responsibility when, after the issuance of the audit reports, the auditor discovers (1) facts that may have existed at the date of the auditor’s reports or (2) omitted audit procedures 21, 22, 23 57, 58 Summarize important communications made by the auditor following completion of the audit and issuance of the auditor’s reports 24, 25 61 McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e © The McGraw-Hill Companies, Inc., 2007 11-1 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: Between the beginning of the year and end of year: Interim tests of controls and substantive procedures 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 Between the last day of fieldwork and issuance of reports: subsequent events Following issuance of the reports: (1) subsequent discovery of facts; (2) omitted audit procedures; (3) management letters; (4) audit committee communications 11.2 Revenue and Expense Account Balance Sheet Account Transaction Cycle Sales revenue and sales returns Receivables Revenue/Collection Dividend and interest revenue Receivables, Investments Finance/Investment Gain or loss on asset disposals Property, plant and equipment Receivables Investments Production Finance/Investment Cost of goods sold Inventories Acquisition/Expenditure Interest expense Liabilities Acquisition/Expenditure Finance/Investment 11.3 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 11.4 “Miscellaneous”, “other”, and “clearing” accounts may represent adjustments made by the client to meet analysts’ earnings expectations (or earnings management) 11.5 a The responsibilities of client management are to (1) respond to the auditor’s 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 client’s description of litigation, claims, and assessments McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e © The McGraw-Hill Companies, Inc., 2007 11-2 11.6 11.7 11.8 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 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 client’s 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 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 auditor’s defense if a question of management integrity arises later The following representations must appear in all management representations: Management’s acknowledgement of its responsibility for the fair presentation of financial statements in conformity with U.S generally accepted accounting principles Availability of all financial records and related data and completeness of the minutes of meetings of stockholders, directors, and important committees Management’s acknowledgement of its responsibility for the design and implementation of programs and controls to prevent and detect fraud Disclosure of all significant deficiencies in internal control 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 McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e © The McGraw-Hill Companies, Inc., 2007 11-3 11.9 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) Management’s 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 11.10 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 11.11 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 11.12 Adjusting entries and note disclosures are labeled proposed because it is ultimately the client’s responsibility to adjust the financial statements for these items 11.13 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 client’s audit committee, regardless of the materiality of these adjustments to the client’s financial statements 11.14 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 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 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 firm’s quality standards 11.15 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 McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e © The McGraw-Hill Companies, Inc., 2007 11-4 11.16 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 firm’s 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) 11.17 A subsequent event is an event occurring between the balance sheet date and the last day of fieldwork 11.18 Procedures performed during the subsequent period include: 11.19 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 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 client’s 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) 11.20 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 auditor’s liability for events after the last day of fieldwork is limited to the event specifically identified in the report date 11.21 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 McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e © The McGraw-Hill Companies, Inc., 2007 11-5 11.22 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 auditor’s 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 11.23 11.24 11.25 If an omitted procedure is found, the following courses of action would be taken: Verify that (1) the omitted procedure is important in supporting the auditor’s opinion and (2) individuals are currently relying on the client’s financial statements and reports If both of the above conditions exist, the auditor should perform the omitted procedure or alternative procedures If both not exist, no further action is necessary If performing the omitted or alternative procedures allow the auditor to support the previouslyexpressed opinion, no further action is necessary However, if they not, the auditor should formally withdraw the original reports, issue revised reports, and inform persons currently relying on the financial statements The auditor should communicate the following information to the audit committee: The auditor’s 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 auditor’s judgment about the quality of the client’s accounting principles The auditor’s 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 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 McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e © The McGraw-Hill Companies, Inc., 2007 11-6 SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS 11.26 11.27 a b Incorrect Correct Interest income is related to the examination of notes receivable Interest expense can be calculated from the notes payable information and is examined in conjunction with that information c Incorrect Notes payable are not related to goodwill amortization d Incorrect Notes payable are not directly related to royalty revenue a Incorrect b c Incorrect Incorrect d Correct Management representations not shift responsibility to auditors for the financial statements Management representations should not substitute for other evidence sources Management makes assertions directly in the financial statements and not as part of the management representations This responsibility is explicitly included in the management representations 11.28Note 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 b c Correct Incorrect Incorrect d Incorrect a b c Incorrect Incorrect Correct d Incorrect a b Incorrect Correct c d Incorrect Incorrect 11.31 a b c d Incorrect Incorrect Incorrect Correct See (d) below See (d) below See (d) below Under the 1933 Securities Act, the auditor’s responsibility extends to the effective date of the registration statement 11.32 a Correct b c d Incorrect Incorrect Incorrect Subsequent discovery of facts refers to knowledge obtained after the issuance of the audit reports See (a) above These types of events are referred to as subsequent events See (a) above These types of events are referred to as subsequent events See (a) above These types of events not require any special audit consideration 11.29 11.30 Scanning expenses is unlikely to reveal any information about a contingency Attorneys letters can provide information about contingencies Minutes of board of directors’ meetings can provide information about contingencies Sales contracts can provide information about right of return that may need to be disclosed as a contingency The issuance of stock occurred after December 31 The injury related to the lawsuit was sustained after December 31 Since 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 The storm occurred after December 31 The report date is the last day of fieldwork, not the balance sheet date The report date is the last day of fieldwork and the dual date is the date related to the specific event The report date is the last day of fieldwork, not the balance sheet date The report date is the last day of fieldwork, not the date of the subsequent event McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e © The McGraw-Hill Companies, Inc., 2007 11-7 11.33 a Incorrect b c Incorrect Correct d Incorrect Management representations are required under generally accepted auditing standards Attorney letters are required under generally accepted auditing standards Management letters, while helpful, are not required under generally accepted auditing standards Engagement letters are required under generally accepted auditing standards 11.34Note 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 11.35 11.36 11.37 a Correct b Incorrect c Incorrect d Incorrect a Incorrect b c Incorrect Incorrect d Correct a Incorrect b c Incorrect Incorrect d Correct The client’s 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 client’s operations The client’s accounting and production managers would provide information about current practices for the management letter The audit firm’s team would play a major role in drafting the management letter based on their observations during the audit examination The audit firm’s consulting and tax experts would participate in drafting the management letter, as they are in position to identify possible efficiencies and income tax savings An engagement letter would be secured prior to the commencement of the audit examination Tests of controls would be performed prior to the end of the year under audit A review for subsequent events would be performed after year-end but prior to the end of fieldwork Management representations would be obtained on the last day of fieldwork Discovery of a subsequent event occurs after issuance of the auditor’s report on the company’s financial statements Dual dating the audit report occurs following the last day of fieldwork The management letter is prepared and presented to the client following the conclusion of the audit examination The review of audit documentation occurs after the balance sheet date but before the last day of fieldwork Note 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 Incorrect b Correct c Incorrect d Incorrect Analytical procedures would be used in conjunction with the examination of revenue and expense accounts The auditor would typically sample and investigate individual transactions in the examination of the related balance sheet accounts, but not revenue and expense accounts 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) The auditor would scan revenue and expense accounts for large and unusual debit and credit entries McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e © The McGraw-Hill Companies, Inc., 2007 11-8 11.38 11.39 11.40 11.41 11.42 a Incorrect b Incorrect c Incorrect d Correct a Incorrect b Incorrect c Correct d Incorrect This statement would typically be included in management representations and not an attorney letter 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 This statement would ordinarily be included in a management letter and not an attorney letter The attorney letter would request that the attorney furnish this information to the auditor 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 company’s financial statements Prior to notifying the board of directors and regulatory agencies who are currently relying on the auditor’s reports, the auditor would determine that the omitted procedure is important in supporting the opinion on the company’s financial statements This is the initial course of action that would be taken upon the discovery of an omitted audit procedure A quality assurance review may reveal the omission of an audit procedure, but would not be performed in response to an omitted procedure Note 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 Correct b Incorrect c Incorrect d Incorrect a Incorrect b Incorrect c Correct d Incorrect a Incorrect b Incorrect c d Incorrect Correct The failure of management to furnish representations would result in either a qualified opinion or a disclaimer of opinion Management representations address disclosure of significant deficiencies in internal control, regardless of materiality Management representations are used by the auditor to corroborate information received from the client and its employees Management representations are dated the same date as the auditor’s reports (the last day of fieldwork) Management 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 Management representations are dated as of the last day of fieldwork (in this case, March 24, year 2), not the date that fieldwork began Management representations are dated as of the last day of fieldwork (in this case, March 24, year 2) Management 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 A charge to a notes receivable would relate to a transaction that has occurred in a prior period, not current period A charge to a notes receivable would relate to a transaction that has occurred in a prior period, not current period A charge would indicate that any obligation has been settled, not incurred The 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 McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e © The McGraw-Hill Companies, Inc., 2007 11-9 11.43 11.44 11.45 11.46 a Correct b Incorrect c Incorrect d Incorrect a Incorrect b Correct c Incorrect d Incorrect a Incorrect b Correct c d Incorrect Incorrect a Correct b Incorrect c Incorrect d Incorrect Comparing interim financial statements with the financial statements being audited would identify potential subsequent events Second request confirmations would provide evidence regarding the valuation of accounts receivable balances but would not provide evidence regarding subsequent events Communicating 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 Reviewing the cutoff bank statement would verify the valuation of cash but would not provide evidence regarding subsequent events This procedure would provide evidence about the valuation of these transactions, but not subsequent events This procedure may provide information about sales and repurchases of the company’s stock This procedure would be used to search for unrecorded accounts payable at year-end, but not the occurrence of subsequent events This procedure would provide evidence about the valuation of cash and potential guarantees of debt, but not subsequent events While the attorney letter will ask for corroboration of management’s information regarding the probable outcome of litigation, claims, and assessments, management is the primary source of this information The attorney letter requests the attorneys to corroborate information furnished from management Historical experiences are not included in an attorney letter A description and evaluation of litigation, claims, and assessments is obtained from the client; the attorney is asked to corroborate this information (see b above) The attorneys’ response should be limited to matters in which they have given substantive attention The attorney should comment on matters of which they are aware that were not disclosed by the entity The attorney should not limit their response to matters in which the entity has historical experience The attorney should also comment upon unasserted claims as well as asserted claims and pending or threatened litigation McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e © The McGraw-Hill Companies, Inc., 2007 11-10 SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS 11.47 Management 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 auditor’s 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 auditor’s 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 McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e © The McGraw-Hill Companies, Inc., 2007 11-11 11.48Management Representations Omissions Other matters that should be confirmed in management representations include: 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) Availability of all financial records and related data and completeness of the minutes of meetings of stockholders, directors, and important committees Management’s acknowledgement of its responsibility for the design and implementation of programs and controls to detect fraud Management’s disclosure of all significant deficiencies in internal control 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 Molar’s 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 McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e © The McGraw-Hill Companies, Inc., 2007 11-12 11.49 Management Representations Appropriate Inappropriate While management representations address fraud involving management and employees who have significant roles in internal control, they not indicate that no frauds that could have a material effect exist Management’s assessment of internal control over financial reporting will not provide management with a basis for a statement of this nature Appropriate Inappropriate The description and evaluation of contingencies would accompany the attorney letter sent to the client’s 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 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 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 Inappropriate Management’s 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 Appropriate McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e © The McGraw-Hill Companies, Inc., 2007 11-13 11.50 Management Representations Included in management representations regardless of materiality Not included in management representations (This would accompany an attorney letter sent from the client to their attorneys.) Not included in management representations (This would be included in a management letter prepared by the auditor to the client.) Included in management representations regardless of materiality Included in management representations, if material Included in management representations regardless of materiality Included in management representations regardless of materiality Not included in management representations (This would be communicated to the client’s audit committee.) 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.) McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e © The McGraw-Hill Companies, Inc., 2007 11-14 11.51Client 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: A description of the progress of each case to date is omitted An evaluation of the likelihood of an unfavorable outcome of each case is omitted An estimate, if one can be made, of the amount or range of potential loss of each case is omitted The various other pending or threatened litigation on which Young was consulted is not identified and included The unasserted claims and assessments probable of assertion that have a reasonable possibility of an unfavorable outcome are not identified Materiality (or the limits of materiality) is not addressed The reference to a limitation on Young’s response due to confidentiality is inappropriate Young is not requested to include matters that existed after December 31, 2006, up to the date of Young’s response 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 Consolidated’s understanding of Young’s 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 Young’s response is needed is not indicated 14 The reference to Young’s 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 McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e © The McGraw-Hill Companies, Inc., 2007 11-15 11.52 Attorney Letters a b Inquire of management regarding 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 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 Jaworski’s 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 Fulbright’s responsibilities with respect to litigation, claims, and assessments are to respond to auditor’s 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 Vinson’s responsibilities with respect to litigation, claims, and assessments are to respond to the auditor regarding Fulbright’s description of litigation, claims, and assessments c d The auditor initiates the request for the client to send the attorney letter 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 The attorneys will respond directly to the auditor on the information contained in the attorney letter The following information is typically included in an attorney letter (prepared from the client’s 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 McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e © The McGraw-Hill Companies, Inc., 2007 11-16 An estimate of the range of potential loss McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e © The McGraw-Hill Companies, Inc., 2007 11-17 11.53 Subsequent Events a A subsequent event is an event or transaction that occurs after the balance sheet date but prior to the issuance of the auditor’s reports and the company’s 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: c d e 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 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) 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 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 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 Company’s 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 auditor’s reports; and, (c) persons are continuing to rely on the financial statements and auditor’s reports 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 McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e © The McGraw-Hill Companies, Inc., 2007 11-18 11.54 Audit Simulation: Subsequent Events and Contingent Liabilities a A subsequent event is an event or transaction that occurs after the balance sheet date but prior to the issuance of the auditor’s reports and financial statements (AU 560.01) 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) b 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 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) 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) McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e © The McGraw-Hill Companies, Inc., 2007 11-19 11.54 Audit 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) 11.55Subsequent Events Procedures a 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 McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e © The McGraw-Hill Companies, Inc., 2007 11-20 11.56Subsequent Events–Cases a This would have come to the auditor’s 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 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 President’s 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 officer’s personal business and has no effect upon Olars’ financial statements 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] a The auditor might learn of the agreement to purchase the treasurer’s 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 CPA’s 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 treasurer’s resignation, does not require disclosure in the financial statements The details underlying the separation (personal disagreements and divorce) need not be disclosed 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 McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e © The McGraw-Hill Companies, Inc., 2007 11-21 11.57Subsequent Discovery of Facts The 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 auditor’s 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 11.58Omitted Audit Procedures a 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 auditor’s 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 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 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 auditor’s reports If the client refuses to 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 McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e © The McGraw-Hill Companies, Inc., 2007 11-22 11.58 Omitted 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 Wildcat’s 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 Hurdman’s reports 11.59Attorney Letter Responses a b The “four” responses were based on AU 9337, as are these solutions 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 Omega’s liability According to AU 9337, this means “remote likelihood of material loss” According to AU 9337, this means “remote likelihood of material loss” “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 Plaintiffs’ counsel would probably assert the merits of the plaintiff’s case, suggesting that the auditor’s 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 11.60Accounting for a Contingency–Attorney Letter Information a 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 McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e © The McGraw-Hill Companies, Inc., 2007 11-23 11.61 Kaplan 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, management’s consultation with other accountants must be communicated to the audit committee) An auditor’s 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 auditor’s 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 Auditing and Assurance Services, Louwers et al., 2/e © The McGraw-Hill Companies, Inc., 2007 11-24 ... improve the effectiveness and efficiency of its operations They are not required by generally accepted auditing standards McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e ©... revenue and expense accounts (see b above) The auditor would scan revenue and expense accounts for large and unusual debit and credit entries McGraw-Hill/Irwin Auditing and Assurance Services, Louwers. .. claims and pending or threatened litigation McGraw-Hill/Irwin Auditing and Assurance Services, Louwers et al., 2/e © The McGraw-Hill Companies, Inc., 2007 11-10 SOLUTIONS FOR EXERCISES, PROBLEMS, AND