CHAPTER30 NONAUDIT ENGAGEMENTS: PROCEDURES AND REPORTS I Review Questions Examples of using “what has held true in the past will hold true in the future:” (a) evaluating the collectibility of accounts receivable based on past collection history, (b) evaluating inventory obsolescence on the basis of past usage patterns, (c) assessing the economic usefulness and useful lives of fixed assets based upon experience with similar assets, (d) relying on a control risk assessment for a period between the time of the original assessment at interim and the fiscal year-end, and (e) expecting to encounter classification and evaluation errors when management has been known to have acted without sufficient decision planning in the past Financial statements are unaudited if the CPA has not applied any auditing procedures or has not applied procedures which produced sufficient evidence upon which to base an opinion on the financial statements as a whole With respect to unaudited statements, in addition to a disclaimer of opinion (public companies), the following guides should be followed: 3 If the CPA should learn that the statements are not in conformity with generally accepted accounting principles (including adequate disclosures), he should explain the departures in the disclaimer If prior years’ unaudited statements are present, the disclaimer should cover them as well as the current year statement Each page of the statements should be clearly labeled as unaudited Prospective financial statements are defined as complete financial statements in the same form as traditional income statements, balance sheets and statements of changes in financial position However, an abbreviated presentation constitutes prospective financial statements if its contains all of these items (if applicable): Sale or gross revenue Gross profit Unusual or infrequently occurring items Provision for income taxes Discontinued operations or extraordinary items Net income 30-2 Solutions Manual - Assurance Principles, Professional Ethics… 10 Primary and fully diluted earnings per share Summary of significant changes in financial position Summary of significant assumptions Summary of significant accounting policies Omission of any items 1–8 makes the presentation a partial presentation Omission of or 10 makes it a deficient presentation Similarities and Differences Examination Report on a Forecast a Identification of financial statements and what they intend to represent b Warning about ultimate attainment of prospective results c Statement about review in accordance with ASPC standards d Opinion / assurance about presentation and reasonable assumptions e Statement about no responsibility to update the report Compilation Report on a Forecast a Identification of financial statements and what they represent b Warning about ultimate attainment of prospective results c d e Statement about compilation in accordance with ASPC standards Disclaimer of opinion / assurance Statement about no responsibility to update the report Audit Report on Historical Statements a Identification of statements audited c d Statement that audit was in accordance with GAAS Opinion about conformity with GAAP Compilation Report on Historical Statements a Identification of statements compiled b c d Statement / warning that information is the representation of management (owners) Same kind of statement about compilation and ASPC standards Disclaimer of opinion / assurance Both review service and compilation service engagements are less than an audit A comparison of the three amounts to a hierarchy of assurance: Audit engagement Auditor obtains sufficient competent evidence that serves as a basis for an opinion on financial statements The auditor obtains reasonable assurance within the inherent limitations of the audit Nonaudit Engagements: Procedures and Reports 30-3 process Review engagement Accountant obtains limited assurance through analytical procedures that there are no material modifications that should be made to financial statements Compilation engagement Accountant puts client information in financial statement form without obtaining any assurance (because no procedures are performed) that material modification should or should not be made to the financial statements Additionally, an accountant who is not independent may report on a compilation service (providing that lack of independence is disclosed), but not on a review service or audit engagement A state of association exists whenever: a b The CPA’s name is used in a document containing the statements; or The CPA has prepared or assisted in preparing the statements a Compilation: In compiling financial statements for a client, the CPA presents information that is the representation of management without undertaking to express any assurance on the statements b Review: More than a compilation, but less than an audit, a review consists mainly of performing inquiry and analytical procedures Such procedures provide the CPA a basis for expressing limited assurance concerning conformance with GAAP c Audit: An audit provides reasonable assurance concerning conformance of financial statements with GAAP In addition to inquiry and analytical procedures, an audit involves a study of the client’s internal controls and application of such evidence gathering procedures as confirmation, observation, inspection, vouching, and examination The major procedures applied in a review consist of reading the financial statements, inquiry as to accounting procedures, and analytical procedures A compilation, in contrast to a review, consists of obtaining an understanding of industry accounting principles and practices and reading the financial statements A CPA who lacks independence may compile financial statements; but may not perform an audit, review, or any other form of attestation service 30-4 Solutions Manual - Assurance Principles, Professional Ethics… 10 Procedures to be applied in compiling prospective financial statements should include the following: a b c d e f Inquire about the accounting principles used in preparing the statements Ask how the key factors are identified and how the assumptions are developed Obtain a list of assumptions and consider whether there are any omissions or inconsistencies Test the mathematical accuracy of computations Read the statements for conformity with PSA presentation guidelines Obtain client representations concerning compliance with the guidelines II Multiple Choice Questions c c b b a b a c 10 11 12 a d a b 13 14 15 16 b b a b 17 18 19 20 c d a b III Comprehensive Cases Case a Liability to Delcee and other stockholders: Delcee in its own right may bring an action, or the other stockholders may bring a derivative action against Canada and Canada on behalf of the corporation, for negligent performance in failing to detect the fraud (embezzlement) A lawsuit based on constructive fraud might be asserted against C & C, because the conduct of the review may be characterized as gross negligence with reckless disregard for the truth Individual shareholders and lending institutions will claim this is the case, and if upheld, privity of contract will not be a valid defense b Liability to financial institutions: Third-party financial institutions have rights to sue accountants for negligence in performing review engagements As a general rule, third parties, even though not direct parties to an audit contract, may successfully assert negligence if they can show that they are members of a class of persons intended to benefit from the services performed by the CPA and that their use of the statements was reasonably foreseeable by the CPA Nonaudit Engagements: Procedures and Reports 30-5 Case Assumption Evidence Sources and Procedures a Sale of real estate Determine market value of real estate: * Review appraisals (if any), inquire of real estate broker for the selling price of similar pieces of land Determine cost and tax basis of land: * Examine underlying documents (use financial statement cost presentations, if previously audited) – deeds, purchase contracts * Review National Internal Revenue Code and appropriate publications to determine proper tax basis, tax rates, treatment Determine after-tax profit and proceeds: * Based on above information, compute profit and proceeds Compare amounts to client representations to determine reasonableness Determine authority for use of proceeds: * Examine minutes of directors’ and officers’ meetings for evidence of authority to sell the real estate and a formal plan for using the proceeds to retire bonds b Retire outstanding debentures Determine probable cost of repurchasing bonds: * Examine amount, terms of bonds outstanding * Review current forecasted market for bonds, in light of terms, amount * Compute estimated cost of repurchase Determine adequacy of funding for repurchase: * Compare amount of proceeds [computed in (a)] to amount estimated for repurchase Determine authority for retirement: * Examine minutes of executives’ and officers’ meetings for evidence of approval of retirement c Labor contract Determine probable wage increase: * Examine prior contract settlements, including subjective analysis of labor- 30-6 Solutions Manual - Assurance Principles, Professional Ethics… management relations Confer with union officials * Examine documents, memos, and minutes regarding upcoming labor negotiations * Examine management’s proposed contract Determine effect of higher than predicted wage settlement: * Recompute effect of percent change in wage increase to net income and correlate to management’s figures d Sales projections Determine estimated completion date of Tarlac facility: * Examine contract plans, consult with contractor, observe facility * Examine contracts for machinery, installation; consult with vendor – dates, type of equipment, product capacity * Compare auditor-estimated completion date to management’s for reasonableness * Consider if company can meet personnel requirements of the new facility Estimate financial impact of Tarlac production: * Compare productive capacity to forecasted sales figure (presumed determined reasonable by the auditor) * Recompute probable effect of delay in Tarlac’s completion date and compare to management’s figures Case Nicky has no accounting staff and has little expertise in preparing financial statements himself However, he needs them occasionally, apparently for credit purposes Three kinds of compiled financial statements are available: Compilation Without Independence Brother Kian can prepare the compiled financial statements (with or without all disclosures), but he will need to disclose in this report his lack of independence Compilation With Full Disclosure CPA Bryan can compile the statements and present them in the complete form used for audited financial statements Compilation That Omits Substantially All Disclosures CPA Bryan can compile statements without footnote disclosures, but his report will indicate the lack of disclosure and will warn users Nonaudit Engagements: Procedures and Reports Case a 30-7 Yes, this is a negative assurance b Negative assurance is generally prohibited in audit reports because the profession wishes such reports to contain positive assertions based on evidence instead of negative statements based on “what did not come to my attention.” c A review service is less than an audit, hence the report can be less than positive assurance Clients get what they paid (less) for Case To the Board of Directors of Francisco Company I have reviewed the accompanying balance sheet of Francisco Company as of December 31, 2004, and the related statements of income, retained earnings, and changes in financial position for the year then ended, in accordance with standards established by the Auditing Standards and Practices Council All information included in these financial statements is the representation of the management of Francisco Company A review consists principally of inquiries of company personnel and analytical procedures applied to financial data It is substantially less in scope than an examination in accordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole Accordingly, I not express such an opinion Based on my review, I am not aware of any material modifications that should be made to the 2004 financial statements in order for them to be in conformity with generally accepted accounting principles The accompanying 2003 financial statements of Francisco Company were compiled by other accountants whose report dated January 11, 2004, stated that they did not express any opinion or any other form of assurance of those statements Jo Cee, CPA January 15, 2005 Note: This report presumes: Jo Cee is independent Francisco and Associates, CPAs made no modifications in their 2003 compilation report Francisco and Associates, CPAs was independent 30-8 Solutions Manual - Assurance Principles, Professional Ethics… The 2003 statements contained all necessary disclosures Case a b c d Case Service Compilation Agreed upon procedures Review Report Compilation Review Examination (attestation) Opinion Review Procedures Read and inquire As agreed and applied to specified elements Read, inquire, and apply analytical procedures Evaluate preparation Examine and evaluate underlying assumptions Determine whether presentation is in conformity with PSA guidelines a Nature of Engagement Type of Report Principal Procedures a Audit Opinion; positive Study and evaluate internal control; observe, examine, confirm, reconcile, calculate, and vouch b Comprehensive basis other than GAAP Opinion; positive Same as (a) c Review; nonpublic entity Review; limited Inquiry; analytical procedures d Compilation; nonpublic entity Compilation; none Understand industry accounting practices; read the financial statements e Agreed-upon procedures Review; limited As specified by engagement letter f Letter for underwriter Review; limited Inquiry-as specified by agreement; read the financial statements Nonaudit Engagements: Procedures and Reports 30-9 g Examination of prospective financial statementsprojection Opinion; positive Examine evidence supporting assumptions; determine whether assumptions provide a reasonable basis for the projection; evaluate preparation and presentation of projected financial statements h Review of interim financial information Review; limited Inquiry; analytical procedures b a b c d e f g h General Restricted to management, the board of directors, and the regulatory commission General General (but a fourth paragraph must be added which states that the CPA is not independent.) Restricted to the parties named in the agreement Restricted to the underwriters, Candy and Lolli Restricted to management, the board of directors, and the prospective lender General ...30-2 Solutions Manual - Assurance Principles, Professional Ethics… 10 Primary and fully diluted earnings per... statements; but may not perform an audit, review, or any other form of attestation service 30-4 Solutions Manual - Assurance Principles, Professional Ethics… 10 Procedures to be applied in compiling... of persons intended to benefit from the services performed by the CPA and that their use of the statements was reasonably foreseeable by the CPA Nonaudit Engagements: Procedures and Reports 30-5