332
CHAPTER 14
Completing the Audit
LEARNING OBJECTIVES
Review
Checkpoints
Exercises
and Problems
Cases
1. Describe the related balance sheet
account group where the audit of
the major revenue and expense
accounts normally is associated.
1, 3
2. Describe the use of analytical
procedures to audit revenue and
expense accounts.
2, 3, 4
3. Explain the use of the client
representation letter and the
attorney's letter as an audit is
completed.
5, 6, 7, 8,
9
36, 37
48
4. Describe the reasons written client
representations are obtained and
list the four items that are
included without regard to a
materiality criterion.
5
36, 37, 38
24
5. Given a set of facts and
circumstances, classify a
subsequent event by type and
describe the proper treatment in
the financial statements.
10, 11, 12,
13
39, 40, 41,
42, 43
49
6. Specify the sequence of decisions
and actions auditors must consider
upon discovery (after the issuance
of the report) of information
about facts that may have existed
at the date of the auditor's
report.
14, 15
44
7. Specify the considerations and
procedures applied by auditors
upon concluding (after the audit
report date) that one or more
auditing procedures were omitted.
16
45
8. Explain the final audit steps
involving adjusting entries,
second-partner review, and the
management letter.
17, 18, 19,
20, 21, 22,
23
46
26, 47
POWERPOINT SLIDES
PowerPoint slides are included on the website. Please take special note of:
333
Analytical Procedures
Summary of Audit Correspondence
* Subsequent Events
SOLUTIONS FOR REVIEW CHECKPOINTS
*
*
14.1
Revenue and Expense Accounts
Lease revenue
Franchise revenue
Royalty and license revenue
Repair and maintenance
Interest expense
Lease revenue
Fixed assets and receivables
Receivables and intangibles
Receivables and investments
Fixed assets and liabilities
Liabilities
14.2
Many of the revenue and expense accounts are not material in relation to the
financial statements and may be combined with other accounts in the financial
statements. These accounts can be audited through analytical procedures. Such
procedures compare the account balance to related balance sheet accounts, to
sales, to industry averages or to a multiple-year trend to ascertain whether
any unusual fluctuations are present. Unusual or unexpected items would have
to be investigated and material items vouched to supporting documents.
14.3
"Unusual revenue transactions" can cause significant audit evidence and
reporting problems when such transactions are designed by management to create
inappropriate earnings. These transactions pose a combination of: evidencegathering problems, auditor responsibility for detecting errors and
irregularities, and reporting-disclosure problems.
14.4
These procedures can be used to obtain information about the material accuracy
of balances in minor expense accounts:
*
Analytical comparison of current balances to two or more prior years'
balances, looking for unusual fluctuations or lack of change when other
information indicates change should have occurred.
*
Vouching supporting documents for expense entries to obtain detail
evidence about existence/occurrence, valuation, and classification.
*
Documents vouched in connection with detail test of controls procedures,
if any, performed in the acquisition and expenditure cycle test of
controls work.
14.5
The primary purpose of the client representation letter is to impress upon
management its ultimate responsibility for the adequacy of the financial
statements and related disclosures.
With respect to receivables, such letters typically state that all receivables
are valid and include proper amounts; also stated is the amount written off in
the past year and the current provision for uncollectibles.
In connection with inventories, the client represents that the dollar amount
of inventories reflects physical quantities determined by a count and priced
by a stated accounting method. The client also represents that provision has
been made by the company for all obsolete and damaged inventory.
In regard to minutes, the client represents that all minutes of meetings of
stockholders, directors, and executive committees which have been transmitted
to the auditor are complete and authentic records for the period under audit
(including the subsequent period).
The client letter of representation should state whether any events occurred
subsequent to the date of the financial statements that, in the client's
opinion, require adjustment or disclosure in the statements.
334
14.6
Written client representations and lawyers' letters are obtained near the end
of the audit field work and dated on or near the audit report date because the
auditors are responsible for determining whether important events that
occurred after the balance sheet date are properly entered in the accounts or
disclosed in the financial statement notes.
14.7
In addition to the letter, other procedures that are used to gather evidence
regarding contingencies include:
*
Standard bank confirmation.
*
Inquiry of client management.
*
Reading of the minutes of the board of directors.
*
Vouching to purchase and sales contracts.
*
Vouching to lease agreements, confirmation with lessor or lessee.
14.8
This statement in a letter from client's counsel is permissible (the lawyer is
not refusing to cooperate) from the auditor's viewpoint. However, it will not
affect the auditor's opinion directly since there is no indication of the
character of the lawyer’s response with respect to litigation for which he is
legal counsel.
14.9
Companies and auditors might experience difficulty making appropriate
disclosures about litigation contingencies for these reasons:
*
High level of emotion surrounding the lawsuits.
*
Fear that financial statement disclosure will be construed as an
admission of guilt.
*
The legal framework for evaluating litigation outcomes varies
significantly from the framework used by auditors.
*
More appropriate channels exist for disclosure of litigation information
(e.g., business press).
*
General disclosure requirements such as FASBs are viewed as only a guide
and therefore need not be taken literally.
14.10 There are two types of subsequent events:
1.
The first type consists of those events that provide additional evidence
with respect to conditions that existed at the date of the balance sheet
and affect the estimates inherent in the process of preparing financial
statements. The use of the evidence requires an adjustment to the
financial statements.
2.
The second type consists of those events that provide evidence with
respect to conditions that did not exist at the date of the balance sheet
being reported on but arose subsequent to that date. These events should
not result in an adjustment of the financial statements. However,
disclosure may be required to prevent the financial statement from being
misleading. In some cases, pro forma financial statements may be required
to ensure adequate disclosure.
14.11 If stock dividends or splits occur in the subsequent period, they are given
retroactive recognition. That is, the financial statements are adjusted.
Retroactive recognition is given since, by the time the statements reach
users, the stock dividend or split may have been effected, and to report
financial data as if it had not occurred might be considered misleading.
14.12 The purpose of dual dating is twofold: (1) To provide a means of inserting
important information in the financial statements even when learned after
field work is complete, while at the same time (2) to inform users that the
auditor takes full responsibility for subsequent events only up to the end of
335
the field work and for the specifically identified later event, but does not
take responsibility for other events which may have occurred after the end of
field work and before the date of the specifically identified subsequent
event.
14.13 In addition to the procedures applied in the subsequent period, the auditor
should read the entire prospectus and other pertinent portions of the
registration statement, and make inquiries and obtain written representations
up to the effective date.
14.14 "Subsequent events" are material events that occur after the balance sheet
date but before the end of field work (and thus, before the audit report date)
that require disclosure in the financial statements and related notes.
Auditors (and management) are responsible for gathering evidence on these
subsequent events and evaluating the proposed disclosure.
"Subsequent discovery of facts existing at the audit report date" is knowledge
gained after the audit report is issued about an event or condition that
existed at the audit report date. Auditors have no responsibility to search
for these facts (as they do for subsequent events); however, once brought to
the auditors' attention, their responsibility is to determine if the financial
statements (and thus their report) are misstated and take appropriate action.
14.15 The actions the partner should take if the client consents to disclose the
information (which existed at the audit report date and materially impacts the
financial statements) is to determine the method and timing of disclosure (AU
561).
The actions the partner should take if the client refuses to make disclosure
are (AU 561):
*
Notify the client that the auditors' report must no longer be associated
with the financial statements.
*
Notify regulatory authorities that the auditors' report should no longer
be relied upon.
*
Notify users known to be relying on the financial statements that the
auditors' report should no longer be relied upon. Such notification may
be to the SEC and the stock exchanges.
14.16 Once auditors have reported on audited financial statements, they have no
responsibility to carry out a retroactive review of their work. However, postissuance review may be made in connection with a firm's internal quality
control monitoring program, peer review or otherwise, and the omission of an
auditing procedure may be discovered.
If an omitted procedure is found, 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 there are persons currently relying or likely to rely on
their report.
*
If the omitted procedure impairs 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 refer to AU 561 (Subsequent
Discovery of Facts Existing at the Date of the Auditor's Report) for
guidance.
14.17 Recommended adjustments and note disclosures may be written by the auditors,
336
but the client must take primary responsibility for the financial statement
numbers and disclosures. The auditor's responsibility is for the audit report
and not for the financial statements.
14.18 Review "to do" lists are notes about unfinished or deficient audit work. Such
notes arise from reviews of the audit working papers. The necessity to clear
the notes and finish the work should be obvious. Examples include: "sign the
working papers," "trace book amounts to the trial balance," "prepare a
schedule of collections on notes receivable and determine collectibility."
14.19 A good reason for keeping the "to do list" in the audit working paper files is
to show evidence of careful review and completion of the audit. Sometimes,
retained "to do lists" backfire on auditors by showing questions raised but
not resolved. The latter case points out sloppy audit work that is probably
evident in the working papers anyway.
14.20 In a "second partner review," a partner not otherwise associated with an
engagement will take the report (in draft copy) and all working papers and
review the entire engagement with a fresh start. The purpose of the review is
to obtain the unbiased view of a professional expert who is not committed to a
particular engagement or its problems. It is performed to aid in maintaining
high standards of professional practice.
14.21 A management letter is an extra audit service. Auditors write to the
management their recommendations about control, tax matters, operating
efficiencies, and other consulting subjects to impress on managers the
benefits of audits in addition to "just an audit." The letter also serves to
promote and sell PAs' consulting services.
14.22 The participants in drafting a management letter should include auditors
(staff making observations, managers and partners deciding the important
points), consultants, and tax professionals. They can all contribute useful
advisory comments to the client.
14.23 A good management letter can show the client some profit potential, and the PA
may be hired to do the consulting work.
SOLUTIONS FOR KINGSTON CASE PROBLEMS
14.24 Client Representation Letter
KINGSTON COMPANY
Kingston, Ontario
February 29, 2003
Anderson, Olds & Watershed
Public Accountants
Toronto, Ontario
Re.: Written representations
Dear Sirs:
In connection with your examination of the financial statements of Kingston
Company as of December 31, 2003, and for the years then ended for the purpose of
expressing an opinion as to whether the financial statements present fairly the
financial position, results of operations, and changes in financial position of
Kingston Company in conformity with generally accepted accounting principles, we
337
confirm to the best of our knowledge and belief, the following representations made
to you during your examination.
1.
We are responsible for the fair presentation in the financial statements of
financial position, results of operations, and changes in financial position
in conformity with generally accepted accounting principles.
2.
We have made available to you all:
a.
Financial records and related data.
b.
Minutes of the meetings of stockholders, directors, and committees of
directors, or summaries of actions of recent meetings for which minutes
have not been prepared.
3.
There have been no irregularities or violations of laws by either management
or employees.
Several legal cases are pending, all of which have been covered in the
attorney's letter submitted to you.
4.
5.
The company has an opportunity to purchase Willie's Woods. The sum of $100,000
was put in escrow as earnest money to hold the deal until it is investigated
further.
6.
There are no capital stock repurchase options, compensating balances, or
agreements to repurchase assets previously sold.
7.
We have no plans or intentions that may materially affect the carrying value
or classification of assets and liabilities.
8.
Related party transactions and related amounts receivable and payable,
including sales, purchases, loans, transfers, leasing arrangements, and
guarantees have been properly recorded or disclosed in the financial
statements. The Vice President of Finance, Mr. Grace, loaned the company
$25,000 in July, 2002, and this amount considered immaterial and is not
separately disclosed in the financial statements.
9.
There are no material transactions that have not been properly recorded in the
accounting records underlying the financial statements.
10.
Provision, when material, has been made to reduce excess or obsolete
inventories to their estimated net realizable value.
11.
The company has satisfactory title to all owned assets, and there are no liens
or encumbrances on such assets nor has any asset been pledged that has not
been disclosed to you.
12.
Provision has been made for any material loss to be sustained in the
fulfillment of, or from inability to fulfill, any sales commitments.
13.
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.
14.
We have complied with all aspects of contractual agreements that would have a
material effect on the financial statements in the event of noncompliance.
15.
No events, other than the one mentioned above concerning the possible purchase
of Willie's Woods, have occurred subsequent to December 31, 2002, that would
require adjustment to, or disclosure in, the financial statements.
338
Larry Lancaster
__________________________
President and Chairman of the Board of Directors
Julian Grace
__________________________
Vice-President of Finance
14.25 Subsequent Events
a.
Subsequent events must be disclosed because financial statements are
issued after the actual balance sheet date. Users of the financial
statements are entitled to have a document (financial statements and
footnote disclosures) that is up-to-date as of (nearly) the time they
receive and use it. Therefore "subsequent events" are relevant to users
when they receive financial statements after the balance sheet date.
Subsequent events differ in their nature and their accounting treatment.
All information learned after the balance sheet date is in the category
of "subsequent events," but some of it (Type I) is actually information
about conditions that existed at the balance sheet date and would have
caused accounting entries had it been known at that time. Auditors use
this information in hindsight to adjust the numbers in the financial
statements. Other events (Type II) are actually occurrences that
transpire after the balance sheet date, and properly belong in the
accounting of the subsequent period. These events are not "postdated" as
if they had happened on the balance sheet date, but disclosure of them is
made in the financial statement footnotes.
b.
Subsequent Event Procedures (See Exhibit 14-5)
Read and compare interim financial statements
Inquire of officers and directors about interim statements and other
important matters.
Read minutes of meetings of stockholders, directors, and other important
committees.
Obtain a lawyer's letter.
Obtain written client representations.
Make other inquiries and do other work considered necessary.
c.
Items for subsequent event treatment
(1)
The related party loan with repayment before year-end followed by
renewal of the loan right after year-end has the appearance of
"window dressing" (making the liability total look smaller
temporarily). Some auditors would insist that the loan repayment in
December be reversed (because of the January loan), thus reporting
the liability and the cash on hand in the balance sheet. Other
auditors would settle for note disclosure of the related party
sequence of events. [The proposed adjusting entries in assignment
21.26 do not include a reversing entry for the December payment.]
(2)
The strike and perhaps the effect on the company needs to be
disclosed.
(3)
The progress on the potential purchase, including the earmarking of
$100,000, needs to be disclosed in the notes. No accounting entry as
of December 31 is appropriate.
339
(4)
This information needs to be entered in the financial statements as
of December 31, when an estimated liability was entered. The entry
is to debit inventory $ 5,400 and credit accounts payable $ 5,400.
No other disclosure about the timing of the information needs to be
made. (As far as users are concerned, this is not a correction of an
erroneous entry. They never knew about the original estimate
anyway.)
14.26 Kingston Company Adjustments
Kingston Company
December 31, 2002
Income Statement
Account
Acct
No.
Debit
Credit
(1)
Cash
101
Accounts Payable
201
Reclassify checks not mailed.
(2)
Sales
401
Accounts Receivable
105
Adjust for billing errors.
Balance Sheet
Debit
$51,040
$51,040
$12,000
(3)
Inventory
111
Cost of Goods Sold
501
$14,000
Inventory
111
Accounts Payable
201
Cost of Goods Sold
501
$10,000
Reduce inventory by 70% of $20,000 cost.
Record $3,500 inventory in transit.
Add $10,000 to inventory for January sale.
(4)
Inventory
111
Utilities Expense
513
$2,100
Accounts Payable
201
Record inventory in transit $75,000.
Record December utility bill.
$12,000
$13,500
$14,000
$3,500
$75,000
$77,100
(5)
Interest Expense
527
$41,250
Accrued Interest
205
Record interest on bank loan.
(6)
Notes Payable
220
Current Part LT Debt
211
Reclassify current part of LT debt.
(7)
Dividends Declared
Dividends Payable
307
207
Credit
$41,250
$200,000
$200,000
$50,000
$50,000
340
(8)
Equipment
125
Land
129
Repairs Expense
523
Misc. Expense
525
Capitalize items charged to expense.
$23,000
$7,310
$23,000
$7,310
Depreciation Expense
509
$37,150
Accum. Deprc. Bldg.
123
Accum. Deprc. Equip.
127
Bldg. depreciation: $300,000 x 4% x 1/2 year
Equip. depreciation: $600,000 x 10% x 1/2 year
Equip. depreciation: $23,000 x 10% x 1/2 year
Subtotals
$106,500
$40,310
(9)
Other Current Assets
115
Income Tax Expense
531
$26,476
Record tax refund resulting from adjustments.
40% x ($106,500 - $40,310)
TOTALS
$106,500
$66,786
$6,000
$31,150
$419,850
$486,040
$26,476
$446,326
$486,040
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KINGSTON COMPANY
Balance Sheet
December 31, 2002
ASSETS
Cash
Accounts Receivable (net)
Inventory
Other Current Assets
Total Current Assets
Fixed Assets
Accumulated Depreciation
Other Assets
TOTAL ASSETS
$535,040
358,000
2,014,500
26,476
$2,934,016
4,030,310
(1,837,150)
0
$5,127,176
LIABILITIES
Bank Loan
Current Part L-T Debt
Accounts Payable
Accrued Expenses
Accrued Interest
Dividends Payable
Other Current Liabilities
$750,000
200,00
731,640
10,000
81,250
50,000
0
Total Current Liabilities
Notes Payable
$1,822,890
200,000
TOTAL LIABILITIES
$2,022,890
DEFERRED CREDITS
$0
OWNERS' EQUITY
Paid-in Capital
Retained Earnings
$2,000,000
1,104,286
TOTAL EQUITY
$3,104,286
LIABILITIES AND EQUITY
$5,127,176
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KINGSTON COMPANY
Income Statement
Year Ended December 31, 2002
Sales (net)
Cost of Goods Sold
$8,088,000
5,269,000
Gross Profit
$2,819,000
EXPENSES
General and Administrative
Depreciation
$1,976,790
337,150
Operating Income before
Interest and Taxes
Interest Expense
Income Taxes
NET INCOME
$505,060
81,250
169,524
$254,286
STATEMENT OF RETAINED EARNINGS
Beginning Balance
Net Income
Dividends Declared
Ending Balance
$900,000
254,286
(50,000)
$1,104,286
343
KINGSTON COMPANY
Statement of Cash Flows
Year Ended December 31, 2002
Cash Flows from Operations:
Net income
Depreciation deducted
Decrease in accounts receivable
Increase in inventory
Increase in other current assets
Increase in accounts payable
Decrease in accrued expenses
Increase in accrued interest
$
254,286
337,150
102,000
(514,500)
( 26,476)
281,640
( 40,000)
21,250
Cash Flow From Operations
$
415,350
Investment Activities:
Purchase of fixed assets
$ (1,030,310)
Financing Activities:
Bank loan
Paid long-term debt
$ 750,000
(200,000)
Net Financing Activities
$
550,000
Increase (Decrease) in Cash
$
( 64,960)
Cash Balance January 1, 2002
$
600,000
Cash Balance December 31, 2002
$
535,040
The audit report is a standard unqualified report on the single year, 2002.
SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS
14.27 a.
b.
Incorrect.
Correct.
c.
d.
Incorrect.
Incorrect.
14.28 a.
b.
Incorrect.
Incorrect.
c.
Incorrect.
d.
Correct.
Interest income is related to notes receivable.
Interest expense can be calculated from the notes payable
information.
Notes payable are not related to goodwill amortization.
Notes payable are not directly related to royalty revenue.
Written rep do not shift responsibility to auditors.
Written reps should not substitute for other evidence
sources.
Management makes assertions directly in the financial
statements.
Management's responsibility is one of the required inclusions
in the standard written rep letter.
14.29 I expect someone will have an argument about a contingency that could be
discovered, but
a.
Correct.
This scanning is least likely to show any information about a
contingency.
b.
Incorrect. Attorney's letters can tell about litigation contingencies.
c.
Incorrect. Directors' minutes can tell about endorsements, guarantees,
344
d.
Incorrect.
14.30 a.
b.
c.
Incorrect.
Incorrect.
Correct.
d.
Incorrect.
14.31 a.
Incorrect.
and other commitments.
Sales contracts can tell about rights of return that might
need to be disclosed as contingencies.
This event did not exist at the prior December 31.
The event occurred 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 should be the end of field work, not the
balance sheet date.
The report date is the end of field work, and the dual date
is the event date.
The report date should be the end of field work, not the
balance sheet date.
The dates are right, but the order is improperly reversed.
b.
Correct.
c.
Incorrect.
d.
Incorrect.
14.32 a.
b.
Incorrect.
Incorrect.
c.
d.
Incorrect.
Correct.
see d.
see d. (This is the right answer when there is no
registration statement involved.)
see d.
According to securities law.
14.33 a.
b.
c.
d.
Correct.
Incorrect.
Incorrect.
Incorrect.
"Subsequent discovery" is after report delivery.
see a.
see a.
see a.
14.34 a.
b.
c.
d.
Incorrect.
Incorrect.
Correct.
Correct.
Written client rep letter is required.
Letter from client's lawyer is required.
A helpful management letter is not required.
An engagement letter is not required.
14.35 a.
Correct.
The client's accounting and production managers often
participate in reviewing the draft of the management letter,
and the audit firm's auditors, and consulting and tax
personnel lend their expertise. The client's outside
attorneys are seldom, if ever, involved in the management
letter constructive comments.
SOLUTIONS FOR EXERCISES, PROBLEMS AND CASES
14.36 a.
1.
The primary responsibility for the correctness of statements lies
with management; written representations emphasize this point.
2.
A letter reduces to and confirms in writing information which is
asked of management. It will prevent misunderstanding between the
client and the auditor and remind management that all appropriate
information should be revealed to the auditor.
3.
The letter provides evidence for review or subsequent use that the
auditor has made the proper inquiries concerning matters which may
not be readily disclosed in the accounting records.
4.
Some items as to which the representations are sought are not
readily observable or found in the records of the firm but their
345
existence would materially affect the fairness and accuracy of the
financial reports.
5.
b.
14.37 a.
Client representations do not in any way relieve the auditor of following
standard audit procedures or reduce his responsibilities when expressing
an opinion on the client's statements.
1.
2.
3.
4.
b.
1.
2.
3.
4.
c.
For an initial audit, such representations prove valuable in
establishing a starting point in building a permanent file.
1.
The objectives of the engagement letter are to:
a.
Make sure that the PA and his client are in agreement about the
nature of the engagement.
b.
Inform the client about the scope of the PA's work and what may
be expected to result.
c.
Provide a written record of the responsibilities assumed by the
PA and those retained by the client. (This understanding
protects both the PA and his client.)
The PA usually prepares the engagement letter as a follow-up to a
verbal understanding reached with the client. It is desirable that
the client sign and return a copy of the engagement letter to the
PA. It also is acceptable for the client to prepare his own letter
summarizing an understanding of the nature of the engagement.
Preferably, the engagement letter should be sent at the beginning of
the engagement so that misunderstandings, if any, can be remedied.
Obviously, the engagement letter will be most useful in clarifying
misunderstandings on a first engagement. But it is desirable that
the letter be renewed periodically. Client personnel or the nature
of the engagement may change, and the resubmission of the letter
gives both parties an opportunity to review the circumstances.
Accordingly, for recurring examinations of financial statements, it
is appropriate to prepare an engagement letter at the start of each
examination. For other continuing engagements, the engagement letter
also should be updated periodically--probably on a yearly basis.
The objectives of the client's representation letter are to: confirm
oral representations given to the auditors, indicate and document
the appropriateness of such representations, and reduce the
possibility of misunderstandings.
The client's representation letter should be prepared by the
auditors (to ensure all items are included) and signed by members of
management whom the auditors believe are responsible for and
knowledgeable about matters covered by the representations.
Normally, the chief executive officer and chief financial officer
should sign.
The client's representation letter should be obtained at the end of
the audit work and should be dated as of the date of the auditors'
report (the date of the end of field work).
The client's representation letter should be prepared for each
examination as the representations apply to one period's financial
statements. The items that need representation will change from one
period or another, as will the people who should sign the letter.
The PAs should obtain an engagement letter when performing
accounting services involving unaudited financial statements, such
as in a compilation or review engagement (Chapter 15). The
engagement letter is probably more important in unaudited
engagements than in audited engagements because there is more
likelihood of misunderstanding.
346
The engagement letter should include: a description of the nature
and limitations of the services to be performed, a description of
the report, a statement that the engagement cannot be relied upon to
disclose errors, irregularities or illegal acts, and that the CPAs
will inform the client of any matters than come to their attention.
2.
The PAs are not required to obtain a client's representation letter
when performing engagements involving unaudited financial
statements. However, the PAs may wish to obtain such a letter.
14.38 Other matters the representation letter should specifically confirm include
whether (SAS list):
*
*
*
*
*
*
*
*
*
*
*
*
*
14.39 a.
b.
Management acknowledges responsibility for the fair presentation in the
financial statements of financial position, results of operations, and
changes in financial position in conformity with generally accepted
accounting principles (or other comprehensive basis of accounting).
All material transactions have been properly reflected in the financial
statements.
There are other 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.
There are 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.
The accountant has been advised of all actions taken at meetings of
stockholders, board of directors, and committees of the board of
directors (or other similar bodies) that may affect the financial
statements.
All financial records and data were made available.
Management is aware of irregularities that could have a material effect
on the financial statements or that involve management or employees who
have significant roles in the system of internal control.
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.
A subsequent event is an event or transaction that occurs subsequent to
the balance sheet date but prior to the issuance of the financial
statements and auditor's report that has a material effect on the
financial statements and therefore requires adjustment or disclosure in
the financial statements.
The occurrence of subsequent events that provide additional evidence
regarding conditions that existed at the date of the balance sheet and
affect the estimates inherent in the process of preparing financial
statements necessitate financial statement adjustment. Those events that
provide evidence regarding conditions that did not exist at the date of
the balance sheet being reported on but arose subsequent to that date
ordinarily would not result in adjustment of the financial statements.
347
Some of these latter events, however, may be such that disclosure of them
is required to keep the financial statements from being misleading.
Occasionally such an event may be so significant that disclosure can best
be made by supplementing the historical financial statements with pro
forma financial data giving effect to the event as if it had occurred on
the balance sheet date.
c.
The specific procedures that should be performed in order to ascertain
the occurrence of subsequent events are these:
*
Read the latest available interim financial statements, compare them
with the financial statements being reported upon, and make any
other comparisons considered appropriate in the circumstances.
Inquire of officers and other executives having responsibility for
financial and accounting matters whether the interim statements have
been prepared on the same basis as that used for the statements
under examination.
*
Inquire of and discuss with officers and other executives having
responsibility for financial and accounting matters (limited, where
appropriate, to major locations) regarding:
a.
b.
c.
d.
14.40 a.
Whether any substantial contingent liabilities or commitments
existed at the date of the balance sheet being reported on or
at the date of inquiry.
Whether there was any significant change in the capital stock,
long-term debt, or working capital to the date of inquiry.
The current status of items in the financial statements being
reported on that were accounted for on the basis of tentative,
preliminary, or inconclusive data.
Whether any unusual adjustments have been made during the
period from the balance sheet date to the date of inquiry.
*
Read the available minutes of meetings of stockholders, directors,
and appropriate committees; inquire about matters dealt with at
meetings for which minutes are not available.
*
Obtain from the client's legal counsel a description and evaluation
of any litigation, impending litigation, claims, and contingent
liabilities (of which counsel has knowledge) that existed at the
date of the balance sheet being reported on, together with a
description and evaluation of any additional matters of such nature
that have come to counsel's attention up to the date the information
is furnished.
*
Obtain a letter of representation, dated as of the date of the
auditor's report, from appropriate officials (generally the chief
executive officer and chief financial officer) regarding whether any
events occurred subsequent to the date of the financial statements
being reported on by the independent auditor that, in the officer's
opinion, would require adjustment or disclosure in these statements.
*
Make such additional inquiries or perform such procedures as
considered necessary and appropriate to dispose of questions that
arise in carrying out the foregoing procedures, inquiries, and
discussions.
1.
A subsequent event is an event or transaction that occurs subsequent
to the balance sheet date but prior to the issuance of the financial
348
2.
b.
1.
2.
statements and auditor's report that has a material effect on the
financial statements and therefore requires adjustment or disclosure
in the financial statements.
The two types of subsequent events are:
*
Events which affect the financial statements at the balance
sheet date--this new information may reveal a heretofore
unknown condition or provide clarity regarding some of the
estimates inherent to the accounting process. These events must
be reported by adjusting the financial statements to recognize
the new evidence.
*
Events that relate to occurrences that arose subsequent to the
balance sheet date--these events do not result in adjustment to
the financial statement; however, the effect of the event on
the future period may be such that note disclosure is
advisable. Proper disclosure requires that the statement reader
be informed that the conditions reported in the balance sheet
cannot be extended into the future.
A contingent liability is an existing condition situation, or set of
circumstances, involving uncertainty as to a possible loss to an
enterprise that will ultimately be resolved when one or more future
events occur or fail to occur.
The business enterprise must have already sustained an event which
exposed it to a loss but all aspects of the event have not yet been
concluded. The ultimate effect of the event will not be known with
certainty until the occurrence of some future event which will
conclude the transaction and resolve the current contingency.
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.
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.
c.
14.41 a.
Subsequent events may provide new and important information about known
or unknown contingency losses 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. A subsequent event occurs which in the accountants' judgment
makes it probable that a contingent liability has been incurred. The
contingent liability will now have to be accrued in the financial
statements (provided an amount can be estimated).
The purpose of this review is to ascertain whether there have been any
material transactions or events which have a significant bearing on the
audited statements and might require qualification of the auditor's
opinion, disclosure by notes, or financial statement adjustments.
The postaudit review period ordinarily ends when field work is completed,
February 20. The auditor, however, is responsible for disclosure of any
349
material event of which he is aware until the delivery of his report,
March 12. His report should be dated February 20, the date of completion
of field work.
b.
In preparing his program, the auditor considers the postaudit review as a
continuation of the regular audit and as in a continuing audit
engagement, all audit steps may not be necessary. The suggested postaudit
program follows:
1.
Review all books of original entry for unusual transactions to
February 20, the date of the end of field work, taking care to see
that an accounting has been made for the serial numbers of all
vouchers and for all check numbers.
2.
Review the January 31 financial statements prepared by the company
as follows:
a.
Trace the balance sheet, income, and retained earnings
statements to the general ledger accounts to ascertain that the
amounts therein are in agreement with the books.
b.
Compare the balance sheet with the audited balance sheet
amounts and investigate important variations.
c.
Compare the results of operations for the month of January with
the January operations in the audited period and investigate
any unusual or important variations.
3.
Discuss the following matter with company officials:
a.
Sales and profit trends and significant sales trends in the
industry.
b.
Company operations and market conditions.
c.
Increases or decreases in the prices of the company's product.
d.
Increases in basic raw material prices--which may result in
decreasing gross profits.
e.
Decreases in basic raw material prices--which may result in
increasing gross profits.
f.
Major purchase commitments for material or capital additions.
g.
Subsequent bookings or cancellations of sales orders.
h.
Federal taxes--changes in law, revenue agents' reports,
deficiency assessments, etc.
i.
Renegotiation proceedings.
j.
Wage and salary adjustments.
k.
Pending lawsuits and settlement of same.
l.
Special dividends.
m.
Losses of important customers, exceptional bad debt losses, or
pledging of receivables.
n.
Changes in accounting and financial policies.
o.
New borrowings, issue of stock or other financing, including
any new dividend restrictions or important covenants agreed to
in connection therewith.
p.
Purchase or sale of major plant and equipment, fires,
explosions, abandonments of plant, etc.
q.
Strikes and status of wage negotiations in progress.
4.
Review corporate minutes of directors and stockholders to the close
of field work.
5.
Obtain letters from company's legal counsel with respect to
developments of any contingent liabilities, together with an opinion
as to the outcome of any pending litigation.
350
6.
14.42 1.
Secure a representation letter from responsible company officers
that there have been no material events or transactions subsequent
to the audit date which might have a material effect on the audited
financial statements.
If the $1.40 price had been used to value the inventory at December 31 on
a lower-of-cost-or-market basis, the inventory figure should be adjusted
because the actual quotation of $1.40 was a transitory error and no
purchases had been made at that price.
2.
Report on the action of the new stock issue in a note to the balance
sheet. Consider presenting a pro forma stockholders' equity section of
the balance sheet.
3.
Report the fire loss in a note to the balance sheet and refer to it in
connection with the income statement, since earning power is presumably
affected. Consider the need for pro forma financial statements reflecting
the loss of production capacity.
4.
Report this change in investment composition in notes to the statements
because it changes the character of the assets and operations which are
being reported upon and which the reader tends to assume are continuing.
Consider presenting a pro forma balance sheet (and detail schedule of
investments).
5.
Although information of the rebellion is common knowledge, the users of
the financial statements may not be aware of the client's subsidiary
located in the foreign country. The statements should disclose through a
note both the location of the subsidiary's operations and the rebellion,
particularly if the parent's investment is a significant portion of its
total assets, or the total assets or gross revenues of the unconsolidated
subsidiary are significant in relation to the consolidated assets or
revenues.
6.
The case presents various issues that involve using judgment in assessing
how accounting policies should be applied. A possible analysis and
conclusion is the following. Strictly speaking the revenue recognition
criterion set out in Comtois’s accounting policy note has not been met.
However, in substance the conditions for revenue recognition may have
been met, as long as the delay in signing the contract is only due to the
Minister’s time constraints and not business uncertainties. The auditor
may be able to get comfort on this from enquiries of Ministry assistants
and that may support recognizing revenue. The exception to the policy
would need to be disclosed in this case, and consideration could be given
to revising the policy if this kind of contract is expected to occur more
often in future.
7.
One possible analysis and conclusion is below. The share issue and loan
are related party transactions and should be disclosed. The loan
forgiveness should also be disclosed as a subsequent event. These are
relevant transactions for the company’s other shareholders to be informed
of.
14.43 1.
The provincial government's approval of a plan for the construction of an
express highway would have to come to the PA's attention through his
inquiries of officers and key personnel, his examination of the minutes
of the meetings of the board of directors and stockholders, and his
351
2.
3.
4.
5.
6.
reading of local newspapers. The details of the item would have to be
disclosed as a separate note.
It is improbable that the PA 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, in which case the interest charges might have led to
his investigation of the use to which the funds were put. Setting out the
loan in the balance sheet as a loan from an officer would be sufficient
disclosure. The source of the funds would not be disclosed because it is
the officer's personal business and has no effect upon the corporation's
financial statements.
The additional liability for the ore shipment would have been revealed to
the PA in his scanning of January transactions. His regular examination
to transactions and related documents such as purchase contracts would
have caused him to note the item for subsequent followup to determine the
final liability. In addition, the client's letter of representation might
have mentioned the potential liability. The item would not require
separate disclosure by footnote or otherwise and would be handled by
adjusting the inventory, and accounts payable by the amount of the
additional charge, $9,064. ($20,600 x 72/50 = $29,664.)
The PA 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 absence of the
treasurer might also arouse the PA's curiosity. The details of the
agreement would be disclosed in a footnote 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 heavy 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.
Through inquiries of management, review of financial statements for
January, scanning of transactions, and observations, the PA would learn
of the reduced sales and of the strike. Disclosure should be made in the
financial statements of these conditions and the facts available at the
date of the report.
The contract with Mammoth Industries would come to the PA's attention
through his inquiries of management and legal counsel, his reading of the
minutes of the meetings of the board of directors and stockholders, and
his examination of the contract. All important details of the contract
should be disclosed in a note because of the great effect upon the
corporation's future. The factors contributing to the entry into the
contract need not be disclosed in the statements; while they might be of
interest to readers, they are by no means essential to make the
statements not misleading.
14.44 The manner in which Faultless treated the subsequently discovered facts is
inappropriate. Once the chief executive of Hopkirk refused to make proper
disclosure, the auditor should have notified the Board of Directors of the
need to disclose. If the Board then agreed to disclose, the auditor and client
should have issued a revised set of statements and audit report or provided
other notification as appropriate. If, after confronting the board, they
refused to make disclosure, the auditor should have (1) notified the client
that the audit report must not be associated with the financial statements,
(2) notified the appropriate regulatory agencies that the report cannot be
relied upon, and (3) notified users or the SEC that the report cannot be
relied upon.
352
Significantly, there is the likelihood that Faultless increased its potential
liability: First, there is the possibility that the auditors released
confidential information. In this regard, auditors are warned to consult
attorneys prior to releasing information which may be governed by state
statutes. Second, the client may continue to issue the report with the
financial statements, increasing the auditor's potential liability to third
parties. Third, by not notifying the SEC and other regulatory agencies, the
auditors may not only increase their potential liability to third parties, but
also risk censure by the SEC.
14.45
The case involves changing business conditions and requires assessing their impact
on accounting estimates for warranty provisions. The client’s estimation methods
need to be considered. The case also suggests management may have higher motives to
increase income through accounting choices, suggesting a greater inherent risk for
the related financial statement items than in past. Points that can be discussed in
the analysis include the following.
a) the increase in competition and price pressures require changes in the
assumptions underlying the method of estimating expected future warranty costs and
developing the warranty liability accrual.
b) The CFO can argue the extended warranty policy is new and more experience is
needed before its impact on warranty costs, if any, can be estimated. This supports
leaving the method as is until need for a change is better established by business
experience.
c) The auditor may be able to analyse the five-year review data to assess the
potential impact of extending the warranty, however the review is several years old
now and may not reflect current conditions well.
14.46
The question requires an analysis of the impact of recording errors on financial
statements and consideration of audit procedures that can detect capital assets
recording errors.
a) Capital assets will be overstated by about $20,000 as the net book value of the
assets sold has not been taken off the books. Sales revenues are overstated by
$400,000, and ‘Gain on sale of capital assets’ is understated by about $380,000.
b) The error would most easily be detected through scrutiny of cash transactions and
sales journals and investigating large, unusual entries. Analytical review of gross
margins may also indicate a discrepancy that, upon follow up, may reveal the
recording error. Physical inspection procedures to test the validity of capital
assets may also indicate this equipment is no longer in the company’s possession.
Changes in insurance coverage, reviewed in connection with accrued liabilities and
contingencies, may also uncover the asset sale if appropriately followed up.
14.47
Various approaches are possible depending on the assumptions made.
The franchise fees audit plan should include developing an understanding of internal
controls, including computer controls, assessment of control risks and procedures
for all control objectives/assertions, a decision on whether to test and rely on
controls, and a complete plan of substantive procedures that cover all the
assertions including relevant and efficient analytical procedures.
353
14.48 Lawyer's Letter Responses
a.
The four "responses" were based on AU 9337, as are these solutions for
part (a):
Response
Audit Interpretation
1.
The action involves unique
characteristics wherein
authoritative legal precedents
bearing directly on the
plaintiff's claim do not seem to
exist. We believe the plaintiff
will have serious problems
establishing the Omega's
liability; nevertheless, if the
plaintiff is successful, the
damage award may be substantial.
Too vague for adequate
information. More evidence
needed.
2.
In our opinion, Omega will be
able to defend this action successfully, and if not, the possible liability to Omega in this
proceeding is nominal in amount.
According to AU 9337, this means
"remote likelihood of material
loss."
3.
We believe the plaintiff's case
against Omega is without merit.
According to AU 9337, this means
"remote likelihood of losing the
lawsuit."
4.
In our opinion, Omega will be
able to assert meritorious
defenses and has a reasonable
chance of sustaining an adequate
defense, with a possible outcome
of settling the case for less
than the damages claimed.
"Meritorious" does not mean
"strong" or "adequate." The
phrases "reasonable chance,"
"adequate defense," "less than
the damages claimed" all
indicate problems. More
information needed.
b.
Plaintiff's counsel would probably assert the merits of the plaintiff's
case, suggesting that the auditor's client (defendant) will certainly
lose large damages. Auditors never obtain written representations from
the other side of a lawsuit.
14.49 Accounting for a Contingency--Lawyer's Letter Information
a.
What weight should be given to the newspaper report about the $250,000
amount MALDEF was expected to ask? What weight should be given to the
attorney's estimate?
The newspaper report should be given very little weight. The attorney
should be asked the amount claimed in court documents by MALDEF. Or, the
auditor should obtain and read the court documents. Alternatively, if the
claim is not yet in writing, the auditor could interview a MALDEF
representative.
The attorney's estimate is usually given considerable weight, since the
attorney is in a position to negotiate on behalf of Central City.
b.
How should this subsequent event be reflected in the 1992 financial
statements of Central City? As an accounting adjustment of the amounts
354
presented (Type I)? As a disclosure with accounting for the amounts in
the 1993 financial statements (Type II)?
This is a Type I event, theoretically being subsequent knowledge of a
"condition" (the city's losing arguments) that existed at the balance
sheet date. The proper accounting is to accrue the lower end of the range
of loss ($30,000) and write a full disclosure of the amount claimed by
the plaintiffs ($supposedly $250,000). The disclosure could include
information about the estimated range of loss, but managers usually do
not do so for fear of giving away too much of their negotiating strategy.
In fact, the frequent accounting practice is to accrue the loss without
disclosing or describing the amount separately. However, the narrative
disclosure would tell about the amount of the claim, without revealing
the attorney's estimate.
14.50
The question involves audit of revenues using analytical procedures. Recognition of
the impact of changing business conditions on reported financial statement numbers,
management decisions and management motivations regarding debt covenant constraints
and bonuses is required to fully assess the situation.
The evidence is analytical in nature. If the analysis results conform to expected
results this is persuasive but not conclusive. Analysis from a number of different
perspectives and using a variety of independent data sources can build to a
conclusive level if all the findings are consistent with each other and the
conclusion. Generally, analysis results indicate questions that should be asked and
further evidence that should be gathered. When the analysis suggests unexpected
situations, further follow up is necessary to gather sufficient evidence. In this
case, while higher sales and higher receivables are consistent with an increase in
sales dollars, an alternate explanation is that the sales are fictitious and thus so
are the receivables and they will not be collected. Confirmation of validity and
valuation of recorded receivables will be required to provide sufficiently
conclusive evidence in this case.
14.51
The question provides an exercise in professional skepticism and requires knowledge
of the accounting model and record-keeping systems to be applied to creatively
analyse the scenario and generate explanations that the auditor should consider
following up on. An sample analysis is outlined below.
a) Taking all the facts together (use of general journal entries, immaterial
amounts, non-cash entries, impact on current working capital ratio and earnings,
lack of reasonable explanation or support) these may be fictitious entries designed
to avoid an impending debt covenant violation. Other possible explanations can be
generated.
b) Analysis of income statement components, cash flows, etc.
14.52
a) Mainly completeness of liabilities, contingency disclosure.
b) Other evidence for these might come from debt confirmation
legal and insurance documents and correspondence, and minutes
be less direct and explicit than from specific enquiry of the
representations relate to these issues but are not considered
purposes.
responses, review of
but this would tend to
lawyers. Management
‘evidence’ for audit
355
c) Ideally the lawyers’ letter would be dated as of the last day of audit field work
to cover any subsequent event that needs to be considered by the auditor.
14.53
Various subsequent events need to be analysed and conclusions stated on how they
would be treated in the year-end financial statements. A sample set of analyses and
conclusions is outlined below.
a) Disclose and provide proformas, significant impact on future operations
b) Disclose, arose after year end and affects 20x2 results
c) Disclose, provide proformas if material to future operations
d) Restate, reflects resolution of an uncertainty that existed at year-end and was
not accrued because of this uncertainty
e) Assuming the auditor can establish solid evidence of the impact of the change in
market condition on the company’s future operations and sales, disclosure would be
required and possibly pro forma presentation of impact if it is estimable.
14.54
a) The main issue to point out is that confusion could arise if earnings per share
is reported on a pre-split basis, as the split will have occurred when this
statistic is reported in February 20x2, since pre-split EPS will be twice postsplit.
b) Double dating the report restricts the auditors responsibility to look for new
evidence up to the the later date. To avoid the double-dating and date the full
audit report as of February 7, 20x2, the auditor would have to extend subsequent
review procedures and other audit documentation and representations of management,
which would increase the costs of the audit and risk to the auditor of missing
something of audit significance.
14.55
This is an exercise in determining the accounting effect of audit findings and the
requirement for adjusting entries. One set of assumptions, interpretations and
adjustments is outlined below.
a)
Technically there is $44,000 of cash still on hand so cash is understated, and this
amount of accounts payable still owing so accounts payable is understated. There is
no income effect. This issue could be addressed through the bank reconciliation,
depending on materiality and other considerations, or it could be adjusted as
follows:
Dr Cash
44000
Cr
A/P
44000
b)
The sales and related cost of sales are not valid (overstated). The income is also
overstated by $26,000.
The error would be adjusted as follows:
Dr Sales
79000
Cr
A/R
79000
Dr Inventory*
53000
Cr
Cost of sales
53000
* Note that the inventory balance would correctly include this amount as this was
356
determined by a physical count, but the book-to-physical adjustment for the year end
would be affected by this entry which adjusts the inventory ‘book’ value, not the
physical count value.
c)
Legal expenses and accrued liabilities are both understated (incomplete).
The error would be adjusted as follows:
Dr Legal expenses
xxx
Cr
Accrued liabilities
xxx
d)
Assessing whether the provision is excessive depends on how reliably expected bad
debts can be estimated, and other factors. Materiality of the difference is also a
consideration in deciding whether an adjustment is required. If adjusted, the entry
would be
Dr Allowance for estimated bad debts
70000
Cr
Bad debt expense, other expense/income
70000
e)
Assuming there is no basis for recognizing a percentage of revenue at this point in
the contract (i.e. assuming nothing that is required to be performed under the
contract has been performed, such as pre-construction work on plans, approvals,
materials sourcing and purchasing, etc.) the revenue is overstated (invalid) by
$250,000 and costs of the contract overstated(invalid) by $40,000. The income is
overstated by $210,000.
The adjusting entry would be as follows:
Dr Construction revenues
250000
Cr
Accounts receivable
250000
Dr Construction costs/WIP
40000
Cr
Cost of Construction
40000
14.56 a.
1.
If an omitted procedure is found, 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 there are persons currently relying or likely to
rely on their report.
*
If the omitted procedure impairs 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
refer to AU 561 (Subsequent Discovery of Facts Existing at the
Date of the Auditor's Report) for guidance.
2.
If after reevaluating the scope of the examination and reviewing the
completed audit workpapers, procedures were found that tend to
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 in subsequently applying the omitted procedure, the auditors
become aware of material new information that should have been
disclosed in the financial statements, they should follow the
provisions of auditing standards (SAS 1, AU 561--subsequent
discovery of a fact existing at the date of the auditor's report).
3.
357
b.
14.57 a.
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.
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 follow the provisions of AU
561, which require that they 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 AH's audit report.
3.
You should immediately inform the partners of AH that the local bank
received AHSO's financial statements and AH's audit report and a
loan from the bank is still outstanding. The partners should also be
informed of the client's representation letter on the garden club
letterhead. They will probably direct you to have AHSO prepare a new
client representation letter on the correct letterhead paper, date
it per the original date and have Al sign it.
The purpose of a "second partner review" is to obtain the unbiased view
of a professional expert who has not become involved in client or audit
personnel affairs and who is in no way committed to the particular
engagement or its problems.
b.
The purpose of dual dating is twofold: (1) To provide a means of
inserting important information in the financial statements even when
learned after field work is complete, while at the same time (2) to
inform users that the auditor takes full responsibility for subsequent
events only up to the end of field work and for the specifically
identified later event, but does not take responsibility for other events
which may have occurred between the end of field work and date of the
report.
c.
The presentation made by the correspondent PA firm is deficient. The
stock splits and stock dividends occurring prior to the issuance of the
financial statements should be given recognition in the statements, in
addition to footnote disclosure. An appropriate recommendation is:
*
Note disclosure of the declaration date, date of record, effective
date, and number of shares involved. It is also appropriate to
disclose comparative earnings per share on the predividend shares.
*
The equity section of the balance sheet should reflect the number of
shares of common stock outstanding and the related dollar amount
existing after the split was effected. The earnings per share on the
income statement should be computed with the number of shares
outstanding after the split.
14.58 This scenario was adapted from SEC Accounting Series Release No. 241 and from
Haskins & Sells' February 1978 statement with regard to ASR 241. The SEC
accused H & S of using the wrong effective date. The portion of the dialogue
attributed to "Eastford and Redwood" is an adaptation of H & S's statement on
the question.
H & S firmly believes January 1 was the proper and substantive accounting
date. H & S consented to the discipline described in ASR 241 in order to avoid
costly and time-consuming administrative proceedings.
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14.59
Overall, the risk is determined as high due to the following factors:
Inherent Risk

significant increase in profits this year when the industry as a
whole has lost money;

record of losses over the past few years;

suspected illegal acts (e.g. fraud);

environmental problems in the industry; and

increase in legal fees in the year.
Therefore, inherent risk is assessed as high.
Control Risk

suspicious termination of old controller;

hiring of new and inexperienced controller;

problematic system conversion; and

president’s refusal to sign management representation letter.
Therefore, control risk is assessed as high.
Materiality
Materiality should be reduced over the previous year in light of the
potential illegal acts and the involvement of users such as government
bodies.
The basis should not be net income, due to the recent
fluctuations, but some other basis such as revenues or assets.
Audit Approach
In light of the weaknesses noted in internal controls, I would recommend
a substantive-based approach be utilized.
Given the risk associated
with this client, we will increase our overall testing to reduce audit
risk.
Specific Issues
New Computerized System
A number of problems with the conversion will affect our decision to rely
on the results.
These include the fact that some of the accounts were
not reconciled, no attempt was made to run the new system parallel with
the old one for a period of time and the new controller was hired in the
middle of the conversion process. Offsetting these problems is the fact
that the pre-packaged program was well known in the industry and likely
is reliable.
Given the above, it appears that we will not be able to
rely on the new system.
Regardless of our decision to rely on the controls of the new system, we
will have to document our understanding.
Also, we will obviously have
to test the conversion.
We should consider using CAATs and requesting
the assistance of an EDP specialist. To the extent that we are relying
on controls, we will have to test both the new and old systems.
In
addition, we should follow up the unreconciled items and report
weaknesses noted in the internal control letter sent to the client.
Environmental Issues
In accordance with the new Handbook Guideline, we should obtain an
understanding of the client’s current procedures with respect to
environmental issues.
It would appear that the current procedures are
inadequate given:
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


the engineer has not developed standards;
no action has been taken on the government letter; and
fines have been assessed.
We should discuss, with management, their plans in this area and observe
the stage of completion of the new plant.
We might also correspond with
the government to determine if there are any fines or other penalties.
Legal or engineering advice could be sought to determine if the company
is meeting the appropriate targets.
Obviously, the qualifications and
work of any specialist would have to be assessed.
Before contacting lawyers and/or government, we should obtain
management’s permission.
We will need to review the disclosure of any current and/or potential
fines to ensure appropriateness of same.
Failure to properly disclose
these fines, if material, would result in a qualified audit report based
upon a GAAP departure.
Depending upon the value of the fines and/or the
ability of the government to close NL’s operations for environmental
offences, we should also consider whether a going concern issue exists.
Should we determine that a going concern issue does exist, we will have
to ensure appropriate disclosure in the notes to the financial statements
or we will have to modify our audit report for this GAAP departure.
Legal Fees
With respect to this issue, we should review legal invoices received
during the year to determine the nature of the legal fees paid.
Confirmation of outstanding legal accounts should be obtained. Once the
minute books are updated, we should review same to ascertain if any other
claims are noted.
Bonus Payments
We should question the legitimacy of the large bonuses received by the
president and engineer half way through the year. As required by GAAS
(Handbook - Auditor Responsibility to Detect and Communicate
Misstatements), if we are at all suspicious as to the nature of these
payments, we must do enough work to confirm or dispel any concerns that
we may have.
Procedures that we can use are as follows:
·
review of minutes once updated;
·
examine documentation supporting these payments; and
·
inquire of other company officials (e.g., VP Finance and/or Board of
Directors).
If the concerns cannot be dispelled, we must present our concerns to the
audit committee for resolution.
We should also consider obtaining
independent legal advice.
14.60 a.
An auditor must consider the possibility that material misstatements can
arise from the consequences of illegal acts. In this case, failing to
comply with pollution control laws and regulations may render the company
liable for lines, legal damages, and the cost of future cleanup. The
auditor has a responsibility to apply his knowledge of the business to
identify specific laws and regulations whose violation could result in
material misstatements.
Since the client produces toxic chemicals,
360
pollution control laws are fundamental to its operations and the auditor
must be aware of their key provisions. In addition, if the inherent risk
of misstatement is deemed to be greater than “low”, the auditor must
design specific procedures to detect possible misstatements. The
controller’s comment that he only “thinks” that the company is still
complying with pollution control laws suggests that the risk of material
misstatement is greater than “low” in this case.
b.
If you agree that confirmation of the foreign receivables would tend to
harm the client’s business, then you should attempt to perform
alternative procedures (for example, examine subsequent cash receipts,
evidence of shipment, etc.). If these yield sufficient appropriate
evidence, then an unqualified opinion should be issued. If the
alternative procedures fail to yield sufficient appropriate evidence or
you do not agree with the client’s position that confirmation would harm
the business, then you must qualify (scope) or deny an opinion.
c.
To determine a DUS sample size, you must specify three values
(parameters):
·
Amount of tolerable misstatement (related to materiality judgment)
·
Expected misstatement (error rate) in the population
·
Acceptable risk of incorrect acceptance.
All of the values should be relatively low in this case, since the
foreign receivables are important to the financial statements. Moreover,
if the expected error rate is high, DUS should probably not be used since
the resulting sample size would be uneconomically large.
d.
The following are audit procedures which would be performed with respect
to the sale of new shares of common stock during the year:
·
Examine minutes of Board of Directors’ meetings for authorization of
the transaction.
·
Examine stock record book or confirm the number of shares issued
with the transfer agent and/or stock registrar.
·
Verify the dollar amount of stock sale by examining related
correspondence, contracts, and evidence supporting proceeds of sale
received.
·
Verify that the capital stock transaction is properly disclosed in
the financial statements.
14.61 a.
The completion of the audit requires a review for contingent liabilities- uncertain as to future losses which will be resolved when some event
occurs or fails to occur. A major procedure auditors rely on for
discovering contingencies is sending a letter of inquiry to the client’s
law firm(s) concerning any outstanding lawsuits against the client as
well as possible future lawsuits (unasserted claims).
b.
An auditor has a responsibility to review transactions and events
occurring after the balance sheet date up to the date of the auditor’s
report, to determine whether anything occurred that might affect the
valuation and/or disclosure in the financial statements being audited.
There are two types of subsequent events: those which have a direct
effect on the financial statements and require adjustment (for example,
the settlement of litigation at an amount which materially differs from
the recorded liability at year end); and those which simply require
disclosure (for example, the issuance of bonds or shares).
c.
Basically, an auditor is required to ascertain that the management
discussion and analysis (MD&A) section of the annual report is consistent
361
with the information contained in the audited financial statements. If
inconsistencies are noted, they must be reconciled and management advised
of any material misstatements in the annual report. If management
refuses to correct material misstatements, the auditor should advise the
audit committee and board of directors, and consider obtaining legal
advice.
d.
Yes, analytical procedures should be performed at the conclusion of the
audit to determine the overall reasonableness of the audited financial
statements. This is usually done by a partner in the auditing firm who
has a good knowledge of the client’s business and can thus take a final
“objective” look at the financial statements.
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14.62
Management assertion
Quality of evidence
2
1.
Existence (validity) of
accounts receivable.
The evidence is of fairly low
quality since negative confirmations
are used and the confirmation is done
one month prior to the balance sheet
date.
2
2.
Completeness of accounts
payable.
High quality evidence since the sources
(vendors) are external to the entity
and should be knowledgeable as to how
much the client owes them.
2
3.
Valuation (cut-off) of
sales and accounts, or
completeness.
Moderate quality evidence. The
duplicate invoices are client prepared,
thus quality depends on the effectiveness of related internal controls. But
the shipping documents can normally be
expected to contain some evidence that
the shipper actually picked up the
goods in 2005.
2
4.
Existence (validity) and
rights and obligations
(ownership) of the
securities (if registered
in client’s name).
High quality evidence because the
auditor obtained direct knowledge
through physical examination.
2
5.
Valuation of accounts
receivable.
High quality evidence since the auditor
directly recalculated the “aging”.
2
6.
Existence (validity) and
valuation of the cash.
Very high quality evidence since the
auditor counted and physically examined
the currency.
14.63 a
i)
ii)
iii)
iv)
v)
vi)
Given the materiality of the transaction and its related party
nature, the transaction was presumably authorized by the Board of
Directors of Octopus. This authorization should be in the minutes
of directors’ meetings, which Sharp should have examined.
Sharp should also have examined the details of the contract
underlying the transaction. IF no contract was executed, then Sharp
should examine all documentation (correspondence, etc.) which
supports the terms of the transaction.
Given its materiality, Sharp should have physically inspected the
machine to verify its existence.
In addition to the invoice stamped “paid”, Sharp should have
examined documentation, such as a canceled cheque, in support of the
amount paid.
Consider requesting independent appraisal or obtaining other
relevant information to determine machine is properly valued.
Finally, Sharp should probably have obtained a letter of
representation from the president stating that all circumstances and
terms related to the transaction have been disclosed to her (as
auditor).
The following is an appropriate auditor’s report for this case. The opinion
should be qualified as to conformance with GAP because of management’s failure
to disclose this material related party transaction.
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AUDITOR’S REPORT
To the Shareholders of Octopus Industries:
We have audited the balance sheet of Octopus Industries as at December 31,
2003, and the statements of income, retained earnings, and changes in
financial position for the year then ended. These financial statements are
the responsibility of the company’s management. Our responsibility is to
express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform an audit to
obtain reasonable assurance whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating overall financial
statement presentation.
During the current year, the company acquired a capital asset costing
$5,000,000 from a related party, and this transaction has not been otherwise
disclosed in these financial statements. The cost of the capital asset is
included in the balance sheet and amortization of the cost for the current
year in the amount of $xxx is included in the income statement and statement
of changes in financial position. Because of this lack of disclosure, these
financial statements are not, in my opinion, in accordance with generally
accepted accounting principles.
14.63 We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform an audit to
obtain reasonable assurance whether the financial statements are free of
material misstatement. An audit includes examining, on a text basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating overall financial
statement presentation.
During the current year, the company acquired a capital asset costing
$5,000,000 from a related party, and this transaction has not been otherwise
disclosed in these financial statements. The cost of the capital asset is
included in the balance sheet and amortization of the cost for the current
year in the amount of $xxx is included in the income statement and statement
of changes in financial position. Because of this lack of disclosure, these
financial statements are not, in my opinion, in accordance with generally
accepted accounting principles.
In our opinion, except for the failure to disclose the information described
in the preceding paragraph, these financial statements present fairly, in all
material respects, the financial position of the company as at December 31,
2003, and the results of its operations and changes in financial position for
the year then ended in accordance with generally accepted accounting
principles.
Signature
Vancouver
February 25, 2004