Audit Exam 3

Contingencies – legal letters and audit procedures

Audit procedures:

• Management inquiry

• Read Board of Director minutes

• Attorney letters (ABA treaty)

• Review of legal invoices

Estimates – acceptable audit approaches

• Test management’s process

• Develop an independent estimate

• Review of subsequent events

Disclosures – Audit tools/Related party transactions [AS 18 (2410)]

Auditor’s report must indicate if disclosures are not reasonably adequate

• Disclosures can be made:

  • On face of financial statements

• In form of classifications or parenthetical notations

  • In notes to statements

Reasonable assurance that auditors should have when assessing adequacy of disclosures

• Disclosed events and transactions have occurred and pertain to the entity

• All disclosures that should have been are included

• Disclosures are understandable to users

• Information is disclosed accurately and at appropriate amounts

Non-compliance with laws and regulations [auditor’s responsibility – direct v. indirect]; audit procedures;

Noncompliance: Acts of omission or commission, either intentional or unintentional, contrary to prevailing laws or regulations

Auditor is responsible to detect and report illegal acts having a direct effect on the financial statements (e.g. taxes, payroll)

Auditor is not required to perform procedures to detect illegal acts having an indirect effect on the financial statements, but must determine impacts (accrual and/or disclosure) if the auditor becomes aware of the illegal acts.

Management may:

• Act to conceal noncompliance

• Override controls

• Intentionally misrepresent facts to the auditor

PCAOB’s proposed new standard

PCAOB seeks to eliminate this long-established direct vs. indirect responsibility of the auditor in the following manner:

• Requiring the auditor to identify laws and regulations with which noncompliance could reasonably have a material effect on the financial statements.

• Based on the laws and regulations identified, further identify whether there are instances of noncompliance that have or may have occurred (without regard to perceived materiality).”

Going Concern Assumption

company will continue operating long enough to carry out its objectives and meet its commitments/obligations [i.e. for an indefinite period]. In other words, there is a belief that the company will not liquidate in the near future

Evaluating the Going-Concern Assumption

Assessing company’s going concern status for a reasonable period of time -

• Reasonable period of time: A period of time not to exceed one year beyond the date of the financial statements being audited

Responsibility of auditor – Make the assessment

(will the company be in business a year from now?)

Form of reporting Going Concern Assumption

Substantial Doubt Alleviated:

• Consider disclosure of conditions that initially caused auditor to believe there was substantial doubt

• Consider possible effects of such conditions or events, and any mitigating factors, including management’s plans

Substantial Doubt Remains:

• Include an emphasis-of-matter paragraph in auditor’s report to reflect that conclusion

• Audit report will include phrase - Substantial doubt about entity’s ability to continue as a going concern

Why auditors resist issuing a going-concern audit opinion

self-fulfilling prophecy that the company will go bankrupt (the common client objection)

• It is difficult to know beforehand whether a financially distressed client will:

  • Cease operations

  • Pull itself away from that outcome

Indicators of Potential Going-Concern Problems

Negative trends (e.g. losses, cash flow)

• Internal matters (e.g. loss of management)

• External matters (debt maturity/acceleration)

• Significant changes in:

  • Competitive market

  • Competitiveness of client’s products

Mitigating Factors for a going-concern problem

• Identify and assess management’s plans to overcome this problem

• Identify factors most likely to resolve the problem and gather independent evidence to determine success of such plans

• Consider, and independently test, adequacy of support for major assumptions

Evaluating reasonableness of other assumptions made by the management

• Increasing prices or market share is analyzed in relation to current industry developments

• Cost savings related to a reduction in work force is recomputed and evaluated

• Selling off assets is evaluated in relation to current market prices

GAAP for Going Concern

FASB – ASU 2014-15. Management responsibilities for going concern evaluation.

• Substantial Doubt definition: “probable” entity will be unable to meet obligations as they become due within one year after the date financial statements are issued

Management representation letter - purpose; key elements; who signs?

Purpose is to help promote audit quality by:

• Reminding management of its responsibility for financial statements

• Confirming oral responses obtained by auditor

• Reducing the possibility of misunderstanding

Management’s refusal to sign the letter:

• Implies their untruthfulness in verbal representations

• Considered a scope limitation

Signed by, at least, CEO and CFO (and CAO)

Subsequent events [Type I and Type II – what is the difference?]

Subsequent events: Occur between the date of the financial statements and date of the auditor’s report

• Subsequent events review: Review of events in the period between the balance sheet date and the audit report date to determine their effect on the financial statements

Type I subsequent events: Existed at the balance sheet date (adjustment to financial statements)

Type II subsequent events: Did not exist at balance sheet date (disclosure)

audit procedures for subsequent events; significance of report date

• Cutoff tests

• Reviewing subsequent collections of receivables

• Searching for unrecorded liabilities

• Reading minutes of meetings

• Reading and comparing interim financial statements to audited financial statements

• Inquire of management concerning:

  • Significant changes noted in the interim statements

• Existence of significant contingent liabilities or commitments at balance sheet date or date of inquiry

• Significant changes in working capital, long-term debt, or owners’ equity

• Status of items for which tentative conclusions were drawn earlier in audit

• Any unusual adjustments made to accounting records after balance sheet date

Subsequently discovered facts - what is the auditor’s responsibility for performing procedures after the report is issued?

If facts had been known at the report date, then auditor should determine:

• Reliability of new information

• Whether development or event had occurred by report date

• Whether users are likely to still be relying on financial statements

• Whether audit report would have been affected had facts been known at report date

Appropriate action for Subsequently Discovered Facts

• Key action - Notify users very soon so they do not continue to rely on incorrect information [Form 8-K]

• If possible, quickly revise and distribute financial statements and audit report

  • Reasons for revision described in a footnote and referred to in auditor’s report

  • Revision and explanation can be made in subsequent- period audited financial statements if distribution is imminent

Subsequently Discovered Facts That Become Known to Auditor after Report Release Date

If extended amount of time is needed to develop revised financial statements, notify users that:

• Previously distributed financial statements and auditor’s report should no longer be relied on

• Revised statements and report will be issued as soon as

For clients who do not cooperate, notify:

• Client and regulatory agency having jurisdiction over it that audit report should no longer be associated with client’s financial statements

• Users that audit report should no longer be relied on possible

Required communications with Audit Committees - what are they? when do communications occur? [AS 16]

• Audit committee serves as an independent subcommittee of board of directors

• Audit committee can assist auditor during a disagreement between the auditor and management

• Audit committee must be assured that auditor:

  • Is free of any restrictions

  • Has not been inappropriately influenced by the management

Form of Standard (unqualified) report – to whom addressed; required sections

Redesigned in 2017 to promote clear communication between auditor and financial statement user by delineating (with labels):

• Opinion section

• Basis for opinion section

• Title

• Adressee

  • Board of directors and shareholders

  • can depend on circumstances

• report date

New requirements of Unqualified Report

• Reference to auditor independence requirements

• Reference to auditor responsibility for misstatements whether due to error or fraud

• Disclosure of auditor tenure

Critical Audit Matters

The auditor is required to communicate “critical audit matters” in the report (difficult judgments; complex areas; hard to get audit evidence)

Example:

1. Revenue from customer contracts

2. Goodwill

3. Business combinations

4. Allowance for credit losses

Standard Unqualified Audit Reports

Separate reports in F/S and ICFR may be issued

• If a combined report on the financial statements and internal controls is made, two additional paragraphs are included

  • Definition paragraph - Defines what is meant by internal control over financial reporting

  • Inherent limitations paragraph - Discusses why internal control may not prevent or detect misstatements

Requirements for a Standard Unqualified Audit Report

• There should be no material violations of GAAP

• Disclosures should be adequate

• Auditor should be able to perform all of the necessary procedures

• There should be no change in accounting principles that had a material effect on the financial statements The auditor should not have significant doubt about the client remaining a going concern

• The auditor should be independent

Modification of the standard unqualified report

When necessary, auditor should modify the standard unqualified report

Potential modifications include:

• Issue an unqualified opinion with explanatory language

• Qualify the audit opinion (SEC will not accept)

• Issue an adverse opinion (SEC will not accept)

• Issue a disclaimer (SEC will not accept)

Unqualified Audit Reports with Explanatory Language

Used to explain:

• Justified departure from GAAP (Virtually never)

• Inconsistent application of GAAP (not incorrect GAAP)

• Substantial doubt about client being a going concern

• Emphasis of some matter, such as unusually important subsequent events, risks, or uncertainties associated with contingencies or significant estimates

• Reference to other auditors (participating in part of the audit)

Inconsistent Application of GAAP

Serves as a flag directing the user’s attention to the relevant footnote disclosure if client has:

• Changed an accounting principle (acceptable to acceptable)

• Reasonable justification for the change

• Followed GAAP in accounting for and disclosing this change

• AS 6 requires additional paragraph for correction of an error

Substantial Doubt About the Client Being a Going Concern

• Auditor’s substantial doubt about client’s continuing as a going concern

• Reference to management’s footnote(s) explaining the problems and plans to overcome the problem

Auditor may not feel comfortable expressing any

opinion for some going-concern situations in which

client is experiencing severe financial distress

• Would issue a disclaimer (Not Common)

Emphasis of a Matter

Can relate to anything the auditor want to emphasize; e.g.

• Significant transactions with related entities

• Important subsequent events, such as a board-of- director decision to divest a major segment of the business

• Important risks or uncertainties associated with contingencies or significant estimates

Reference to Other Auditors

The principal auditor (group engagement partner) needs to decide whether to mention the other auditor in the overall audit report

Care must be taken when relying on other auditors’ reports

• Principal auditor should have participated in the audit at a sufficient level

• Regardless of reference being made in auditor’s report to the report of another auditor, principal auditor is responsible for the overall opinion

If the principal audit firm chooses to mention the other firm in the audit report

• Wording of the standard report is modified

• No additional paragraph is needed

Change appears in:

• Introductory paragraph to indicate the shared responsibility for the overall opinion

• Scope and opinion paragraphs modified to reference the other auditors

Pervasive

GAAP departures, generally affecting more than one item, would result in an adverse opinion

Describes the effects or the possible effects on the financial statements of misstatements that are undetected due to an inability to obtain sufficient appropriate audit evidence

Not pervasive

affects a specific part of the financial statements but not the financial statements as a whole

Qualified - which situations require qualification? “Except for” language

• A material unjustified departure from GAAP that is not pervasive

• Inadequate disclosure that is not pervasive

• A scope limitation such that the possible effects on the financial statements of undetected misstatements, if any, could be material but not pervasive

Qualified Report - Material Unjustified Departure from GAAP That is Not Pervasive

Qualified opinion will be expressed if a client has a departure from GAAP that can be isolated to (generally) one item.

Qualified Report - Inadequate Disclosure

If client refuses to make appropriate disclosures, auditor should:

• Express a qualified or adverse opinion, depending on pervasiveness of omitted disclosures

• Provide the omitted information in the audit report, if practicable

Explanatory paragraph - Should describe the nature of the omitted disclosures

Opinion paragraph - Should be modified to describe nature of qualification

Qualified/Disclaimer Report - Scope Limitation (disclaimer of opinion)

Restrictions on scope of audit, whether imposed by client or by circumstances beyond the auditor’s or client’s control, may require auditor to qualify an opinion

• In some situations circumstances may be such that a disclaimer would be more appropriate

Circumstances that may limit the audit scope

• Timing of the fieldwork

• Inability to gather sufficient appropriate evidence

• Inadequacy in the accounting records

Adverse - which situations require an adverse opinion? “Does not present fairly” language

Adverse report is appropriate when financial statements contain:

• Pervasive and material unjustified departure from GAAP

• Lack of important disclosures that is pervasive

• When a significant number of items in the financial statements violate GAAP

Reports on ICFR

Auditor evaluates identified control deficiencies individually, and in aggregate, to assess material weakness in ICFR

Auditor issues an:

• Unqualified opinion when it is determined that there are no material weaknesses in ICFR

• Adverse opinion when it is determined that there is one or more material weaknesses in ICFR

SEC filing dates

large accelerated filer: 60 days after year end

accelerated filer: 75 days after year end

non-accelerated filer: 90 days after year end

Reviews of historical financial statements (review procedures: inquiry and analytics; negative assurance; report language)

Enables a practitioner to state whether anything has come to the practitioner’s attention that causes the practitioner to believe that annual financial statements are not prepared, in all material respects, in accordance with applicable financial reporting framework

Thus, it’s negative assurance

• Based on procedures which do not provide all evidence that would be required in an audit

Reviews of historical financial statements: inquiry

• Obtain a written engagement letter

• Inquire about actions taken at meetings of board of directors and other decision-making bodies

• Inquire whether financial statements have been consistently prepared in conformity with the comprehensive basis of accounting

• Inquire about changes in business activities or accounting principles and practices and events

Reviews of historical financial statements: analytics

• Obtain or prepare a trial balance of general ledger and foot and reconcile it to general ledger

• Trace financial statement amounts to trial balance

• Perform basic analytical procedures

• Obtain explanations from management for any unusual results and consider the need for further investigation

• Read financial statements to determine whether they appear to conform to GAAP Obtain a management representation letter about important assertions that management has made

Reviews of historical financial statements: report language

Obtain limited assurance that there are no material modifications to be made to financial statements

Do not involve:

• Obtaining an understanding of entity’s internal control

• Assessing fraud risk

• Testing accounting records by obtaining appropriate evidence

• Obtaining assurance that a practitioner will become aware of all significant matters that would be investigated in an audit

Compilations of historical financial statements (purpose of compilation; no assurance)

Accountant uses accounting expertise to collect, classify, and summarize financial information

• Assists management in presenting financial information in the form of financial statements

• Does not undertake to obtain any assurance that there are no material modifications that should be made to the financial statements in order for the statements to be in conformity with the applicable financial reporting framework

Compilation Procedures

Practitioner is not required to make inquiries or perform procedures to verify, corroborate, or review information provided by the client

• Additional or revised information should be obtained if practitioner believes that client-provided information may be:

  • Incorrect

  • Incomplete

  • Unsatisfactory

Practitioner should withdraw from engagement if client refuses to provide information

Potential Modifications to the Standard Compilation Report

Situations in which the practitioner will modify the report

• Omission of disclosures for compilations

• Practitioner’s lack of independence (should be independent!)

• Obvious misstatements

Reviews of interim financial information (for public companies)

SEC requires public companies to:

• File quarterly financial information with SEC on Form 10-Q within 40 to 45 days and provide shareholders with quarterly reports

• Include quarterly information in annual reports to SEC (Form 10-K) and in annual reports to shareholders

• Have quarterly financial information reviewed by independent auditors

• Review report not required to be included in quarterly information

Review Procedures for Interim Financial Information

Performed on quarterly information:

• Contained in annual report to shareholders

• Issued at end of each of first three quarters of fiscal year when engaged to do so

Include:

• Making inquiries

• Performing analytical procedures

• Reading minutes of board of directors’ meetings

• Reading interim information to conform to GAAP

• Reviewing new contracts and major agreements

Review Procedures for Interim Financial Information

Auditor should obtain:

• Written representations from management concerning things as its responsibility for financial information

• Completeness of minutes

• Subsequent events

Reporting on Interim Financial Statements

Standard report on a review of separately issued interim financial statements of public companies:

• Identifies the information reviewed

• Indicates whether the standards of PCAOB were followed in performing the review

• Explains nature of a review

• Disclaims an opinion

• Provides negative assurance that auditor is not aware of any material departures from GAAP

• Disclosure and reporting requirements for interim financial statements differ from those for annual financial statements

• Negative assurance should be modified when there is a known material departure from GAAP – not likely to happen. Client will fix known material errors.