ACC 372 Exam 3

Wrapping up Engagement

Doing final check of work, making sure everything is neat and tidy before finishing audit job

5 Key steps of ‘Wrapping up Engagement’

1. Review of Subsequent Events and Discovery of Facts

2. Send Letters of Inquiry to Attorney

3. Identify and Address Related Party Transactions

4. Obtain Management Representation Letter

5. Communicate with Audit Committee

Wrapping up Engagement- 1 Review of Subsequent Events and Discovery of Facts

Checking if something wild happens after the year ends

Wrapping up Engagement- 2 Send Letters of Inquiry to Attorney

Asking company lawyers: ‘Is anyone suing our client right now?’

Wrapping up Engagement- 3 Identify and Address Related Party Transactions

Making sure the company isn’t secretly doing sneaky business deals with own best friends or family

Wrapping up Engagement- 4 Obtain Management Representation Letter

Getting boss-level people to sign paper promising ‘We didn’t lie to you!’

Wrapping up Engagement- 5 Communicate with Audit Committee

Telling big-boss board members how the audit went

Wrapping up Engagement SARMC- Super Auditors Read Many Cards

1. Subsequent events

2. Attorney letters

3. Related parties

4. Management letter

5. Committee communication

Timeline and Subsequent Events/Discovery

BS Date 12/31/XX → auditor does work → Audit Report Date (enough proof and is done) → company files report to public

Subsequent Events

Things that happen after BS date (12/31) but before audit report wraps up. Auditor MUST search for them

Procedures to find Subsequent Events

1. Discuss with management (did anything crazy happen?)

2. Read internal subsequent FS (look at newer FS)

3. Read Board of Directors’ meeting minutes (read secret notes from leadership meetings)

after Audit Report Date

Once audit report is officially dated, auditor is NOT REQUIRED to go looking for new trouble after date. BUT 2 things can arrise

1. Subsequent Events / Refinancing

2. Subsequent Discovery of Facts

2 types of Subsequent Events

Recognized (Real condition already on 12/31) and Non Recognized (New surprise that happened later)

Recognized Subsequent Event

Event that gives extra info about conditions that already existed at the BS date 12/31. Client MUST change (record adjustment) in FS

[On 12/31, customer owes $100. On 1/8, customer files for bankruptcy (customer was already financially sick 12/3, officially collapsed in January) → adjust books]

Non-Recognized Subsequent Event

Event that pops up because of conditions that happened AFTER 12/31 (did not exist at year end). DO NOT change FS but write up disclosure note for investors. [On 12/31, customer is ok. On 1/8, natural disaster destroys building so they can’t pay (disaster DID NOT exist 12/31) → no adjustment needed]

Letters of Inquiry to Client’s Attorneys

To corroborate (double check and confirm) what management said about lawsuits, claims, legal trouble

What Attorney gives back in response to Letter of Inquiry to Client’s Attorneys

• Description of lawsuit and progress so far

• estimate of potential financial loss

[Think of attorney letter as a report card from company’s legal superhero. if management says ‘all is fine’ lawyer’s letter is how auditor checks if management is telling the truth]

Related Party Transactions

[CEO sells broken car to own company → price is fake and not fair]

Auditor’s concern- form of transaction might look normal, but economic substance (real truth) is shady cause not independent

Auditors Job for Related Party Transactions

• Makes sure all related party deals are found

• understand why they did it, what it looks like, how it affects FS

• Evaluate if properly disclosed so public not tricked

Management Representation Letter

Ultimate ‘pinky swear’ paper- auditors don’t trust people blindly, force top bosses to sign formal letter repeating everything they claimed

Objective of Management Representation Letter

• Turn verbal promises into written proof

• Avoid any misunderstandings so bosses can’t later say ‘I never told the auditor that’

Key Things Management promises in letter

• We are responsible for repairing fair FS

• We are responsible for setting up good internal controls

• We gave auditor access to all info

Communicate with Audit Committee

Audit Committee is like Board of Directors acting as supervisors

Objective of Communicating with Audit Committee

Make sure audit committee has all details they need to properly oversee financial reporting

What is talked about with Audit Committee

• Critical Accounting policies and practices

• Reasonableness of estimates

• Engagement outcomes

  • Adjusting entires actually fixed

  • Schedule of uncorrected misstatements

  • Disagreements with management

Ethics and Decision Making Framework

Internal compass for doing the right thing, even when no one is looking

General Ethics

Knowing right from wrong (not stealing)

Professional Ethics

Taking good rules and applying them when you are on the job as CPA

Ethical Dilemma

Super tricky situation where 2 things you care about pull you in opposite directions (boss tells you to lie, your honesty rules say tell the truth)

3 Step Ethical Decision Making Framework

1. Identify

2. Analyze

3. Choose

3 Step Ethical Decision Making Framework- Identify

Figure out what the real problem is, what actions you can take, what rules are holding you back

3 Step Ethical Decision Making Framework- Analyze

Think about what will happen if you choose each path (who gets hurt and who benefits)

3 Step Ethical Decision Making Framework- Choose

Pick the absolute best action

AICPA and Structure of Code

AICPA is like superhero headquarters for CPAs. Made rulebook - Code of Professional Conduct- to make sure everyone trusts accountants

Code applies to every member!

Code Structure

1. Principles

2. Rules of Conduct

3. Interpretations

(Please Remember Independence)

Code Structure- Principles (top)

Big picture goal guidelines. Tell you to use moral judgement, serve public interest, be just and fair

Code Structure- Rules of Conduct (middle)

actual enforceable rules you must follow. Can lose CPA license if broken

Code Structure- Interpretations (bottom)

Detailed guidelines explaining how to apply rules to specific real-world situations

Independence Rule and Covered Members

Independence- completely neutral (referee in sports game) → can’t referee if own is playing

2 pillars of Independence

1. Independence in MIND

2. Independence in APPEARANCE

Independence in MIND

Being truly unbiased inside your brain

Independence in APPEARANCE

Looking unbiased to outside public

Covered Member

People who strictly MUST be independent for specific audit client

1. Everyone on Engagement Team

2. People of influence of audit outcome (managers)

3. Partners/managers with 10+ hours of non-audit work for client

4. All partners in office where lead engagement partner works

5. CPA firm itself

Immediate Family Rule

Spouse (equivalent) and Dependents are treated EXACTLY like you! (if you can’t own stock, they can’t either)

Violations of Independence Rules

1. Financial Investments

2. Loans

3. Employment and Relationships

4. Gifts and Events

5. Litigation and Acting as Management

Violations of Independence Rules- 1 Financial Investments

1. Direct Investments

2. Indirect Investments

3. Other Close Relatives

1 Financial Investments- Direct Investments

Owning stock directly in client

FORBIDDEN for Covered Members (no matter how small)

Materiality does not matter for Direct Investments

1 Financial Investments- Indirect Investments

Owning stock through mutual fund

Allowed ONLY if immaterial (small fraction of money)

1 Financial Investments- Other Close Relatives

Parents, siblings, non-dependent grown kids

Break independence ONLY if investment is material to relative AND covered member knows about it

Violations of Independence Rules- 2 Loans

1. Normal Loans to/from Clients

2. Loans from Financial Institutions

   1. Mortgage and Auto Loans

   2. Credit Cards

   3. Bank Accounts

2 Loans- Normal Loans to/from Clients

Treated like direct investments- forbidden regardless of materiality

2 Loans- Loans from Financial Institutions- Mortgage and Auto Loans

Allowed only if obtained under normal, standard bank lending terms before becoming a covered member

2 Loans- Loans from FInancial Institutions- Credit Cards

Allowed only if balance is kept under $10K

2 Loans- Loans from Financial Institutions- Bank Accounts

Allowed as long as balance is fully insured by FDIC

Violations of Independence Rules- 3 Employment and Relationships

• If auditor is seeking a job with client, must step off audit team

• If covered member’s Immediate Family/Close Relative works at client in Key Position, independence is broken

Violations of Independence Rules- 4 Gifts and Events

• cannot accept gifts unless value is CLEARLY INSIGNIFICANT

• going to business lunch/event is okay, but lavish trips/expensive tickets break independence

Violations of Independence Rules- Litigation and Acting Management- Litigation

Litigation- if client sues auditor (or opposite) → independence is destroyed

Violations of Independence Rules- Litigation and Acting Management- Acting as Management

Auditor CANNOT make management decisions, supervise client employees, design/implement the client’s main financial systems (can’t grade own work)

Integrity and Objective Rule

• Be honest (integrity) and don’t let bias sway judgement (objectivity)

• Must never knowingly lie/misrepresent facts

Applies to ALL

General Standards Rule

1. Professional Competence (only take jobs you know how to do)

2. Due Professional Care (work carefully and no laziness)

3. Planning and Supervision (properly plan job and supervision)

4. Sufficient Relevant Data (Get enough solid proof first)

CCPD (Cool CPAs Do Care)

Confidential Client Info Rule

Keep client’s secrets!

Confidential Client Info Rule Exceptions

1. Subpoenaed by Court of Law

2. Official AICPA or State Board investigation

3. Ethical complaints

Contingent Fees Rule

• Getting paid based on result of work

• PROHIBITED for audits, reviews, tax return prep (creates incentive to lie for more money)

Advertising and Acts Discreditable Rules- Advertising Rule

Ads cannot be false, misleading, deceptive

Advertising and Acts Discreditable Rules- Acts Discreditable Rule

Don’t do terrible things that bring shame to accounting

1. Discrimination or harassment

2. Stealing/sharing CPA Exam questions

3. Holding client records hostage

4. Gross negligence

Anatomy of Independent Auditor’s Report

Auditor gives opinion on whether the FS is presented fairly, in material respects, ICW GAAP

4 Main Sections of Audit Report

1. Title and Addressee

2. Opinion Paragraph

3. Basis for Opinion Section

4. Closing Section

4 Main Sections of Audit Report- 1 Title and Addressee

Tells who wrote and who it’s for (usually to Board of Directors and Stockholders)

4 Main Sections of Audit Report- 2 Opinion Paragraph

Most Important! States clearly if numbers follow GAAP

4 Main Sections of Audit Report- 3 Basis for Opinion Section

• Responsibility 1- Management is responsible for making FS

• Responsibility 2- Auditor is responsible for expressing independent opinion by planning/performing audit to obtain reasonable assurance that FS are free of MM (error or fraud)

4 Main Sections of Audit Report- 4 Closing Section

Includes auditor’s signature, city, report date, how many years they’ve audited company

Nonissuers

• Private companies

• Follow GAAS

Issuers

• Public companies traded on stock market

• Follow PCAOB

• Call report ‘Report of Independent Registered Public Accounting Firm’

Critical Audit Matters (CAM) for Issuers

• Required by PCAOB for public companies (issuers)

• Material accounts/disclosures that require challenging, complex, subjective auditor judgement

• Warning for public companies

• DOES NOT change auditor’s opinion; extra inside info for investor

4 elements included in report (Key Audit Matters- KAMs)

1. What

2. Why

3. How

4. Where

(KAMs for nonissuers)

4 elements included in report- What

Identify tricky accounting issue

4 elements included in report- Why

Explain why it was so hard (required massive judgement)

4 elements included in report- How

Describe how auditor tested (testing internal controls, reviewing historical models, using specialists)

4 elements included in report- Where

Reference specific FS footnote where it’s located

Part of Audit Performed by Other Auditors

When massive company has a subsidiary in another country audited by different local accounting firm- auditor has 2 options

• Share responsibility- mention other auditor in report

• Accept full responsibility- take on whole job themselves without mentioning other auditor

4 Types of Opinions and Going Concern

1. Unmodified

2. Qualified

3. Adverse

4. Disclaimer

4 Types of Opinions and Going Concern- 1 Unmodified

Clean bill of health! Books look great and follow GAAP

4 Types of Opinions and Going Concern- 2 Qualified

All good expect for small specific flaw

4 Types of Opinions and Going Concern- 3 Adverse

Total disaster. FS completely wrong and do not follow GAAP

4 Types of Opinions and Going Concern- 4 Disclaimer

Auditor couldn’t get enough evidence to form opinion

Going Concern (Special Case)

If auditor has substantial doubt about company’s ability to survive, add Emphasis of Matter Paragraph to unmodified report

Choosing between Qualified, Adverse, Disclaimer

Departure from GAAP (we have data, they broke rules)

• Material, not Pervasive = Qualified

• Material and Pervasive = Adverse

Scope Limit (we are missing data)

• Material, not Pervasive = Qualified

• Material and Pervasive = Disclaimer

Auditor’s Legal Liability and Common Law

If auditor screws up, angry clients and investors will sue them. Auditor faces liability under Common Law and Statutory Law

3 Ways a Client can sue under Common Law

1. Breach of Contract

2. Negligence

3. Fraud

3 Ways a Client can sue under Common Law- Breach of Contract

Breaking terms of engagement letter (missing delivery deadline required for bank loan covenant)

3 Ways a Client can sue under Common Law- Negligence

• Ordinary Negligence- Lacking reasonable care (violating auditing standards)

• Gross Negligence- Reckless disregard for standards (total recklessness)