chp 24 - completing the audit

steps to complete the audit

contingent liabilites

• A potential future obligation to an outside party (or an impairment of assets) for an unknown amount resulting from activities that have already taken place

• The outcome is contingent upon some other activity

• When we identify a potential future obligation, we are thinking about contingent liablities

• Whether it should be a liability on the B/S will depend on the likelihood it will occur or that the company will owe somebody money

likelihood of occurrence

• Probable: the future event is likely to occur

  • Reflect in F/S if possible, otherwise - Foot Note Disclosure

  • Ex: think about your company is in a lawsuit - if it is probable that the company will lose and have to pay a settlement, you should estimate the amount they will end up owing

    • If you can estimate that, it needs to be in the F/S as a liability

    • If you can’t estimate the amount, it won’t be required to go on the B/S, but will be discussed in the foot notes

• Reasonably Possible: the chances of the future event occurring is more than remote but less than likely

  • Foot Note Disclosure

• Remote: the chance of the future event occurring is slight

  • No disclosure

procedures to identify contingent liabilites

• READ - minutes of meetings of the BOD, committee of the board, and stockholders

• REVIEW - contracts, loan agreements, leases, and correspondence, including income tax filings, from government agencies

  • Anything that could create a contingent liabilities

  • Ex: clause that says “if you pull out of your lease early, you will have to pay us ___”

• EXAMINE & INSPECT - legal expense for the period

  • Lots of contingent liabilities arise out of outstanding lawsuits

  • Might talk to the legal team (internal or external), what they’re paying in legal fees and ask what they’re for

• CONFIRM - contractual guarantees and letters of credit

• OBTAIN - legal letters from the client’s attorney

  • Ask legal counsel to tell us what they know about the client; Also ask management

    • Acts as a safeguard; if they purposefully choose not to disclose something, the letters are proof that they left it out

review for subsequent events

A subsequent event is one that occurs between the B/S date and the date on the auditor’s report

• Are things happening between when their year end and when we issue our opinion? (usually a couple months later)

• Things are still happening in these months and can be important for financial statement users

Procedures are required by auditing standards:

• Auditor must review transactions and events occurring after the B/S date

types of subsequent events

When subsequent events happen, auditor must distinguish between:

1. Direct Effect (Type I) - conditions that existed at the B/S date

   1. Helps determine presentation/disclosure of account balances as of the B/S date

      1. Ex: outstanding litigation: At year end they might still be in the middle of the case, we don’t know the outcome yet. During February the case is settled and we now know the outcome

2. No Direct effect (Type II) - conditions that came into being following the end of the year

   1. May be significant enough to require disclosure

   2. Informs users judgements going forward

Direct Effect Subsequent Events

Event or transaction provides additional information to:

• Management in determining account balances as of B/S date

• Auditors in verifying the balances

Requires adjustment of F/S for effects of event

• Company must update that number to reflect new information

• Example: Auditors use subsequent litigation activity (e.g., recorded estimate of litigation liability at balance sheet date is settled for an amount that is different) to provide information regarding contingent liabilities at the B/S date

No Direct Effect Subsequent Events

Subsequent events of this type

• Do not provide evidence of conditions that existed at the B/S date

• but are material and thus require disclosure even though they do not require adjustment

  • Important to users still

Typically, footnote disclosure will suffice

• Example: Uninsured loss of inventories due to fire/natural disaster

  • On 12/31 they still had $1million in inventory; however, after the disaster and the auditor picks up the inventory record in March and that inventory is gone from a fire in January, the users need to know that.

Audit Tests - Subsequent Events Review

1. Procedures normally integrated as a part of the verification of year-end account balances

   1. Ex: examining subsequent payments in January

      1. That relates to activities from the prior year

2. Procedures performed specifically to discover subsequent events:

   1. Inquiries of management.

      1. Has anything material happened that we are not aware of?

   2. Review internal statements and records prepared subsequent to B/S date.

      1. Look at January and February F/S to see if anything seems strange

   3. Examine minutes of BOD and shareholder meetings issued subsequent to B/S date.

   4. Obtain a management letter of representation.

   5. Correspond with attorney

Subsequent Discoveries of Fact

• Discovering information after the audit report

• Although rare, if the auditor becomes aware, after the audited F/S have been issued, that some information in the F/S is materially misstated, the auditor has the obligation to make certain that users who are relying on the F/S are informed of the misstatements

  • What we do depends on if our audit opinion is still correct or not

  • If audit opinion is wrong:

    • The client can inform users by revising F/S and we would reissue our audit opinion

    • If client refuses to cooperate, we can recall our audit opinion and auditor must notify regulatory agencies and all users relying on F/S

Final Evidence Accumulation

• Perform final analytical procedures

  • High level review of F/S and footnote disclosures

• Evaluate going concern

• Obtain a management representation letter

  • What contingent liabilities do you know about? What ongoing litigation do you know about? What subsequent events do you know about?

  • “Us, as management, have been truthful in what we’ve told you”

  • Auditors way of covering by having management confirm they told us what we asked

• Read the F/S and all supplementary information for consistency

Evaluate Resutls

• We need to combine and integrate everything we learned from the audit to from ONE overall conclusion about whether the F/S are reasonably free from material misstatement

• Sufficient appropriate audit evidence must have been obtained

  • Review each audit area to determine whether all material areas have been adequately evaluated

    • Did we evaluate everything from both a qualitative and quantitative perspective

  • Review all audit documentation to ensure it is accurate and complete

    • Did we document everything to show report of our opinion

  • Determine if all audit objectives have been met and all planned procedures have been satisfactorily performed

  • Evaluate identified misstatements

Evaluating Misstatements

• Determine the amount of all material misstatements that must be corrected

• Accumulate all unadjusted/uncorrected misstatements

  • All identified misstatements during the audit that were less than materiality or not corrected by the client

  • Just because the net effect might not be material (misstatements that cancel out) each individual misstatement needs to be fixed

  • Management just needs to fix the misstatements we find material

    • As long as we’re under materiality level, we are good to go