CHAPTER 14 ACTIVITIES REQUIRED IN COMPLETING A QUALITY AUDIT

1. CHAPTER 14ACTIVITIES REQUIRED IN COMPLETING A QUALITY AUDIT

2. Learning Objectives • Review, summarize, and resolve detected misstatements and identified control deficiencies • Review and assess the appropriateness of the client’s accounting for and disclosure of loss contingencies • Review and assess the appropriateness of the client’s significant accounting estimates • Review the adequacy of disclosures • Review and assess the implications of noncompliance with laws and regulations

3. Learning Objectives • Review the appropriateness of the going-concern assumption using relevant professional guidance • Perform final analytical review procedures • Review management representations in certifications required under the Sarbanes-Oxley Act (for public clients) and describe the contents of a management representation letter • Review subsequent events that occur after the balance sheet date and assess proper treatment

4. Learning Objectives • Determine how to address situations in which omitted audit procedures come to the auditor’s attention after the audit report has been issued • Assess the adequacy of supervision and perform an engagement quality review • Identify issues to communicate to the audit committee • Identify issues to communicate to management via a management letter

5. Learning Objectives • Describe the process by which audit firms make client acceptance and continuance decisions • Identify the requirements concerning mandatory partner rotation and mandatory audit firm rotation for publicly traded audit clients • Apply the frameworks for professional decision making and ethical decision making to issues involved in completing the audit

6. THE AUDIT OPINION FORMULATION PROCESS

7. PROFESSIONAL JUDGMENT IN CONTEXT - A Case of Poor Review Quality and Improper Professional Conduct • The Practice Office Assurance Director for BDO’s Philadelphia office assigned an audit manager to the audit of Hemispherix Biopharma Incorporated • BDO’s internal quality control review team selected Hemispherix for inspection • Led to the director forcing the manager to sign the audit papers in spite of the papers not being reviewed • PCAOB detected the fraud and barred the director from performing audits of public companies for at least one year

8. PROFESSIONAL JUDGMENT IN CONTEXT - A Case of Poor Review Quality and Improper Professional Conduct • During the conduct of the audit engagement, reviews of work performed by lower-level staff are necessary to be sure that audit steps have been competently completed. Toward the end of the audit, what other types of reviews should be conducted? (LO 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11) • Why are engagement quality reviews important? (LO 11)

9. PROFESSIONAL JUDGMENT IN CONTEXT - A Case of Poor Review Quality and Improper Professional Conduct • Why were the director’s actions harmful to the BDO and the Hemispherx audit? (LO 11, 16) • What was the ethical dilemma faced by the manager? (LO 16) • What alternative courses of action could the director have taken when he discovered that the engagement had not been reviewed and that it was about to be inspected during the engagement quality review? (LO 10, 11, 16)

10. Learning objective 1 Review, summarize, and resolve detected misstatements and identified control deficiencies

11. Reviewing, Summarizing, and Resolving Detected Misstatements • Misstatement may be: • Difference between the amount reported in the financial statements and what should be reported under Generally Accepted Accounting Principles (GAAP) • Omission of an amount that should be disclosed in accordance with GAAP

12. Categories of misstatements

13. Resolving Detected Misstatements • Audit firms use a schedule to: • Accumulate known and projected misstatements • Carryover effects of prior-year uncorrected misstatements • Immaterial misstatements are waived (left uncorrected)

14. EXHIBIT 14.1 - Summary of Possible Adjustments

15. Resolving Detected Misstatements • Materiality of a misstatement is based on: • Quantitative amount of the misstatement • Nature of misstatement to determine the qualitative features that would make it material

16. Auditing in Practice - The PCAOB Position on Management Bias in Correcting Detected Misstatements • Decide whether refusal to correct a detected misstatement is indicative of intentional bias • Management bias should lead auditors to reevaluate: • Risk assessments • Risk of fraud

17. Additional Considerations for an Integrated Audit • Assessing whether financial statement misstatements were a result of: • Significant deficiencies in internal control • Material weaknesses in internal control • Evaluating severity of each individual control deficiency to determine whether it is a material weakness • Accumulating deficiencies less severe than material weaknesses, on a summary work sheet

18. Learning objective 2 REVIEW AND ASSESS THE APPROPRIATENESS OF THE CLIENT’S ACCOUNTING FOR AND DISCLOSURE OF LOSS CONTINGENCIES

19. Reviewing Contingencies • Categories of potential losses • Probable • Reasonably possible • Remote • Management is responsible for designing and maintaining policies and procedures to identify, evaluate, and account for contingencies • Auditor is responsible for determining that client has identified, accounted for , and disclosed contingencies

20. Auditing in Practice - Contingent Liabilities at British Petroleum (BP) • In July 2010, BP released its second quarter earnings report discussing: • Risks associated with ongoing events and cleanup effort in the Gulf of Mexico due to an oil spill associated with BP • BP’s auditors should have obtained assurance that the contingency in connection with oil spill was accurately reported and disclosed

21. Sources of Audit Evidence related to Contingencies • Description and evaluation of contingencies • Assurance that accounting and disclosure requirements have been met • Information about major contracts in which contingencies may be present • Documentation of communication the legal counsel of the client • Documentation of contingent liabilities contained in: • Corporate minutes and bank confirmations • Correspondence from governmental agencies

22. Letter of Audit Inquiry • Letter that the auditor asks the client to send to its legal counsel to gather corroborative evidence concerning litigation, claims, and assessments • Legal counsel should be instructed by the client to respond directly to the auditors • Scope limitation - If a lawyer refuses to furnish the requested information

23. Learning objective 3 REVIEW AND ASSESS THE APPROPRIATENESS OF THE CLIENT’S SIGNIFICANT ACCOUNTING ESTIMATES

24. judgmental estimates included in Financial statement balances • Fair value of many assets • Net realizable values of inventory and receivables • Property and casualty insurance loss reserves • Revenues from contracts accounted for by percentage-of-completion method • Warranty expenses and associated liabilities • Depreciation and amortization methods • Impairment of depreciable assets and goodwill

25. judgmental estimates included in Financial statement balances • Useful lives and residual values of productive facilities, natural resources, and intangibles • Valuation and classification of: • Financial instruments • Pensions • Other postretirement benefits • Compensation in stock option plans

26. Reviewing Significant Estimates • Auditors should be alert to period-end adjusting journal entries • They are responsible for providing assurance that: • Estimates are reasonable • Estimates are presented in conformity with GAAP • Disclosure about estimates is adequate

27. Reviewing Significant Estimates • Management estimates are based on: • Subjective factors • Objective factors • Events or transactions useful in identifying and evaluating reasonableness of estimates occur: • After balance sheet date • Before audit report date

28. Reviewing Significant Estimates • Auditor should focus on factors and assumptions that are: • Significant to accounting estimate • Sensitive to variations • Deviations from historical patterns • Subjective and susceptible to misstatement and bias • Inconsistent with current economic trends

29. Auditing in Practice - PCAOB Fines Ernst & Young for an Issue Involving Accounting Estimates • Medicis’ management convinced their audit partners that their revenue recognition policy was acceptable • Even though it violated GAAP • National-level consultation experts suggested that partners involved in the Medicis audit were incorrect • After investigation PCAOB imposed a penalty on: • Ernst & Young • Individual partners on Medicis engagement

30. Learning objective 4 Review the adequacy of disclosures

31. Reviewing the Adequacy of Disclosures • 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

32. Auditing in Practice - Related Party Disclosures at OAO Gazprom • Company’s International Financial Reporting Standards (IFRS) based disclosures led to difficulty for PwC due to: • Complex nature of related-party transactions • High-level interrelationships between executives in companies operating in the Federation

33. 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 included • Disclosures are understandable to users • Information is disclosed accurately and at appropriate amounts

34. Learning objective 5 Review and assess the implications of noncompliance with laws and regulations

35. AUDITORS’ RESPONSIBILITIES REGARDING CLIENTS’ NONCOMPLIANCE WITH LAWS AND REGULATIONS • Noncompliance: Acts of omission or commission, either intentional or unintentional, contrary to prevailing laws or regulations • Limitations in an auditor’s ability to detect material misstatements • Information systems relating to financial reporting may not capture noncompliance

36. AUDITORS’ RESPONSIBILITIES REGARDING CLIENTS’ NONCOMPLIANCE WITH LAWS AND REGULATIONS • Management may: • Act to conceal noncompliance • Override controls • Intentionally misrepresent facts to the auditor • Legal implications of noncompliance are ultimately a matter for legal authorities to resolve

37. Auditing in Practice - Triton Energy and Noncompliance with Laws and Regulations • When violations like these occur the auditor should notify audit committee about: • The violations • Their circumstance • The effect on the financial statements • Consider whether risk assessments made prior to knowledge of violations are still appropriate

38. main provisions of FCPA for Companies with securities listed on U.S. markets • Anti-bribery provision - No company may make a payment to a foreign official for obtaining or retaining business • Financial records should accurately reflect transactions • Adequate system of internal accounting controls should be designed and maintained • Certain payments to foreign officials are acceptable • Grease payments - Made to an official to expedite performance of his duties

39. Learning objective 6 Review the appropriateness of the going-concern assumption using relevant professional guidance

40. Evaluating the Going-Concern Assumption • Responsibility of management - 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 - Evaluating appropriateness of that assessment • Use of bankruptcy prediction models to analyze whether a particular client might have a going-concern problem

41. EXHIBIT 14.3 - Going-Concern Process

42. Evaluating the Going-Concern Assumption If substantial doubt about entity’s ability to continue as a going concern is alleviated If substantial doubt about entity’s ability to continue as a going concern for a reasonable period of time remains Consider disclosure of conditions that initially caused auditor to believe there was substantial doubt Include an emphasis-of-matter paragraph in auditor’s report to reflect that conclusion Consider possible effects of such conditions or events, and any mitigating factors, including management’s plans Audit report will include phrase - Substantial doubt about entity’s ability to continue as a going concern

43. Reasons auditors might resist issuing a going-concern audit opinion • It can be a self-fulfilling prophecy that the company will go bankrupt • It is difficult to know beforehand whether a financially distressed client will: • Cease operations • Pull itself away from that outcome

44. Indicators of Potential Going-Concern Problems • Negative trends • Internal matters • External matters • Significant changes in: • Competitive market • Competitiveness of client’s products

45. Indicators of Potential Going-Concern Problems • Altman Z-scores: Series of ratios that have predictive power in indicating the likelihood of bankruptcy • Five-ratio model - For publicly owned manufacturing companies • Four-ratio model - For public or privately owned manufacturing and service companies

46. EXHIBIT 14.4 - Altman Z-Score Models

47. 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

48. Mitigating Factors for a going-concern problem • 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

49. Learning objective 7 Perform final analytical review procedures

50. Four-step process for using analytical procedures Develop an expectation Define when difference between auditor’s expectation and client’s balance would be considered significant Compute the difference between auditor’s expectation and client’s balance Follow up on significant differences