Chapter 16

1. Chapter 16 Completing the Audit

2. Assessing the Quality ofthe Audit Analytical review • Required by GAAS • Do company results make sense in relation to industry and economic trends? Concurring partner review • Independent review by experienced auditor who is not part of audit team • Sarbanes/Oxley Act requires for audits of public companies Partner rotation • Sarbanes/Oxley Act requires new audit engagement and concurring review partner every 5 years • Does not apply to CPA firms with less than 10 partners and 5 public company audit clients

3. Other Considerations in the Final Review Stage of the Audit: Contingencies Contingent losses that are both probable and reasonably estimated should be accrued and disclosed Contingent losses that are reasonably possible, and remote contingencies disclosed because of common practice, should be disclosed in the notes to the financial statements Contingencies include: • Collectibility of receivables and loans • Product warranty liability • Litigation, claims, and assessments • Threat of expropriation of assets in a foreign country • Guarantees of debts of others • Purchase and sale commitments • Agreements to repurchase receivables that have been sold • Obligations of banks under standby letters of credit

4. Contingencies Responsibilities • Management is responsible for identifying, evaluating, and accounting for contingencies • Auditor is responsible for determining client has properly identified, accounted for, and disclosed material contingencies Sources of Evidence • Primary sources include management and client's legal counsel • Additional sources include corporate minutes, contracts, correspondence from government agencies, and bank confirmations

5. The Letter of Audit Inquiry Primary source of corroborative evidence concerning litigation, claims, and assessments is the client's legal counsel Letter of inquiry should include • Management's list that describes and evaluates its contingencies • A request that the attorney furnish auditor with the following: • Comment on the completeness of management's list and evaluations • For each contingency, • Description of the matter, progress to date, and action client intends to take • Evaluation of the likelihood of unfavorable outcome and estimate of potential loss, if possible • Any limitations on the attorney's response

6. The Letter of Audit Inquiry(continued) The letter of inquiry is good for establishing completeness of potential liabilities and providing factual information about contingencies However, because audit workpapers are not privileged, attorney responses will be less than forthcoming about the likelihood of unfavorable outcomes, and the estimated amount of any potential losses An attorney's refusal to provide the requested information is a scope limitation sufficient to preclude issuing an unqualified opinion

7. Adequacy of Disclosures Third standard of reporting states "Informative disclosures in the financial statements are to be regarded as reasonably adequate unless otherwise stated in the report." Auditor must be sure that: • Disclosed events and transactions occurred and pertain to the client • All disclosures that should be included are included • Disclosures are understandable to users • Disclosures are accurate

8. Management Representations Management Certification of Financial Statements • Sarbanes/Oxley Act requires CEO and CFO to certify financial statements are fairly presented in accordance with GAAP • Auditor should review management's processes for certification Management Representation Letter • Reminds management of its responsibility for the financial statements • Confirms significant oral responses made by management • Reduces possibility of misunderstandings between management and auditor

9. Management Representations (continued) • Letter is prepared by auditor on client letterhead, addressed to the auditor, and normally signed by CEO and CFO • Letter is dated as of the audit report date (end of fieldwork) • Because management representations are not strong evidence, the auditor should perform procedures to corroborate the information in the letter • Management's failure to provide this letter is a scope limitation sufficient to preclude issuance of unqualified opinion

10. What is the management comment letter? • Auditors often notice things that might make the client more profitable • Many of these observations related to control deficiencies or operational matters • The observations are included in a management comment letter typically delivered to the Board of Directors with the audit report • Management letter is not required, but does add value to the audit

11. What is the going concern issue? Auditor is required to evaluate client's ability to remain a going concern for a period not to exceed one year from the balance sheet date Indicators of potential going concern problems include • Negative trends in key financial areas like cash flow, sales, profits • Internal matters, such as loss of key personnel, and outdated facilities and/or products • External matters, such as new legislation, loss of significant customer or supplier, uninsured casualty loss • Other matters, such as loan default, inability to pay dividends, attempted debt restructuring

12. What is the going concern issue? (continued) If there is substantial doubt about ability of client to remain a going concern, auditor should • Discuss the situation with management • Assess management's plan to overcome problems • Consider the effects on the financial statements • Auditor should evaluate the adequacy of financial statement disclosure • Disclosures might include conditions causing the going concern doubt and management's plan to overcome the problem • Consider the effects on the audit report • Add explanatory paragraph to the unqualified audit report • Disclaim opinion • Issue qualified opinion if disclosure is not adequate

13. Review of Significant Estimates Management estimates provide opportunities for the entity to "manage" or even manipulate earnings. The auditor provides reasonable assurance that - Management has information system to develop estimates material to the financial statements • Estimates are reasonable • Estimates are presented per GAAP In evaluating management estimates, the auditor concentrates on key factors and assumptions that are • Significant to the accounting estimate • Sensitive to variations • Deviations from historical patterns • Susceptible to misstatement • Inconsistent with current economic trends

14. Communicating with the Audit Committee Items the auditor should discuss with the audit committee include • Auditor's responsibility under GAAS • Management judgments and accounting estimates • Audit adjustments • Uncorrected misstatements • Accounting policies and alternative treatments • Major accounting and reporting disagreements with management • Difficulties encountered in performing the audit • Copies of significant communications between auditor and management • Management's discussion with other CPA firms • Significant fraud or illegal acts • Significant deficiencies in internal control • Any independence issues • Any other significant matters

15. What aresubsequent events? Subsequent events occur after the balance sheet date. Audit procedures used to identify subsequent events include: • Read minutes of meetings of the board of directors, stockholders, and other authoritative groups held after year-end • Read interim financial statements; investigate significant changes • Inquire of management about • Significant changes in noted in interim statements • Significant contingent liabilities • Significant changes in working capital, debt, or owners' equity • Status of any tentative items • Unusual accounting adjustments made after balance sheet date • Inquire of management and legal counsel about subsequent events • Obtain management representation letter

16. Subsequent Events (continued) How an auditor handles a subsequent event depends on two things: • Whether the subsequent event provides evidence about conditions that existed at the balance sheet date (type 1), or conditions arising after the balance sheet date (type 2) • When the subsequent event occurred: during fieldwork, after fieldwork but before the audit report has been issued, or after the audit report has been issued

17. Subsequent Events (continued) Types of Subsequent Events Type 1 subsequent events provide evidence about conditions that existed at the balance sheet date The financial statement numbers should be adjusted to reflect this information; footnote disclosure may also be necessary Examples of type 1 subsequent events: • Major customer files for bankruptcy during subsequent period, its deteriorating financial condition existed prior to the balance sheet date • Lawsuit settled for different amount than accrual • Stock dividend or split during the subsequent period • Sale of inventory below carrying value when loss occurred during the subsequent period

18. Subsequent Events (continued) Type 2 subsequent events provide evidence about conditions that did not exist at the balance sheet date The financial statement numbers should not be adjusted for these events, but they should be considered for disclosure Examples of type 2 subsequent events: • Uninsured casualty loss that occurs after the balance sheet date • Significant lawsuit initiated for incident occurring after the balance sheet date • Significant loss due to natural disaster occurring after the balance sheet date • Major decisions made during the subsequent period such as decision to merge, discontinue a line of business, or issue new securities • Material change in value of investment securities after the balance sheet date

19. Subsequent Events (continued) If subsequent event occurs after end of fieldwork but before audit report is issued, auditor must decide whether to single or dual date the audit report • Single date • Date of subsequent event is the audit report date • Auditor must make sure there are no other subsequent events prior to report date • Dual date • Use dates of end of fieldwork and subsequent event

20. Subsequent discovery of facts existing at the date of the auditor's report Auditor must determine • Reliability of new information • Whether the event had occurred by the audit report date • Whether users are likely to still be relying on the financial statements • Whether the audit report would have been affected had the facts been known

21. Subsequent discovery of facts existing at the date of the auditor's report If the auditor decides further reliance on the financial statements and audit report is not appropriate, client is advised to make appropriate and timely disclosure of these new facts Appropriate actions: • Revise financial statements and audit report • Revision and explanation reflected in subsequent period financial statements • If revision will take extended period, notify users that statements and audit report should no longer be relied on If client will not cooperate, auditor should • Notify client and regulatory agency that the audit report should no longer be associated with the financial statements • Notify known users that the audit report should no longer be relied on