sm_19

CHAPTER 19 COMPLETING

THE AUDIT /

POSTAUDIT

RESPONSIBILITIES Learning Check  19-1.

The three categories of activities in in completing the audit are (a) completing field work, (b) evaluating the findings, and (c) communicating with the client.

19-2. The activiti activities es involved involved in complet completing ing the field field work work are are (a) making making subseue subseuent nt events events review, (b) reading minutes of meetings, (c) obtaining evidence concerning litigation, claims, and assessments, assessments, (d) obtaining ob taining client representation letter, and (e) performing anal!tical procedures. 19-" 19-".. a.

#ubse #ubseu uen entt event eventss are are event eventss that that occu occurr betw betwee een n the the bala balanc ncee shee sheett date date and and the the issuance date of the auditor$s report (which is not the same as the date of the report) that ma! affect the financial statements on which the report is rendered. The subseuent events period e%tends from the balance sheet date to the end of field work on the engagement.

 b.

The t!pes are& th ose events that provide provid e additiona ad ditionall eviden evidence ce wit with h resp respect ect to • T!pe 1 consists of those conditions that e%isted at the date of the balance sheet and affect the estimates inherent in the process of preparing financial statements. • T!pe 2 consists of those events that provide evidence with respect to conditions that did not e%ist at the date of the balance sheet but arose subseuent to that date. T!pe pe 1 events reuire ad'ustment of the financial statements. T!pe 2 events • T! reuire disclosure, and in ver! material cases, b! attaching pro-form data to the financial statements.

c.

The audi The audito torr is is reu reuir ired ed b! b!  # # to sear search ch for for and to eval evalua uate te sub subse seue uent nt event eventss up to the date of the auditor$s report, which should be as of the end e nd of field work. This responsibilit! is discharged b! (1) being alert for subseuent events in performing !ear-end substantive tests after the balance sheet date, and (2) performing specific  procedures at or near the completion of field work.

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19-1

19-0 19-0..

19-4. 19-4.

a.

egar egardi ding ng liti litigat gatio ion, n, clai claims ms,, aand nd asse assess ssme ment ntss (+ (+) ),, the the audi audito torr sho shoul uld d obt obtai ain n evidential matter on Th e e%ist e% isten ence ce of a cond co nditi ition on,, situa sit uatio tion, n, or set set of circ circum umst stan ances ces indi indicat catin ing g an an unc uncer erta tain int! t! • The as to the possible loss to an entit! arising from the +. • The period in which the underl!ing cause for legal action occurred. • The degree of probabilit! of an unfavorable outcome. • The amount or range of potential loss.

 b.

 letter letter of audit inuir! is a letter sent b! management to the compan!$s outside legal counsel reuesting the law!er to send specified information directl! to the auditor about + against the compan!. The letter is the auditor$s primar! means of obtaining evidence about +.

c.

hen hen the the law! law!er er fai fails ls to res respo pond, nd, the the audi audito torr has has a sco scope pe lim limit itat atio ion. n. 3ep 3epen endi ding ng on on materialit!, materialit!, the auditor will e%press either a ualified ua lified opinion or a disclaimer of opinion.

a.

The ob'ect ob'ective ivess of a 5rep5 5rep5 letter letter are& are& (1) confirm confirm oral oral repres represent entati ations ons given given to the auditor, aud itor, (2) docume doc ument nt the continu con tinuing ing approp app ropriat riatene eness ss of such such repr repres esen enta tati tion ons, s, and and (") (") reduce the possibilit! of misunderstandings concerning management$s representations.

 b.

19-6 19-6..

a.

 b.

hen the auditor is unable to obtain a rep letter or support a management representation that is material to the financial statements b! other audit procedures, there is a scope limitation. 3epending on materialit!, materialit!, the auditor will e%press either a ualified opinion or a disclaimer of opinion The ob' The ob'ec ecti tive vess of of an overa overall ll revi review ew are are to to ass assis istt the the aud audit itor or in (1) (1) asse assess ssin ing g conclusions reached in the audit and (2) evaluating the financial statement  presentation taken as a whole. The review should be made b! an individual having comprehensive knowledge of the client$s business and industr!. industr!. 7ormall!, 7ormall!, either the partner in charge of the audit or the top manager on the engagement makes the review.

c.

nal! nal!ti tical cal proc procedu edure ress per perfo form rmed ed dur durin ing g the the fin final al sta stage gess of the the audi auditt sho shoul uld d be • pplied to critical audit areas identified during the audit. aud it ad'ustments and reclassifications • 8ased on financial statement data after all audit have been recognied. s in other cases, the data ma! be compared to (1) e%pected compan! results, (2) available industr! data, and (") relevant nonfinancial data. 19-: 19-:.. a.

The two The two ob'e ob'ect ctiv ives es in evalu evaluat atin ing g the the findi finding ngss are are deter determi mini ning ng (1) (1) the the t!p t!pee of of opi opini nion on to be e%pressed and (2) whether # has been met in the audit.

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19-2

 b.

19-ertinent conditions and events giving rise to the assessment of substantial doubt about the entit!$s abilit! to continue as a going concern for a reasonable period of  time. • The possible effects of such conditions and events. • *anagement$s evaluation of the significance of those conditions and events and an! mitigating factors. • >ossible discontinuance of operations. • *anagement$s plans (including relevant prospective financial information). fn " • /nformation about the recoverabilit! or classification of recorded asset amounts or the amounts or classification of liabilities.

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19-"

d.

/f, after considering identified conditions and management$s plans, the auditor concludes that substantial doubt about the entit!$s abilit! to continue as a going concern for a reasonable period of time remains, the audit report is normall! an unualified audit opinion with an e%planator! paragraph about the uncertaint! (following the opinion paragraph) to reflect that conclusion. The auditor$s conclusion about the entit!$s abilit! to continue as a going concern should be e%pressed through the use of the phrase 5substantial doubt about its (the entit!$s) abilit! to continue as a going concern.5 /f the auditor concludes that the entit!$s disclosures with respect to the entit!$s abilit! to continue as a going concern are inadeuate, a departure from generall! accepted accounting principles e%ists. This ma! result in either a ualified (e%cept for) or an adverse opinion.

19-1. The technical review of the financial statements includes matters pertaining to the form and content of each of the basic statements as well as to reuired disclosures. *ost +> firms use separate checklists for #A+ and non-#A+ clients. The auditor who performs the initial review of the financial statements completes the checklists. The manager and partner in charge of the engagement (in the case of a publicl! held client then review the checklists, a  partner who was not a member of the audit team) reviews them again. 19-11. a.

 b.

19-12. a.

The opinion to be e%pressed is determined b! the partner in charge of the engagement. The decision is made on the basis of the findings made b! the audit team during the audit. >roposed ad'ustments and disclosures are discussed with the client and differences are resolved. @rdinaril!, agreement is reached and an unualified opinion can be e%pressed. The primar! reviewers and the nature of their reviews are& eviewer *anager

>artner in charge of engagement  b.

7ature of eview eviews working papers prepared b! seniors and reviews some or all of the working papers reviewed b! seniors. eviews working papers prepared b! managers and reviews other working papers on a selective basis.

The engagement partner$s review of the working papers is designed to obtain assurance that • The work done b! subordinates has been accurate and thorough. • The 'udgments e%ercised b! subordinates were reasonable and appropriate in the circumstances. • The audit engagement has been completed in accordance with the conditions and terms specified in the engagement letter. • ll significant accounting, auditing, and reporting uestions raised during the audit have been properl! resolved.

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• •

c.

The working papers support the auditor$s opinion. enerall! accepted auditing standards and the firm$s ualit! control policies and  procedures have been met.

The second partner ma! be more ob'ective than the partner on the engagement. Thus, the second partner review provides additional assurance that # have been met. #econd partner reviews are mandator! for #A+ registrants.

19-1". The auditor$s communications with the client at the conclusion of the audit involve the audit committee of the board of directors (or the board directl!) and management. 19-10. a.

eportable conditions represent significant deficiencies in the design or operation of the internal control structure, which could adversel! affect the organiation$s abilit! to record, process, summarie, and report financial data consistent with the assertions of management in the financial statements. The magnitude of a reportable condition determines whether it is also a material weakness.  material weakness is defined as a reportable condition in which the design or operation of the specific internal control structure elements does not reduce to a relativel! low level the risk that misstatements in amounts that would be material in relation to the financial statements being audited ma! occur and not be detected within a timel! period b! emplo!ees in the normal course of performing their assigned duties.

 b.

 report issued on reportable conditions should& • /ndicate that the purpose of the audit is to report on the financial statements and not to provide assurance on the internal control structure. • /nclude the definition of reportable conditions. • /nclude the restriction on distribution (e.g. restricted to the audit committee, management, and others within the organiation). /n addition, the reportable conditions should be described in one or more separate paragraphs. 19-14. hen the auditor separatel! identifies and describes material weaknesses in his or her report, two additional paragraphs are reuired. The first paragraph should contain a definition of the term material weakness and a description of the reportable conditions that are material weaknesses. The second additional paragraph should describe the limitations of the auditor$s work, noting specificall! that the auditor$s consideration of the internal control structure would not necessaril! disclose all matters considered to be material weaknesses. 19-16. a.

 b.

The communication ma! be oral or written, and it ma! occur during or shortl! after the audit. The communication with the audit committee ma! include such matters as • uditor$s responsibilities under #. • #ignificant accounting policies. • *anagement 'udgments and accounting estimates. • #ignificant audit ad'ustments.

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19-4

3isagreements with management. • +onsultation with other accountants. • *a'or issues discussed with management prior to retention. • 3ifficulties in performing the audit. /n addition, the auditor must communicate reportable conditions. •

19-1:. a.

 b.

19-1lans or intentions that ma! affect the carr!ing value of assets and liabilities.

1.

The purpose of the management letter is to communicate to management the auditor$s recommendations regarding improvements in the efficienc! and the effectiveness of matters that came to the auditor$s attention during the audit.

2.

Three ma'or sub'ects that ma! be addressed in the management letter include the following. • /nternal control structure weaknesses that are considered immaterial. • /mprovements to the accounting and information s!stem. • /mprovements to the internal controls related to achieving the ob'ectives of the organiation.

19-2:. (Astimated time - 24 minutes) Item No. 1.

2.

Audit Procedures oods in-transit would be detected in the course of the auditor$s review of the !earend cutoff of purchases. The auditor would e%amine receiving reports and purchase invoices to make certain that the liabilit! to suppliers had been recorded for all goods included in inventor!, and that all goods for which the client was liable at !ear end were recorded in inventor!. #ettlements of litigation would be revealed  b! reuesting from the compan!$s legal counsel a description and evaluation of an! litigation, impending litigation, claims, and contingent liabilities of which he or she has knowledge that e%isted at the date of the  balance sheet being reported upon, together with a description and evaluation of an! additional matters of a like nature which come to his or her attention up to the date the information is furnished.  review of cash disbursements for the period between the balance sheet date and completion of field work ma! also reveal evidence of the settlement.

Required isc!osure or "ntr# and Reasons The receipt of the goods provides additional evidence with respect to conditions that e%isted at the date of the balance sheet and hence the financial statements should be ad'usted to take into account such additional information.

#ettlements of litigation would reuire an ad'ustment of the financial statements since the events that gave rise to the litigation had taken place prior to the balance sheet date.

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19-1

Item No. ".

Audit Procedures The purchase would normall! be evealed in general conversations with the client and would further be detected b! reading the minutes of meetings of stockholders, directors, and appropriate committee. /n addition, because the amount paid is likel! to be unusuall! large in relation to other cash disbursements, a review of cash disbursements for the period between the  balance sheet date and completion of field work is likel! to reveal such an e%traordinar! transaction. *oreover,  because a purchase of a business usuall! reuires a formal purchase agreement, the letter from the firm$s legal counsel would  probabl! have revealed the purchase.

0.

/nventor! losses attributable to a flood would be brought to the auditor$s attention through inuires and discussions with corporate officers and e%ecutives. *oreover, the auditor would know the location of the plants and warehouses of clients and upon becoming aware of an! ma'or floods in such a location, he or she would investigate to determine if the client$s facilities had suffered an! damage.

4.

The sale of bonds or other securities would reuire a filing with the #A+ in which the auditor would presumabl! be involved. /n addition, the sale would be revealed b! reading the minutes of directors and finance committee$s meetings, b! corresponding with the client$s attorne!s and b! e%amining the cash receipts books in the period subseuent to the balance sheet date for evidence of unusuall! large receipts.

Required isc!osure or "ntr# and Reasons The purchase of a new business is not an event that provides evidence with respect to conditions e%isting at the balance sheet dateC hence, it does not reuire ad'ustments in the financial statements. Bowever, such an event would normall! be of such importance that disclosures of it is reuired to keep the financial statements from being misleading. /f the acuisition is significant enough, it might be advisable to supplement the historical statements with pro-forma statements indicating the financial results if the two firms had been consolidated for the !ear ending 3ecember "1, 19D@. @therwise, disclosure in footnotes to the financial statements would be adeuate. @ccasionall!, a situation of this t!pe ma! have such a material impact on the entit! that the auditor ma! wish to include in the audit report an e%planator! paragraph directing the reader$s attention to the event and its effect. osses attributable to floods subseuent to the balance sheet date to not provide in formation with respect to conditions that e%isted at the balance sheet dataC hence, ad'ustment in the financial statements is not reuired. Bowever, because the losses are material, the! should be revealed in footnotes to the financial statements. @ccasionall!, situation of this t!pe ma! have such a material /mpact on the entit! that the auditor ma! wish to include in the audit report an e%planator! paragraph directing the reader$s attention to the event and its effect. #ales of bonds or capital stock are transactions of the t!pe that do not provide information with respect to conditions that e%isted at the balance sheet dateC hence, ad'ustment of the financial statements is not reuired. Bowever, such sales ma! be of sufficient importance to reuire footnote disclosure. @ccasionall!, a situation of this t!pe ma! have such a material impact on the entit! that the auditor ma! wish to in the audit report an e%planator! paragraph directing the reader$s attention to the event and its effect.

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19-11

19-2& (1) a broad view is obtained of the date o f the financial statements, and (2) the +>$s attention is focused on e%ceptions or variations in the data.  broad view of the data under audit is needed b! the +> to draw conclusions about the data as a whole. *erel! looking at individual transactions ma! lead the auditor to overlook important variations in the underl!ing data. The application of anal!tical  procedures to the final data to obtain this broad view reuires a discerning anal!sis of the data, which results in overall conclusions upon which the +>$s audit satisfaction rests. The +> is thus able to satisf! him or herself as to the reasonableness, validit!, and consistenc! of the data in view of the surrounding circumstances. The focusing of the +>$s attention on e%ceptions or variations in the data results in a more efficient and economical audit because there is a reduction in the amount of detailed testing which would be reuired, in the absence of overall checks, to uncover these e%ceptions or variations. ;urthermore, manipulations of accounts ma!  be revealed because the double-entr! bookkeeping s!stem e%tends the effects of manipulations to additional accounts, which will then bear a changed relationship to other accounts. /n addition, managerial problems and trouble spots will be highlighted for the +> and ma! lead to the opportunit! to be of additional service to the client.  b.

The ratios that a +> ma! compute during an audit as overall checks on balance sheet accounts and related nominal accounts ma! include the following& • ccruals of individual e%penses to related total e%penses. • +alculations of the entit!?s operating c!cle. • /ndividual components of return on assets and return on euit!. • The impact of an entit!?s financing and investing activities. • The abilit! of cash flow from operations to service debt and dividends. • @ther measures of the entit!?s liuidit! and solvenc!.

c.

1.

The possible reasons for a decrease in the rate of inventor! turnover include the following& • 3ecline in sales. • /ncrease in inventor! uantities, intentional or unintentional. • /ncorrect computation of inventor! because of errors in pricing, e%tensions, or taking of ph!sical inventor!. • /nclusion in inventor! of slow-moving or obsolete items. • Arroneous cutoff of purchases. • Arroneous cutoff of sales under the perpetual inventor! accounting method. • Fnrecorded purchases.

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19-10

+hange in inventor! valuation method. The possible reasons for an increase in the number of da!s$ sales in receivable include the following& • +hange in credit terms. • 3ecreasing sales. • +hange in the sales mi% of products with different sales terms. • +hange in mi% of customers. • /mproper sales cutoff. • Fnrecorded sales. • apping. • #lower collections caused b! tighter economic conditions or lowering of the ualit! of the receivables. •

2.

19-"2. (Astimated time - 2 minutes) a.

eportable conditions are matters that come to an auditor$s attention, which, in the auditor$s 'udgment, should be communicated to the client$s audit committee or its euivalent because the! represent significant deficiencies in the design or operation of the internal control structure, which could adversel! affect the organiation$s abilit! to record, process, summarie, and report financial data consistent with the assertions of management in the financial statements. *aterial weaknesses are reportable conditions in which the design or operation of specific internal control structure elements do not reduce, to a relativel! low level, the risk that errors or irregularities in amounts that would be material in relation to the financial statements being audited ma! occur and not be detected within a timel! period b! emplo!ees in the normal course of performing their assigned functions.

 b.

n auditor is reuired to identif! reportable conditions that come to the auditor$s attention in the normal course of an audit, but is not obligated to search for reportable conditions. The auditor uses 'udgment as to which matters are reportable conditions. >rovided the audit committee has acknowledged its understanding and consideration of such deficiencies and the associated risks, the auditor ma! decide certain matters do not need to be reported unless, because of changes in management or the audit committee, or because of the passage of time, it is appropriate to do so. +onditions noted b! the auditor that are considered reportable should be reported,  preferabl! in writing. /f information is communicated orall!, the auditor should document the communication. The report should state that the communication is intended solel! for the information and use of the audit committee, management, and others within the organiation. The auditor ma! identif! and communicate separatel! those reportable conditions the auditor considers to be material weaknesses, but ma! not state that no reportable conditions were noted during the audit. eportable conditions ma! be communicated during the course of the audit rather than after the

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19-14

audit is concluded., depending on the relative significance of the matters noted and -the urgenc! of corrective follow-up action. 19-"". (Astimated time - " minutes) a.

e$icienc#

1. 2. ". 0.

/n completing our audit /ts internal control environment 7ot to e%press an opinion The design and effectiveness of the s!stem f internal control Fnder # >otential weaknesses To prepare financial statements in conformit!

4. 6. :.

$s attention through inuiries of officers and ke!  personnel, e%amination of the minutes of the meetings of the board of directors and

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19-1<

stockholders, and reading local newspapers. The details of the item would not have to be disclosed as a separate footnote because all fi%ed assets of the corporation, including the right to the condemnation award, were to be sold as of *arch 1, 19D1. 2.

/t is improbable that the +> would learn the source of the G24, unless it were revealed in a discussion with the president or his personal accountant, or unless the auditor prepared the president$s personal income ta% return, in which case the interest charges would have led to his investigation of the use to which the funds were put. #etting out the loan in the balance sheet as a loan from an officer would be sufficient disclosure. The source from which the officer obtained the funds would not be disclosed because it is the officer$s personal business and has no effect upon the corporation$s financial statements. /ndeed, disclosure of the funds$ source might be construed as detrimental to the officer.

".

The additional liabilit! for the ore shipment would have been revealed b! +>$s scanning of anuar! transactions. The +>$s regular e%amination of 19D@ transactions and related documents such as purchase contracts would have caused him or her to note the item for subseuent follow-up to determine the final liabilit!. /n addition, the client$s letter of representation might have mentioned the potential liabilit!. The item would not reuire separate disclosure b! footnote or otherwise and would be handled b! ad'usting the financial statement accounts pa!able b! the amount of the additional charge, G9,60

0.

The +> might learn of the agreement to purchase the treasurer$s stock ownership through inuiries of management and legal counsel, e%amination of the minutes of the meetings of the board of directors and stockholders, and subseuent reading of the agreement. The absence of the treasurer might also arouse the +>$s curiosit!. The details of the agreement would be disclosed in a footnote because the use of compan! cash for the repurchase of stock and the change in the amount of stock held  b! stockholders might have a heav! impact on subseuent !ears$ financial statements. Fsuall! a management change, such as the treasurer$s resignation, does not reuire disclosure in the financial statements. The details underl!ing the separation (personal disagreements and divorce) should not be disclosed because the! are personal matters.

4.

Through inuiries of management, review of financial statements for anuar!, scanning of transactions, and observations, the +> would learn of the reduced sales and of the strike. 3isclosure would not be made in the financial statements of these conditions because such disclosure might create doubt as to the reasons therefore and misleading inference might be drawn.

6.

The contract with *ammoth /ndustries would come to the +>$s attention through inuiries of management and legal counsel, reading the minutes of the meetings of the board of directors and stockholders, and e%amination of the contract. ll important details of the contract should be disclosed in a footnote because of the

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19-19

great effect upon the corporation$s future. The factors contributing to the entr! into the contract need not be disclosed in the statementsC while the! might be of interest to readers, the! are b! no means essential to make the statements not misleading. 19-"