Chapter 24 Completing the Audit

Review Questions There are four presentation and disclosure-related audit objectives:

24-1

PRESENTAT !N AN" " SC#!S$RE-RE#ATE" A$" T !%&ECT 'ES Occurrence and rights and obligations Completeness Accuracy and valuation Classification and understandability

"ESCR PT !N Account-related information as described in the footnotes exists and represents the rights and obligations of the company. All required disclosures are included in the financial statement footnotes. ootnote disclosures are accurate and valued correctly. Account balances are appropriately classified and related financial statement disclosures are understandable.

24-2 A financial statement disclosure chec!list is an audit tool that summari"es all disclosure requirements contained in generally accepted accounting principles. Auditors use the disclosure chec!list to determine that all required disclosures are completely presented and disclosed in the financial statements and accompanying footnotes. This helps the auditor obtain sufficient appropriate evidence about the completeness objective for the presentation and disclosure-related audit objective. 24-( A contingent liability is a potential future obligation to an outside party for an un!no#n amount resulting from activities that have already ta!en place. $ome examples #ould be:

%ending litigation &ncome tax disputes %roduct #arranties 'otes receivable discounted (uarantees of obligations of others )nused balances of outstanding letters of credit

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24-( )*ontinued+ An actual liability is a real future obligation to an outside party for a !no#n amount from activities that have already ta!en place. $ome examples #ould be:

'otes payable Accounts payable Accrued interest payable &ncome taxes payable %ayroll #ithholding liabilities Accrued salaries and #ages

24-4 &f you are concerned about the possibility of contingent liabilities for income tax disputes- there are various procedures you could use for an intensive investigation in that area. One good approach #ould be an analysis of income tax expense. )nusual or nonrecurring amounts should be investigated further to determine if they represent situations of potential tax liability. Another helpful procedure for uncovering potential tax liabilities is to revie# the general correspondence file for communication #ith attorneys or internal revenue agents. This might give an indication that the potential for a liability exists even though no actual litigation has begun. inally- an examination of internal revenue agent reports from prior years may provide the most obvious indication of disputed tax matters. 24-, The auditor #ould be interested in a client.s future commitments to purchase ra# materials at a fixed price so that this information could be disclosed in the financial statements. The commitment may be of interest to an investor as it is compared to the future price movements of the material. A future commitment to purchase ra# materials at a fixed price may result in the client paying more or less than the mar!et price at a future time. 24-The analysis of legal expense is an essential part of every audit engagement because it may give an indication of contingent liabilities #hich may become actual liabilities in the future and require disclosure in the current financial statements. $ince any single contingency could be material- it is important to verify all legal transactions- even if the amounts are small. After the analysis of legal expense is completed- the attorneys to #hom payment #as made should be considered for letters of confirmation for contingencies /attorney letters0. 24-. %yson should determine the materiality of the la#suits by requesting from 1errill.s attorneys an assessment of the legal situations and the probable liabilities involved. &n addition- %yson may have his o#n attorney assess the situations. %roper disclosure in the financial statements #ill depend on the attorneys. evaluations of the probable liabilities involved. &f the evaluations indicate highly probable- material amounts- disclosure #ill be necessary in the form of a footnote- assuming the amount of the probable material loss cannot be reasonably estimated. &f the client refuses to ma!e adequate disclosure of the *+-*

contingencies- a qualified or adverse opinion may be necessary.

*+-2

24-/ An asserted claim is an existing legal action that has been ta!en against the client- #hereas an unasserted claim represents a potential legal action. The client.s attorney may not reveal an unasserted claim for fear that the disclosure of this information may precipitate a la#suit that #ould be damaging to the clientand that #ould other#ise not be filed. 24-0 &f an attorney refuses to provide the auditor #ith information about material existing la#suits or li!ely material unasserted claims- the audit opinion #ould have to be modified to reflect the lac! of available evidence. This is required by A) 223- and has the effect of requiring management to give its attorneys permission to provide contingent liability information to auditors and to encourage attorneys to cooperate #ith auditors in obtaining information about contingencies. 24-11 The first type of subsequent event is one that has a direct effect on the financial statements and requires adjustment. 4xamples of this type of subsequent event are as follo#s:

5eclaration of ban!ruptcy by a customer #ith an outstanding accounts receivable balance due to the deteriorating financial condition $ettlement of a litigation for an amount different from the amount recorded on the boo!s 5isposal of equipment not being used in operations at a price belo# the current boo! value $ale of investments at a price belo# recorded cost $ale of ra# material as scrap in the period subsequent to the balance sheet date

The second type of subsequent event is one that has no direct effect on the financial statements but for #hich disclosure is advisable. 4xamples include the follo#ing:

5ecline in the mar!et value of securities held for temporary investment or resale &ssuance of bonds or equity securities 5ecline in the mar!et value of inventory as a consequence of government action barring further sale of a product )ninsured loss of inventories as a result of fire

24-11 1alano.s approach does not ta!e into consideration the need to obtain letters from attorneys as near the end of field #or! as possible. &f the letters are received near the balance sheet date- the period from the balance sheet to the end of the auditor.s field #or! #ill not be included in the attorneys. letters. 6is procedure #ould not obtain the most current information regarding contingent liabilities- and #ould not provide adequate information for disclosure of pertinent subsequent events.

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24-12 The major considerations the auditor should ta!e into account in determining ho# extensive the subsequent events revie# should be are:

The company.s financial strength and stability of earnings The effectiveness of the company.s internal controls The number and significance of the adjustments made by the auditor The length of time bet#een the balance sheet date and the completion of the audit Changes in !ey personnel

Auditors of public companies should be a#are that %CAO7 $tandard 8 requires them to also inquire about changes in internal control over financial reporting occurring subsequent to the end of the fiscal period that might significantly affect internal control over financial reporting. 24-1( Audit procedures normally performed as a part of the revie# for subsequent events are:

Cutoff and valuation tests of various balances and related transactions9 e.g.- sales cutoff tests &nquire of management Correspond #ith attorneys :evie# internal statements prepared subsequent to the balance sheet date :evie# records prepared subsequent to the balance sheet date 4xamine minutes of meetings of board of directors and stoc!holders subsequent to the balance sheet date Obtain a letter of representation

24-14 $ubsequent events occurring bet#een the balance sheet date and the date of the auditor.s report are those transactions and events #hich might affect the financial statements being audited /either adjustment- disclosure- or both0. 4xamples of these types of events #ould be:

5eclaration of ban!ruptcy by a customer #ith an outstanding accounts receivable balance due because of a deteriorating financial condition $ettlement of a litigation for an amount different from the amount recorded on the boo!s 5isposal of equipment not being used in operations at a price belo# the current boo! value $ale of investments at a price belo# recorded cost $ale of ra# material as scrap in the period subsequent to the balance sheet date 5ecline in the mar!et value of securities held for temporary investment or resale

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24-14 )*ontinued+

&ssuance of bonds or equity securities 5ecline in the mar!et value of inventory as a consequence of government action barring further sale of a product )ninsured loss of inventories as a result of fire

&f these events and transactions have a material effect on the financial statements- they may require adjustment of the current period financial statements or disclosure. Auditors of public companies should also be alert for subsequent changes in internal control over financial reporting. The subsequent discovery of facts existing at the date of the auditor.s report occurs #hen the auditor becomes a#are that some information included in the financial statements #as materially misleading after the audited financial statements have been issued. $ome examples of such facts #ould be:

$ubsequent discovery of the inclusion of fraudulent sales $ubsequent discovery of the failure to #rite-off obsolete inventory Omission of an essential footnote

&n such cases #hen the auditor discovers the statements to be misleading- he or she should request the client to issue a revised set of financial statements as soon as possible containing a ne# audit report and an explanation of the reasons for the revisions to the financial statements. 24-1, The #ea!ness in ;a#son.s approach is the danger of discovering an inadequacy in one audit area #hich could affect other areas of the audit. or example- if misstatements #ere discovered as part of the tests of controls for sales- the initial plans for the tests of details of balances for accounts receivable may have been insufficient and should have been revised. $imilarly- the audit of fixed assets is related to the contracts and notes payable #henever fixed assets are used as collateral. Another difficulty #ith ;a#son.s approach is that there is no combining of the misstatements in different audit areas to determine if the combined misstatements are material. &f the combined misstatements are considered material- it may be necessary to expand the testing in certain areas or require adjusting entries to some balances. 24-1- The accumulation of audit evidence is crucial to the auditor in determining #hether the financial statements are stated in accordance #ith generally accepted accounting principles- applied on a basis consistent #ith the preceding year. The evaluation of the adequacy of the disclosures in financial statements is made to determine that the account balances on the trial balance are properly aggregated and disclosed on the financial statements.

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24-1- )*ontinued+ 4xamples #here adequate disclosure could depend heavily upon the accumulation of evidence are:

The disclosure of declines in inventory values belo# cost The segregation of current from noncurrent receivables The segregation of trade accounts receivable from amounts due from affiliates The disclosure of contingent liabilities that the auditor has not been informed of by the client

4xamples #here audit evidence does not normally significantly affect the adequacy of the disclosure are:

5eciding #hether a disposal of equipment should be recorded as an extraordinary item The disclosure of an acquisition made subsequent to year end The disclosure of contingencies that the auditor #as informed of by the client

24-1. A letter of representation is a #ritten communication from the client to the auditor #hich formali"es statements that the client has made about matters pertinent to the audit. Auditing standards /A) 2220 suggest four categories of items that should be included in the letter. 7elo# are those four items #ith examples in each category follo# /refer students to A) 222 for a comprehensive list0: ,. Financial statements 1anagement.s ac!no#ledgment of its responsibility for the fair presentation in the financial statements of financial position- results of operations- and cash flo#s in conformity #ith generally accepted accounting principles 1anagement=s belief that the financial statements are fairly presented in conformity #ith generally accepted accounting principles *. Completeness of information Availability of all financial records and related data Completeness and availability of all minutes or meetings of stoc!holders- directors- and committees of directors Absence of unrecorded transactions

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24-1. )*ontinued+ 2. Recognition, measurement, and disclosure 1anagement=s belief that the effects of any uncorrected financial statement misstatements are immaterial to the financial statements &nformation concerning fraud involving /,0 management- /*0 employees #ho have significant roles in internal control- or /20 others #here the fraud could have a material effect on the financial statements &nformation concerning related party transactions and amounts receivable from or payable to related parties )nasserted claims or assessments that the entity=s la#yer has advised are probable of assertion and must be disclosed in accordance #ith inancial Accounting $tandards 7oard / A$70 $tatement 'o. 8- Accounting for Contingencies $atisfactory title to assets- liens or encumbrances on assetsand assets pledged as collateral Compliance #ith aspects of contractual agreements that may affect the financial statements Subsequent events 7an!ruptcy of a major customer #ith an outstanding account receivable at the balance sheet date A merger or acquisition after the balance sheet date

+.

or audits of public companies- %CAO7 $tandard 8 requires the auditor to obtain specific representations from management about internal control over financial reporting. $ome of those representations are noted belo#: 8. Internal controls 1anagement=s ac!no#ledgement of its responsibility for establishing and maintaining effective internal controls over financial reporting. 1anagement=s conclusion about the effectiveness of internal control over financial reporting as of the end of the fiscal period. 5isclosure to the auditor of all deficiencies in the design or operation of internal control over financial reporting identified as part of management=s assessment- including separate disclosure of significant deficiencies and material #ea!nesses. 1anagement=s !no#ledge of any material fraud or other fraud involving senior management or other employees #ho have a significant role in the company=s internal control over financial reporting. Auditors of public companies may obtain a combined representation letter for both the audit of the financial statements and the audit of internal control over financial reporting. *+->

24-1. )*ontinued+ A management letter is a letter directed to the client to inform management of certain recommendations about the business #hich the C%A believes #ould be beneficial to the client. &tems that might be included in a management letter are:

:ecommendation to s#itch inventory valuation methods :ecommendation to install a formal security system :ecommendation to prepare more timely ban! reconciliations :ecommendation to segregate duties :ecommendation to have certain types of transactions authori"ed by specific individuals

24-1/ &nformation accompanying basic financial statements is any and all information prepared for management or outside users included #ith the basic financial statements. 4xamples include detailed comparative statements supporting control totals in the basic statements- supplementary information required by the $4C- statistical data such as ratios and trends- and specific comments on the changes that have ta!en place in the financial statements. The auditor can provide one of t#o levels of assurance for information accompanying basic financial statements. The auditor may issue a positive opinion indicating a high level of assurance- or a disclaimer indicating no assurance. 24-10 Auditing standards /A) 88?0 require the auditor to read information in annual reports containing audited financial statements for consistency #ith the financial statements and the auditor.s report. Types of information the auditor examines include statements about financial condition in the president.s letter and displays and summaries of statistical financial information. 24-21 A regular audit documentation revie# is the one that is done by someone #ho is !no#ledgeable about the client and the unique circumstances in the audit. The purposes of this revie# are to:

4valuate the performance of inexperienced personnel To ma!e sure that the audit meets the C%A firm.s standard of performance To counteract the bias that frequently enters into the auditor.s judgment. potential findings in a regular audit

4xamples of important documentation revie# are:

&ncorrect computations &nadequate scope ;ac! of proper documentation for audit decisions *+-@

24-21 )*ontinued+ An independent revie# is one done by a completely independent person #ho has no experience on the engagement. The purpose is to have a competent professional from #ithin the firm #ho has not been biased by the ongoing relationship bet#een the regular auditors and the client perform an independent revie#. 4xamples of important potential findings in an independent revie# are:

A number of small adjustments #aived that should have been accumulated into an adjusting journal entry due to materiality Too narro# and too biased of a scope in an audit area &nadequate disclosure of contingencies

24-21 &n addition to the required communications to those charged #ith governance required by auditing standards- the $arbanes-Oxley Act expands these communications requirements by also requiring public company auditors to timely report the follo#ing items to the audit committee:

All critical accounting policies and practices to be used. All alternative treatments of financial information #ithin generally accepted accounting principles that have been discussed #ith management- ramifications of the use of such alternative disclosures and treatments- and the treatment preferred by the auditor. Other material #ritten communications bet#een the auditor and management- such as any management letter or schedule of unadjusted differences.

As the audit of the public company is completed- the auditor should determine that the audit committee is informed about the initial selection of and changes in significant accounting policies or their application during the current audit period. Ahen changes have occurred- the auditor should inform the committee of the reasons for the change. The auditor should also communicate information about methods used to account for significant unusual transactions and the effect of significant accounting policies in controversial or emerging areas.

2ultiple Choi*e Questions 3rom CPA E4amination a. a. a. a. /*0 /+0 /20 /+0 b. b. b. b. /20 /*0 /+0 /20 c. c. c. c. /,0 /+0 /,0 /*0

24-22 24-2( 24-24 24-2,

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"is*ussion Questions And Pro5lems a. A contingent liability is a potential future obligation to an outside party for an un!no#n amount arising from activities that have already ta!en place. A commitment is an agreement to commit the entity to a set of fixed conditions in the future- regardless of #hat happens to profits or the economy as a #hole. Bno#ledge of both contingencies and commitments is extremely important to users of financial statements because they represent the encumbrance of potentially material amounts of resources during future periods- and thus affect the future cash flo#s available to creditors and investors. 7ecause of this- generally accepted accounting principles require that material contingencies and commitments be disclosed. The auditor has an obligation to discover the existence of such items to determine that they are properly disclosed in order to have complied #ith auditing standards. Cohnson=s tests of controls and substantive tests of transactions related to payments of notes payable and related interest expense #ould provide her information about scheduled debt payments and related interest rate terms- #hich are required footnote disclosure related items. $imilarly- substantive tests of transactions #ould reveal additions and retirements of notes payable- #hich both affect notes payable disclosures. Tests of details of balances- such as notes payable confirmations- #ould provide sufficient appropriate evidence about the existence of ending balances and related notes payable terms- such as interest rates and required collateral. Three useful audit procedures for uncovering contingencies that Cohnson #ould li!ely perform in the normal conduct of the audit- even if she had no responsibility for uncovering contingencies- are:

24-2-

b.

c.

:evie# internal revenue agent reports of income tax settlements :evie# minutes of meetings of board of directors and stoc!holders Confirm used and unused balances of lines of credit

d.

Three other procedures Cohnson is li!ely to perform specifically for the purpose of identifying undisclosed contingencies are:

1a!e inquiries of management Analy"e legal expenses for indication of contingent liabilities :equest letters from attorneys regarding the existence and status of litigation and other potential contingent liabilities

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24-2.

a.

A contingent liability is a potential future obligation to an outside party for an un!no#n amount resulting from activities that have already ta!en place. The most important characteristic of a contingent liability is the uncertainty of the amount9 if the amount #ere !no#n it #ould be included in the financial statements as an actual liability rather than as a contingency. Audit procedures to learn about these items #ould be as follo#s: The follo#ing procedures apply to all three items:

b.

5iscuss the existence and nature of possible contingent liabilities #ith management and obtain appropriate #ritten representations. :evie# the minutes of directors. and stoc!holders. meetings for indication of la#suits or other contingencies. Analy"e legal expense for the period under audit and revie# invoices and statements of legal counsel for indications of contingent liabilities. Obtain letters from all major attorneys performing legal services for the client as to the status of pending litigation or other contingent liabilities.

The follo#ing are additional procedures for individual items: Lawsuit Judgment no additional procedures9 see above list of procedures applicable to all three items. Stock dividend Confirm details of stoc! transactions #ith registrar and transfer agent. :evie# records for unusual journal entries subsequent to year-end. uarantee of interest pa!ments 5iscussspecificallyany related party transactions #ith management and include information in letter of representation. :evie# financial statements of affiliate- and #here related party transactions are apparent- ma!e direct inquiries of affiliate management- and perhaps even examine records of affiliate if necessary.

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24-2. )*ontinued+ c. 'ature of adjusting entries or disclosure- if any- #ould be as follo#s: ,. The la#suit should be described in a footnote to the balance sheet. &n vie# of the court decision- retained earnings may be restricted for D+-???-???- the amount of the first court decision. Also- in vie# of the court decision any reasonable estimate of the amount the company expects to pay as a result of the suit might be used in lieu of the D+-???-???. A current liability #ill be set up as soon as a final decision is rendered or if an agreement as to damages is reached. &f liability is admitted to by 1arco- and only the amount is in dispute- a liability can be set up for the amount admitted to by the company #ith a corresponding charge to expense or sho#n as an extraordinary item if the amount is material. The declaration of such a dividend does not create a liability that affects the aggregate net #orth in any #ay. The distribution of the dividend #ill cause a reduction in retained earnings and an increase in capital stoc!. 'o entry is necessary- but an indication of the action ta!en- and that such a transfer #ill subsequently be made- should be sho#n as a footnote or as a memorandum to :etained 4arnings and Common $toc! in the balance sheet. &f payment by 'e#art is uncertain- the D,23-8?? interest liability for the period Cune * through 5ecember ,- *??@could be reflected in the 1arco Corporation.s accounting records by the follo#ing entry:
&nterest %ayments for 'e#art Company D,23-8?? Accrued &nterest %ayable E 'e#art 7onds D,23-8??

*.

2.

The debit entry should be included as other assets. Collection is uncertain and the 1arco Corporation may not have a right against the 'e#art Company until all interest payments have been met and the bonds retired. &f this treatment is follo#ed- the balance sheet should be footnoted to the effect that the 1arco Corporation is contingently liable for future interest payments on 'e#art Company bonds in the amount of D*-*??-???. &f the interest has been paid by the time the audit is completed- or if for other reasons it seems certain that the payment #ill be made by 'e#art on Canuary ,8- no entry should be made by 1arco. &n this circumstance a footnote disclosing the contingent liability of D*-223-8?? and the facts as to the D,23-8?? should be included #ith the statements.

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24-2/

a.

b. c. d.

e.

f.

g.

2 F Amount should have been determined to be uncollectible before end of field #or!- but it #as discovered after the issuance of the statements. The financial statements should have been !no#n to be misstated on >-,@-?@. + F The amount appeared collectable at the end of the field #or!. , F The uncollectible amount #as determined before end of field #or!. * F The cause of the ban!ruptcy too! place after the balance sheet date- therefore the balance sheet #as fairly stated at <-2??@. 1ost auditors #ould probably require that the account be #ritten off as uncollectible at <-2?-?@- but they are not required to do so. ootnote disclosure is necessary because the subsequent event is material. * F The sale too! place after the balance sheet date but- since the loss #as material and #ill affect future profits- footnote disclosure is necessary. , F The settlement should be reflected in the <-2?-?@ financial statement as an adjustment of current period income and not a prior period adjustment. + F The financial statements #ere believed to be fairly stated on <-2?-?@ and >-,@-?@. * F The cause of the la#suit occurred before the balance sheet date and the la#suit should be included in the <-2?-?@ footnotes. 'ote: &f the loss is both probable and can be reasonably estimatedthen ans#er , is correct - adjust the <-2?-?@ financial statements for the amount of the expected loss. * F The la#suit originated in the current year- but the amount of the loss is un!no#n. The practice of revie#ing the audit files of subordinates on a continuing basis rather than #hen the audit is completed is a good one because it enables the auditor to refine the audit approach based on the information provided from the audit files that are revie#ed. &n addition- since many areas of the audit relate to each other- revie#ing the audit files on a continuing basis gives the auditor a more integrated picture of the company.s operations. &t is also an excellent practice from a supervisory point of vie#. &t is acceptable for Adams to prepare the financial statements provided he obtained sufficient and appropriate audit evidence to #arrant their fair presentation. This is a common practice on many audits because the C%A has greater expertise in financial statement presentation than the client. 7y not having a revie# of the audit documentation by another partner in the firm- there is no chec! against any bias and *+-,+

h.

i. 24-20 a.

b.

c.

unintentional error that may exist on the part of the auditor. An independent revie# is essential in this case.

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24-(1

a.

&t is desirable to have a letter of representation in spite of the accumulated audit evidence to impress upon management its responsibility for the representations in the financial statements and to formally document the responses from the client to auditor inquiries about various aspects of the audit. The letter of representation is not very useful as audit evidence since it is a #ritten statement from a nonindependent source. &n effect- the client being audited ma!es certain representations related to the audit of itself. $everal categories of information commonly included in a letter of representation #ith examples in each category follo# /$ee A) 222 for a complete list0: ,. Financial statements 1anagement.s ac!no#ledgment of its responsibility for the fair presentation in the financial statements of financial position- results of operations- and cash flo#s in conformity #ith generally accepted accounting principles 1anagement=s belief that the financial statements are fairly presented in conformity #ith generally accepted accounting principles Completeness of information Availability of all financial records and related data Completeness and availability of all minutes or meetings of stoc!holders- directors- and committees of directors Absence of unrecorded transactions Recognition, measurement, and disclosure 1anagement=s belief that the effects of any uncorrected financial statement misstatements are immaterial to the financial statements &nformation concerning fraud involving /,0 management- /*0 employees #ho have significant roles in internal control- or /20 others #here the fraud could have a material effect on the financial statements &nformation concerning related party transactions and amounts receivable from or payable to related parties )nasserted claims or assessments that the entity=s la#yer has advised are probable of assertion and must be disclosed in accordance #ith inancial Accounting $tandards 7oard / A$70 $tatement 'o. 8- Accounting for Contingencies $atisfactory title to assets- liens or encumbrances on assets- and assets pledged as collateral Compliance #ith aspects of contractual agreements *+-,<

b.

c.

*.

2.

that may affect the financial statements

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24-(1 )*ontinued+ +. Subsequent events 7an!ruptcy of a major customer #ith an outstanding account receivable at the balance sheet date A merger or acquisition after the balance sheet date

or audits of public companies- %CAO7 $tandard 8 requires the auditor to obtain specific representations from management about internal control over financial reporting. $ome of those representations are noted belo#: 8. Internal controls 1anagement=s ac!no#ledgement of its responsibility for establishing and maintaining effective internal controls over financial reporting. 1anagement=s conclusion about the effectiveness of internal control over financial reporting as of the end of the fiscal period. 5isclosure to the auditor of all deficiencies in the design or operation of internal control over financial reporting identified as part of management=s assessment- including separate disclosure of significant deficiencies and material #ea!nesses. 1anagement=s !no#ledge of any material fraud or other fraud involving senior management or other employees #ho have a significant role in the company=s internal control over financial reporting. Auditors of public companies may obtain a combined representation letter for both the audit of the financial statements and the audit of internal control. 24-(1 a. $ch#art".s legal and professional responsibility in the issuance of management letters is only to ma!e sound recommendations based on his professional interpretation of the audit evidence accumulated and to not omit information of serious systems deficiencies. 6e must follo# due care in management letters and management services in the same manner as is required for audits. 1ajor considerations that #ill determine #hether $ch#art" is liable in this situation are #hether the client installed the system according to $ch#art".s instructions or #hether they deviated from his instructions and #hether they could have foreseen the possibility of the erased master file based on their understanding of the system. Another major consideration is the degree to #hich $ch#art" follo#ed due care considering the needs of the client and the competence of existing employees of Cline Aholesale Co.

b.

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24-(2

,.

A retroactive pay increase could be uncovered by reading the minutes of the board of directors. or stoc!holders. meetingsexamining contracts- holding discussions #ith managementreading the local ne#spaper- and analy"ing internal financial statements prepared subsequent to the balance sheet date. (ranting of a retroactive pay increase is li!ely to create a liability at the balance sheet date for the earned but unpaid #ages in the year under audit. A liability clearly exists if a union contract #as under negotiation at the balance sheet date but not settled until later. &f the retroactive pay increase #as unexpected at the balance sheet date- the expense could be related to the date of the settlement- but even then- most auditors #ould require that retroactive #ages be accrued at the balance sheet date. The liability and related expense that should be accrued at the balance sheet date is the amount of unpaid #ages existing at the balance sheet date assuming the pay increase is accrued. 'o mention in the audit report is necessary. The declaration of a stoc! dividend subsequent to the balance sheet date could be uncovered by reading the minutes of the board of directors or stoc!holders subsequent to the balance sheet dateby confirmation #ith the independent stoc! registrar- or through discussion #ith management. The stoc! dividend should be disclosed in a footnoteincluding the date of declaration- the percent of the stoc! dividendand the effect on issued shares- capital stoc!- paid-in capital and retained earnings. 'o audit report modification is necessary. The sale of a major fixed asset at a substantial profit could be uncovered by revie#ing minutes of the board of directorsrevie#ing correspondence files- revie#ing cash receipts records of the subsequent period- or through discussions #ith management. The sale should be disclosed in a footnote- and the explanation should include the amount of the gain and the effect- if any- on future operations of the company. 'o audit report modification is necessary. An additional tax assessment could be uncovered by examining subsequent cash disbursements- revie# of the minutes of the board of directors or stoc!holders- examining internal revenue agent reports for all expenses not cleared by the &nternal :evenue $ervice- requesting letters from attorneys near the end of the field #or!- and through discussions #ith management. The tax assessment should be accrued as a tax expense and a liability for the year under audit and clearly disclosed if the amount is material. &f the tax assessment is accrued and adequately disclosed- no audit report modification is necessary. The antitrust suit may have been uncovered through inquiries of the client- the client representation letter- or letters from client.s legal *+-,@

*.

2.

+.

8.

counsel. The antitrust suit should be disclosed in a footnote.

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24-((

a.

&tems ,- *- 8- and < are li!ely to be subsequent events. &tems 2The purchase of equipment occurred after the balance sheet but does not affect the valuation of the current year financial statements and is not li!ely to be sufficiently material to #arrant disclosure. &tem + occurred before the balance sheet and is therefore not a subsequent event. &tem 3 does not #arrant disclosure because the client has merely engaged in a discussion. All seven items can be found by inquires of and discussions #ith management. &tem , :evie# of the sales journal subsequent to the balance sheet- obtain a letter of representation- and examine sales transactions for larger sales. &tem * :evie# subsequent period minutes of the board of directors- obtain a letter of representation and examine transactions in the cash receipts journal after year-end. &tem 2 :evie# of the acquisitions journal subsequent to the balance sheet and examine acquisitions transactions for larger purchases. &tem + :evie# current period minutes of the board of directors and discussions #ith the credit manager. &tem 8 :evie# subsequent period minutes of the board of directors- obtain a letter of representation- and examine transaction in the cash disbursements journal after yearend. &tem < :evie# subsequent period minutes of the board of directors- obtain a letter of representation- and correspond #ith attorneys. &tem 3 :evie# subsequent period minutes of the board of directors before and after the balance sheet date- obtain a letter of representation and read the local ne#spaper.

b.

c.

&tem , &tem * &tem 2 &tem + &tem 8 &tem < &tem 3

Adjust the current year financial statements. &nclude a footnote in the current year financial statements. 'o action needed Adjust the current year financial statements. Adjust the current year financial statements. &nclude a footnote in the current year financial statements. 'o action needed

24-(4

a.

&n this situation- ;ittle need only send requests for letters to those attorneys #ho are involved #ith legal matters directly affecting the financial statements. The letters should be sent reasonably near to the completion of the field #or!- but the follo#up on nonresponses and unsatisfactory responses should not be deferred until the last day of field #or!. $he should have examined the letters #hen they #ere returned and performed follo#-up #or! at that time. urthermore- the third letter should have addressed the la#suit if the client informed the auditor of its existence. *+-*,

24-(4 )*ontinued+ b. The auditor #ould be required to follo# up on the first attorney.s letter by sending a second request or calling the attorney to solicit a response. The second letter #ould not require any additional follo#-up due to the nature of the #or! performed by this attorney. :egarding the third attorney.s letter- it is necessary to have a conference #ith the attorney- client- and auditor to determine the nature and significance of the la#suit. &t #ould be a serious violation of due care to ignore the information in the third attorney.s letter. &n rare circumstances- a disclaimer of opinion is necessary if the information cannot be obtained. A typical additional information report includes the financial statements associated #ith a short-form report plus additional information li!ely to be useful to management and other statement users. The statements included #ith short form audit reports are defined by the profession- but the additional information included in additional information reports varies considerably. The purpose of additional information reports is to provide management and other users information that is useful for their decision ma!ing that has not been included in the basic financial statements. &t #ould be appropriate to include all of the items as additional information except the follo#ing: *. The adequacy of insurance coverage. The auditor is not an insurance professional- and any comments about the insurance coverage should be factual. or example- it #ould be appropriate to state that the insurance coverage is less than the recorded boo! value. Adequacy of the allo#ance for uncollectible accounts. Comments that an account balance is correctly stated are inappropriate. The auditor has already issued an auditor.s opinion on the statements as a #hole. &f an opinion on a specific account balance is desired- it should be done in accordance #ith a special report. 1aterial #ea!nesses in internal control. These should be identified and communicated to management as a part of the auditor=s internal control deficiencies letter to those charged #ith governance /e.g.- the audit committee0.

24-(,

a.

b.

c.

2.

8.

*+-**

24-(, )*ontinued+ d. The follo#ing could also be included as additional information:

5etailed brea!do#n of sales and expenses by month 5etailed financial statements ma!ing up cost of goods soldselling and administrative expenses A detailed brea!do#n of inventory

e.

The follo#ing #ould be added to the standard audit report: "ur audit was made for t#e purpose of forming an opinion on t#e basic financial statements taken as a w#ole$ %#e accompan!ing information on pages & t#roug# ! is presented for purposes of additional anal!sis and is not a required part of t#e basic financial statements$ Suc# information #as not been sub'ected to t#e auditing procedures applied in t#e audit of t#e basic financial statements, and, accordingl!, we e&press no opinion on it$

Case a. b. $ee the G$ummary of %ossible AdjustmentsG on page *+-*, that follo#s. Aviary.s management may refuse to ma!e some or all of the proposed adjustments because all of the adjustments except /+0 reduce net income. 1anagement #ill most li!ely be reluctant to ma!e any adjustments that #ill ma!e the company loo! less profitable. Aviary.s management may also refuse to ma!e some or all of the proposed entries because they do not #ant to admit that their records contain misstatements. As indicated on the G$ummary of %ossible AdjustmentsH on page *+-*,- you should attempt to have Aviary.s management record all of the potential adjustments found. 6o#ever- at a minimum- entries /80 and /<0 should be recorded. One positive #ay for you to convince Aviary.s management to ma!e these entries #ould be to stress that /,0 considerable judgment is required to determine the allo#ances for inventory obsolescence and doubtful accounts and /*0 it is not uncommon for auditors to assist clients in adjusting these accounts. This may help minimi"e management.s reluctance to admit ma!ing a mista!e.

24-(-

c.

*+-*2

24-(- )*ontinued+ Iou should also stress that it #ould be #ise to adjust the allo#ance accounts in a year #ith substantial net income. The allo#ance accounts #ill most li!ely increase in future yearsespecially if entries /80 and /<0 are not made in the current year. $ince management cannot be sure that the company #ill generate substantial net income in future years- it #ould be best to adjust the allo#ance accounts in the current year and avoid a substantial reduction to net income in a future year that is not as profitable as the current year. d. Iour responsibility related to unadjusted misstatements that management has determined are immaterial individually and in the aggregate is to determine for !ourself #hether the combined effect of these unadjusted misstatements are material for the audit. The combined effect of the unadjusted misstatements must be compared to overall materiality. Assuming that the remaining unadjusted misstatements are #ell belo# your materiality threshold- you do not need to qualify your audit opinion. Iou should consider having the client include a summary of this audit schedule in the management representation letter- along #ith management=s representation that the uncorrected misstatements are immaterial. e. Auditors of public companies must evaluate the noted adjustments to determine their impact on the auditor=s report on internal control over financial reporting. As discussed in Chapter ,?- the audit of the financial statements and the audit of internal control over financial reporting for a public company are to be integrated. %ublic company auditors must consider the results of audit procedures performed to issue the audit report on the financial statements #hen issuing the audit report on internal control. or example- if the possible adjustments identified by Aviary &ndustries= auditor are deemed to be material misstatements that #ere not initially identified by the company=s internal controls- the auditor should consider this as at least a significant deficiency- if not a material #ea!ness for purposes of reporting on internal control. &n this case- the auditor=s report on Aviary=s financial statements #ould be unqualified as long as management corrected the misstatement before issuing the financial statements. 6o#ever- the auditor=s report on internal control over financial reporting #ould include an adverse opinion if the auditor concludes that it is a material #ea!ness.

*+-*+

24-(- )*ontinued+ a. Client 'ame Aviary &ndustries S$22AR6 !3 P!SS %#E A"&$ST2ENTS Iear-ended 5ecember 2,- *??@
Possi5le Ad9ustments - "r )CR+ A7C "r8 A7C Cr8 $ales :KA AL: %urchases AL% $ales AL: Cash AL% ;oss ALC &nventory Allo#. ALC 7ad debt exp. A 5A Total Amount *<-+8, *8-<32 Current Assets /*<-+8,0 /*8-<320 +,->,+ NonCurrent Assets Current #ia5ilities NonCurrent #ia5ilities %eginning E:uit;

"es*ription /,0 )nrecorded credit memosJ /*0 )nrecorded inventory purchases

n*ome *<-+8,

E4penses

*8-<32

*+-*,
J JJ

/20 $ales recorded in #rong period /+0 6eld chec!s /80 Obsolete inventoryJJ /<0 A 5A understatedJJ Totals

+,->,+ +2-<3, ,8-??? 28-???

/+,->,+0 +2-<3, /+2-<3,0

/,8-???0 /28-???0 /3+-8@+0 /<@-2++0 <>-*<8

,8-??? 28-??? 38-<32

Conclusions: The net effect of the above items is as follo#s: Aor!ing capital Total assets: 'et income: D ,+2-@2> decrease D 3+-8@+ decrease D ,+2-@2> decrease

!pinion as to need <or A&E: %reliminary materiality #as D,??-???. 6o#ever- revised materiality based on 8M of actual income before taxes N D,-8?>-@*@ x 8M N D38-++<.+8. :ounded N D38-???. The combined effect of the above proposed entries on net income exceeds revised materiality. %ropose that all entries be recorded. 6o#ever- at a minimum- entries /80 and /<0 should be recorded in order to decrease the effect of the above entries to a level belo# revised materiality of D38-?????. 4ntry /,0 or /*0 may also have to be recorded in order to have some cushion bet#een the net income misstatement and revised materiality after recording entries /80 and /<0.

4ntry assumes that items #ere returned prior to ,*-2,-?@ and counted in inventory at year-end /no CO($Linventory misstatement0. 7ecause entry deals #ith an accounting estimate- the lo#er end of the range #ould be sufficient.

nternet Pro5lem Solution= Audit Committee Responsi5ilities

24-1 Audit committees of public companies have many responsibilities in today=s financial reporting environment. Among those responsibilities are hiring the company=s external audit firm- overseeing the company=s financial reporting processes- meeting #ith management to understand decisions around accounting and auditing matters and so forth. 1icrosoft Corporation has made information about its audit committee available on the company=s #ebsite Ohttp:LL###.microsoft.comLaboutLcompany informationLcorporategovernanceLcommitteesLaudit.mspxP. Qisit the #ebsite and ans#er the follo#ing questions: ,. Ahat are the committee=s responsibilitiesR Answer= According to the company=s #ebsite: SThe Audit Committee of the 7oard of 5irectors assists the 7oard of 5irectors in fulfilling its responsibility for oversight of the quality and integrity of the accounting- auditing- and reporting practices of the Company- and such other duties as directed by the 7oard. The Committee.s purpose is to oversee the accounting and financial reporting processes of the Company- the audits of the Company.s financial statements- the qualifications of the public accounting firm engaged as the Company.s independent auditor to prepare or issue an audit report on the financial statements of the Companyand the performance of the Company.s internal audit function and independent auditor. The Committee revie#s and assesses the qualitative aspects of financial reporting to shareholders- the Company.s processes to manage business and financial ris!- and compliance #ith significant applicable legal- ethical- and regulatory requirements. The Committee is directly responsible for the appointment /subject to shareholder ratification0- compensationretention- and oversight of the independent auditor.H *. 6o# many times does the committee meet on an annual basisR Answer= The committee meets at least eight times a year #ith additional meetings occurring as necessary. 2. Ahat authority does the committee have in carrying out its responsibilitiesR Answer= According to the company=s #ebsite: SThe Committee #ill have the resources and authority necessary to discharge its duties and responsibilities. The Committee has sole authority to retain and terminate outside counsel or other experts or consultants- as it deems *+-*<

*+-*3

nternet Pro5lem 24-1 )*ontinued+ appropriate- including sole authority to approve the firms. fees and other retention terms. The Company #ill provide the Committee #ith appropriate funding- as the Committee determines- for the payment of compensation to the Company.s independent auditoroutside counsel- and other advisors as it deems appropriate- and administrative expenses of the Committee that are necessary or appropriate in carrying out its duties. &n discharging its oversight role- the Committee is empo#ered to investigate any matter brought to its attention. The Committee #ill have access to the Company.s boo!s- records- facilities- and personnel. Any communications bet#een the Committee and legal counsel in the course of obtaining legal advice #ill be considered privileged communications of the Company- and the Committee #ill ta!e all necessary steps to preserve the privileged nature of those communications.H +. 6o# do the required auditor communications to those charged #ith governance help the audit committee fulfill its responsibilitiesR Answer= Auditing standards require the auditor to communicate certain additional information obtained during the audit to those charged #ith governance- #hich is generally the audit committee. The purpose of this required communication is to !eep the audit committee- or others charged #ith governance- informed about significant and relevant information for the oversight of the financial reporting process and to provide an opportunity for the audit committee to communicate important matters to the auditor. Thusthe requirements of auditing standards are designed to encourage t#o-#ay communications bet#een the auditor and those charged #ith governance. There are four principal purposes of this required communication: A. To communicate auditor responsibilities in the audit of financial statements. This communication helps ensure that the audit committee /i0 understands the nature of the assurance provided by audited financial statements and /ii0 comprehends limitations of an audit of financial statements /and audit of internal control financial reporting- if the company is publicly traded0. To overvie# the scope and timing of the audit. The purpose of this required communication is to provide the audit committee a high-level overvie#- such as the auditor=s approach to addressing significant ris!s and consideration of internal control- and timing of the audit. This information

7.

*+-*>

helps

the

audit

committee

*+-*@

nternet Pro5lem 24-1 )*ontinued+ understand !ey ris! areas identified for examination by the auditor- #hich increases audit committee oversight of !ey ris! areas affecting financial reporting and broader business ris! issues. C. To provide those charged #ith governance #ith significant findings arising during the audit. These communications might include discussion of material- corrected misstatements detected during the audit- the auditor=s vie# of qualitative aspects of significant accounting practices and estimatessignificant difficulties encountered during the auditincluding disagreements #ith management- among other matters. One of the major information sources for an audit committee is the external auditor. Thus- !no#ledge about significant findings identified by the auditor is highly relevant to the audit committee in its oversight of financial reporting. To obtain from those charged #ith governance information relevant to the audit. The audit committee or others charged #ith governance- such as the full board of directors- may share strategic decisions that may affect the nature and timing of the auditor=s procedures. These communications #ill be informative to both the auditor and audit committee.

5.

/Note: &nternet problems address current issues using &nternet sources. 7ecause &nternet sites are subject to change- &nternet problems and solutions may change. Current information on &nternet problems is available at ###.pearsonhighered.comLarens.0

*+-2?