Three conditions are required for a contingent liability to exist:
There is a potential future payment to an outside party or the impairment of some other asset that would result from an existing condition.
There is uncertainty about the amount of the future payment or impairment.
The outcome will be resolved by some future event(s).
Note: Page 712 contains examples of possible contingencies.
B. Likelihood of Occurrence and Financial Statement Treatment
If the amount can be reasonably estimated, financial statement accounts are adjusted.
If the amount cannot be reasonably estimated, footnote disclosure is necessary.
Probable (likely to occur) Footnote disclosure is necessary Reasonably possible (more than remote, but less than probable) No disclosure is necessary Remote (slight chance) Financial Statement Treatment Likelihood of Occurrence of Event
In a commitment, the most important characteristic is the agreement to commit the firm to a set of fixed conditions in the future regardless of what happens to profits or the economy as a whole.
All commitments are ordinarily either described together in a separate footnote or combined in the contingencies footnote.
D. Common Audit Procedures for Contingencies
Inquire of client management about unrecorded contingencies.
Review current and prior year revenue agent reports for income tax settlements.
Review of board of director minutes.
Analysis of legal expense and related invoices from legal counsel.
Obtain a letter from client’s legal counsel.
Review of bank confirmations and notes.
E. Inquiry of Client’s Attorney
The standard inquiry to the client’s attorney should include the following:
A list including (1) pending threatened litigation and (2) asserted and unasserted claims with which the attorney as had significant involvement.
A request that the attorney furnish information about the progress of each item listed.
A request for the identification of any unlisted pending or threatened legal actions or a statement that the client’s list is complete.
A statement informing the attorney of their responsibility to inform client management of legal matters requiring disclosure in the financial statements and to respond directly to the auditor.
Note: Page 715 contains an example of the letter.
F. Sarbanes-Oxley and Attorneys
The Sarbanes-Oxley Act directed the SEC to issue rules requiring attorneys to report material violations of the federal securities laws to the chief legal officer, CEO, and possibly the audit committee.
Previously, attorneys only reported crimes when there was a threat of physical harm or death or the release of hazardous materials or defective products.
The American Bar Assoc. has amended the attorney-client confidentiality rules to permit breach of confidentiality for crime and fraud of an audit client.
II. Review for Subsequent Events
Time Period of Auditor Responsibility
Subsequent Events Requiring Adjustment
Subsequent Events Requiring Disclosure
Audit Tests for Subsequent Events
Dual Dating for Subsequent Events
A. Time Period of Auditor Responsibility
The auditor’s responsibility for reviewing subsequent events is normally limited to the period beginning with the balance sheet date and ending with the date of the auditor’s report.
Client’s ending balance sheet date Audit report date Date client issues financial statements Period to which review for subsequent events applies Period for processing the financial statements 12-31-02 3-11-03 3-26-03
B. Subsequent Events Requiring Adjustment
Subsequent events require financial statement adjustment if they provide additional information regarding conditions that:
Existed at the balance sheet date, and
Affect the fair presentation of account balances.
C. Subsequent Events Requiring Disclosure
Subsequent events of this type provide evidence of conditions that did not exist at the balance sheet date, but are so significant that they require disclosure. Page 718 provides some examples.
D. Audit Tests for Subsequent Events
Inquiry of key client management.
Correspondence with attorneys
Review of internal client statements and other records prepared subsequent to the balance sheet date
Examine minutes of board of director meetings
Obtain a letter of representation from client management
E. Dual Dating for Subsequent Events
Occasionally, the auditor determines that an important subsequent event occurred after the field work was completed but before the audit report was issued.
The auditor may chose to (1) extend the date of field work to cover the discovery, or (2) issue a dual-dated audit report. For this 2 nd option, the first date would be for the completion of field work except for a specific exception. The next date would cover the date of the discovery of the subsequent event after the field work date.
III. Accumulate Final Evidence
Perform Final Analytical Procedures
Evaluate Going-Concern Assumption
Obtain Client Management Representation Letter
Consider Information Accompanying the Basic Financial Statements
Read Other Information in the Annual Report
A. Perform Final Analytical Procedures
Analytical procedures done during the completion of the audit are useful as:
A final review for material misstatements or financial problems not noted during other testing.
Providing a final objective look at the financial statements.
B. Evaluate Going-Concern Assumption
SAS 59 requires the auditor to evaluate whether there is substantial doubt about a client’s ability to continue as a going concern for at least one year beyond the balance sheet date.
C. Obtain Client Management Representation Letter
SAS 85 requires the auditor to obtain a letter of representation documenting client management’s most important oral representations during the audit.
Refusal to furnish the letter would require a qualified opinion or disclaimer of opinion.
SAS 85 and PCAOB Standard 2 suggest categories of specific matters that should be included in the letter. See pages 721-722.
D. Consider Information Accompanying the Basic Financial Statements
In many cases, the auditor has not performed a sufficiently detailed audit to justify an opinion on the additional information. Two types of opinions are allowed:
A positive opinion indicating a high level of assurance.
A disclaimer indicating no assurance.
Note: Page 723 contains examples of report wording.
E. Read Other Information in the Annual Report
SAS 8 requires the auditor to read other information included in annual reports pertaining directly to the financial statements.
Examples are the president’s letter and explanations of company activities.
If the client refuses to modify material inconsistencies, the auditor should add an explanatory paragraph to the audit report or withdraw from the engagement.
IV. Evaluate Results
The Sufficiency of Audit Evidence
Support for the Auditor’s Opinion
Financial Statement Disclosures
Audit Documentation Review
Summary of Evidence Evaluation
A. The Sufficiency of Audit Evidence
As an aid in drawing final conclusions about the adequacy of the audit evidence, auditors often use a completing the engagement checklist (See Figure 24-5 on page 724).
The auditor has two choices if sufficient evidence has not been obtained:
Obtain additional evidence
Issue a qualified or disclaimer of opinion
B. Support for the Auditor’s Opinion
It is necessary to combine individually immaterial misstatements to evaluate whether the combined amount is material. (See Figure 24-6 on page 725)
The auditor has two choices if the financial statements are not fairly stated:
Have statements revised to auditor satisfaction.
Issue a qualified or adverse opinion.
C. Financial Statement Disclosures
Adequate disclosure includes consideration of all of the statements, including the related notes.
Account balance verification also includes consistent application of GAAP with the preceding year.
Many CPA firms require the completion of a financial statement disclosure checklist. (See Figure 24-7 on page 727)
D. Audit Documentation Review
The review of audit documentation generally involves three increasing levels of personnel, ending with the partner in charge of the audit. Three main reasons for review include:
Evaluation of performance of inexperienced personnel
Ensure that audit meets CPA firm’s standard of performance.
Counteract bias in auditor judgment.
Partner Auditor Senior Auditor Manager Auditor
E. Independent Review
At the completion of larger audits, it is common to have the financial statements and the entire set of audit files reviewed by a completely independent reviewer who has not participated in the engagement.
A independent review is required for SEC engagements.
Reviewer takes an adversary position.
F. Summary of Audit Evidence
Auditor evaluates the sufficiency of audit evidence by first evaluating achieved audit risk, by account and by cycle, and then making the same evaluation for the overall financial statements.
Auditor also (often simultaneously) evaluates whether the evidence supports the audit opinion by first estimating misstatements in each account and then for the overall financial statements.
V. Issue the Audit Report
The auditor should not decide the appropriate audit report until all evidence has been accumulated and evaluated.
Because the audit report is the only thing that many users see in the audit process and the consequences of issuing an inappropriate report can be severe, it is critical that the report be correct.
VI. Communicate with the Audit Committee and Management
Audit Committee Communication
A. Audit Committee Communication
SAS 99 and SAS 54 require the auditor to communicate all fraud and illegal acts to the audit committee, regardless of materiality.
Auditor must also communicate significant deficiencies and material weaknesses in the design or operation of internal control.
SAS 61 states that certain major items be communicated to the audit committee for all SEC engagements and other audits where there is an audit committee or similarly designated body. (See page 729)
B. Management Communication
A management letter is intended to inform client personnel of the CPA’s recommendations for improving any aspect of the client’s business.
A management letter is optional and is intended to help the client operate its business more effectively.
VII. Subsequent Discovery of Facts
If the auditor becomes aware after the financial statements have been issued to some information included in the statements is materially misleading, the auditor has an obligation to make certain that users who are relying on the financial statements are informed about the misstatements.
Request the client to issue an immediate revision of the financial statements containing an explanation of the reasons.
Client should inform the SEC and other regulatory agencies of the misleading financial statements.
If the client refuses to cooperate, the auditor must inform the board of directors. Auditor must also notify regulatory agencies and, when practical, each person who relies on the financial statements, that the statements are no longer trustworthy.
Summary of the Audit Process Phase I Phase II Phase III Phase IV Plan and design an audit approach. Perform tests of controls and substantive tests of transactions. Perform analytical procedures and tests of details of balances. Complete the audit and issue an audit report.
Phase IV – Completing the Audit Review for contingent liabilities Review for subsequent events Accumulate final evidence Evaluate results Issue audit report Communicate with audit committee and management