Lecture 2: Completing the Audit Engagement

Question 1

What is contingent liability?

Answer 1

It is an existing condition or set of circumstances involving uncertainty as to possible loss that’ll ultimately be resolved when some future event occurs or fails to occur (potential future obligation by a co. that needs to be reviewed by auditors at the completion stage of the audit)

Question 2

How should we determine if a contingent liability should be disclosed or adjusted in the financial statement?

Answer 2

We need to determine the likelihood of occurrence:

1. Probable: future event is likely to occur & amount is known (req. adjustments) *litigation is settled (disclosed as provision liability instead of a contingent liability)
2. Reasonably possible: the chances of future event occurring is more than remote but less than likely & the amount is unknown (req. disclosures in the footnotes to the financial statements)
3. Remote: the chances of future event occurring is slight/ minimal (doesn’t req. any disclosure in the footnotes or adjustment)

Question 3

Why do we need to disclose potential future obligation?

Answer 3

• To show the true & fair view of the co.
• To properly assess the going concern of a co.
• Disclose the true value of a co.’s image to potential investors or existing shareholders

Question 4

What are the Audit Procedures for identifying contingent liabilities?

Answer 4

• Read minutes of the meetings
• Review contracts, loan agreements, leases & correspondence from gov agencies
• Review tax returns supporting the entity’s income tax liability
• Confirm or document guarantees & letters of credit obtained from financial institutions or other lending agencies
• Inspect other documents for possible guarantees or other similar arrangements

Question 5

What are the more specific audit procedures conducted near the completion of audit?

Answer 5

1. Inquire & discuss w/ management regarding entity’s policies & procedures for identifying, evaluating, and accounting for contingent liabilities
2. Examine docs in the entity’s records such as correspondence & invoices from attorneys for pending or threatened lawsuits
3. Obtain a legal letter that describes & evaluates any litigation, claims or assessments
4. Obtain a written representation from management that all litigation, asserted & unasserted claims and assessments have been disclosed in accordance to the standards or policies

Question 6

What is a legal letter?

Answer 6

It is a letter of audit inquiry sent by management to the entity’s attorneys which acts as a primary means of corroborating info provided by management to auditor about litigation, claims and assessments.

Question 7

Why do co. enter long-term commitments?

Answer 7

It is mainly to purchase raw materials or to sell products at a fixed price. This is to obtain a favorable or predictable pricing arrangement and to secure the availability of raw materials.

Question 8

Why are auditors concerned w/ commitments made by an entity?

Answer 8

They have to ensure that appropriate disclosures & accruals are made in the financial statements.

Question 9

What are the 2 types of subsequent events?

Answer 9

1. Type I (adjusting events): those that provide additional evidence about conditions that existed at the date of balance sheet & affects the amount or estimates involved in the financial statement preparation process.
2. Type II (non-adjusting events): those that provide evidence about conditions that did not exist at the balance sheet date but arose subsequent to that date. Usually only req. disclosure in the notes to financial statements. If say the event is very significant, then a pro forma financial statement is req. to prevent the FS from being misleading.

Question 10

What is Dual Dating?

Answer 10

It limits the auditors’ responsibility for events occurring subsequent to the date on which auditor has obtained sufficient appropriate audit evidence to only the specific subsequent event referred to in the footnotes.

Question 11

What are the 2 options for dating of the auditors’ report when a subsequent event is recorded or disclosed in the financial statement after sufficient, appropriate audit evidence has been obtained but before the issuance of financial statements?

Answer 11

Option 1: dual date the report (original date + subsequent date of subsequent event - helps to limit liability
Option 2: change the date of auditors’ report to the date of the subsequent event - helps to extend liability

Question 12

What are the Audit Procedures for subsequent events?

Answer 12

1. Inquire management about any substantial contingent liabilities or commitments existing at the balance sheet date or at the date of inquiry
2. Read interim financial statements available for the period after the year-end
3. Examine books of original entry & investigate any unusual transaction or information related to subsequent events
4. Read mins of meetings
5. Ask legal counsel about any developments relating to litigations, claims or assessments against the co.
6. Evaluate entity’s policies & procedures to identify & properly record subsequent events as part of its internal control over financial reporting

Question 13

Review of subsequent events for audit of internal control over financial reporting

Answer 13

Auditors of public co. are responsible for reporting any changes in internal control that might adversely affect financial reporting between the end of reporting period & the date of the auditors’ report.

Question 14

If the event reveals info about a material weakness that existed as of the end of reporting period, what should the auditor do?

Answer 14

He should issue an adverse opinion on the effectiveness of internal control over the financial reporting.

Question 15

If event reveals adverse info about internal control that didn’t exist as of the end of reporting period & is material, what should the auditor do?

Answer 15

He should include an explanatory paragraph that describes the event & its effects.

Question 16

What should auditors do before deciding on the appropriate audit report for entity (final evidential evaluation processes)

Answer 16

• performance of final analytical procedures
• obtain a management representation letter
• review of working papers
• final evaluation of audit results
• evaluation of financial statement presentation & disclosure
• obtain independence review of the engagement
• evaluation of the entity’s ability to cont. as a going concern

Question 17

Final Analytical Procedures

Answer 17

Objective: to help auditor assess the conclusions reached on the financial statement components & evaluate the overall financial statement presentation. This is to consider the overall reasonableness of the financial statement amounts. Eg of analytical procedure: include recalculating some of the ratios

Question 18

Management Representation Letter

Answer 18

Purpose: to document, in writing, significant oral representations made to the auditor by management, which reduces the possibility of misunderstanding between management & auditor.

Question 19

What if management refuses to provide a representation letter?

Answer 19

It’d result in a scope limitation that is sufficient to preclude an unqualified opinion.

Question 20

Working Paper Review

Answer 20

All audit work should be reviewed by an audit team member who is senior to the person preparing the working papers. He should conduct a detailed review of the working papers prepared by the staff auditors. The engagement partner is responsible to ensure that the body of evidence gathered fully justifies & supports the auditors’ opinion.

Question 21

Final evaluation of Audit Results

Answer 21

Auditors are primarily concerned w/:

1. the sufficiency of the audit evidence (if not sufficient to meet the planned detection risk, then auditor needs to gather additional evidence)
2. the effects of detected misstatements in the financial statements (compare amount of materiality arrived at to the amount of materiality allocated)

Question 22

What are the 2 methods used to evaluate a current year misstatement?

Answer 22

1. Iron curtain approach: quantifies the misstatement based on the amount req. to correct the misstatement in the balance sheet at the year end
2. Roll-over approach: quantifies misstatement based on only the amount of error that originates in the current year income statement. It ignores the carryover effects.

Question 23

Evaluate financial statement presentation & disclosure

Answer 23

Auditor reviews the financial statements to ensure compliance w/ GAAP, proper presentation of accounts & inclusion of all necessary disclosures. Ensure that all req. footnotes have been properly included.

Question 24

Obtain an independent review of the engagement (engagement quality review - EQR)

Answer 24

• req. by publicly traded co. & those whose FS are widely distributed
• EQR is a partner who is NOT associated w/ the details of the engagement & is expected to provide an independent, objective review.
• reviews selected audit documentation relating to the significant judgements made by the engagement team & related conclusion reached

Question 25

Evaluate the entity’s ability to continue as a going concern

Answer 25

The issue is whether the auditor has substantial doubt about the co.’s ability to continue as such for a reasonable period of time.
If it is probable that the entity will be unable to meet its obligations within the period, management must make appropriate disclosures.

Question 25

Evaluate the entity’s ability to continue as a going concern

Answer 25

The issue is whether the auditor has substantial doubt about the co.’s ability to continue as such for a reasonable period of time.
If it is probable that the entity will be unable to meet its obligations within the period, management must make appropriate disclosures.

Question 26

Archiving & Retention according to Companies Act 2016 Sarbanes-Oxley Act standards

Answer 26

• req. audit firm to archive their public audit files for retention within 45 days following the time auditor grants permission to use auditors’ report in connection w/ issuance of financial statements.
• req. audit firm to retain audit docs for 7 years from date of audit completion, unless a longer period of time is req. by law
• req. audit firms to retain all docs that form the basis of audit & review
• req. audit firm to include in the audit file for significant matters. Significant changes in audit plans or conclusions must also be documented.

Question 27

Steps in the Auditors’ going concern evaluation

Answer 27

Step 1: Independently evaluate whether results of audit procedures performed indicate whether there’s substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time.
Step 2: If there’s substantial doubt, obtain info about the managements’ plan to mitigate the going concern problem & assess the likelihood that such plans can be successfully implemented.
Step 3: Conclude whether it’s probable that the entity will be able to continue as a going concern.
Step 4: Assess managements’ going concern evaluation & related disclosures.

Question 28

Communications regarding the audit of internal control over financial reporting

Answer 28

Auditor has a number of communication responsibilities w/ respect to the audit of internal control over financial reporting. Auditor must communicate in writing to the management & audit committee all significant deficiencies & material weaknesses identified in the audit. The communication must be made prior to the issuance of the auditors’ report on internal control over financial reporting.

Question 29

Who prepares the management letter and what is its functions?

Answer 29

The auditors prepare the management letter. It is to make recommendations to the entity based on observations during the audit, letter may include suggested improvements in various areas, such as org. structure or even efficiency issues.

Question 30

If auditor determines that the previously issued financial statements are in error & the audit report is affected, what should he do?

Answer 30

He should request that the entity issue an immediate revision to the financial statements. The reasons for revision should be described in the footnotes to the revised FS.

Question 31

If entity refuses to cooperate & make the necessary disclosures or adjustments, what should the auditor do?

Answer 31

He should notify the BOD & take the following steps:

1. Notify entity that the auditors’ report must no longer be associated w/ the financial statements
2. Notify regulatory agencies having jurisdiction over the entity that the auditors’ report can no longer be relied upon.
3. Notify each person known to the auditor to be relying on the financial statements. (audit report is no longer reliable)