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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 forincome tax disputes there are various procedures you could use for anintensive investigation in that area. One good approach #ould be an analysis ofincome tax expense. )nusual or nonrecurring amounts should be investigatedfurther to determine if they represent situations of potential tax liability. Anotherhelpful procedure for uncovering potential tax liabilities is to revie# thegeneral correspondence file for communication #ith attorneys or internalrevenue agents. This might give an indication that the potential for a liabilityexists even though no actual litigation has begun. inally an examination ofinternal revenue agent reports from prior years may provide the most obviousindication of disputed tax matters.

24-, The auditor #ould be interested in a clients future commitments topurchase ra# materials at a fixed price so that this information could bedisclosed in the financial statements. The commitment may be of interest to aninvestor 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 clientpaying more or less than the mar!et price at a future time.

24- The analysis of legal expense is an essential part of every auditengagement because it may give an indication of contingent liabilities #hich maybecome actual liabilities in the future and require disclosure in the currentfinancial statements. $ince any single contingency could be material it isimportant to verify all legal transactions even if the amounts are small. After theanalysis of legal expense is completed the attorneys to #hom payment #asmade should be considered for letters of confirmation for contingencies /attorneyletters0.

24-. %yson should determine the materiality of the la#suits by requestingfrom 1errills attorneys an assessment of the legal situations and the probableliabilities involved. &n addition %yson may have his o#n attorney assess thesituations. %roper disclosure in the financial statements #ill depend on theattorneys evaluations of the probable liabilities involved. &f the evaluationsindicate highly probable material amounts disclosure #ill be necessary in theform of a footnote assuming the amount of the probable material loss cannot bereasonably estimated. &f the client refuses to ma!e adequate disclosure of the

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24-/ An asserted claim is an existing legal action that has been ta!en againstthe client #hereas an unasserted claim represents a potential legal action. Theclients attorney may not reveal an unasserted claim for fear that the disclosureof 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 aboutmaterial 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 isrequired by A) 223 and has the effect of requiring management to give itsattorneys permission to provide contingent liability information to auditors and toencourage attorneys to cooperate #ith auditors in obtaining information aboutcontingencies.

24-1 The first type of subsequent event is one that has a direct effect on thefinancial statements and requires adjustment. 4xamples of this type ofsubsequent event are as follo#s:

5eclaration of ban!ruptcy by a customer #ith an outstandingaccounts receivable balance due to the deteriorating financialcondition

$ettlement of a litigation for an amount different from the amountrecorded on the boo!s

5isposal of equipment not being used in operations at a pricebelo# 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 onthe financial statements but for #hich disclosure is advisable. 4xamplesinclude the follo#ing:

5ecline in the mar!et value of securities held for temporaryinvestment 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 1alanos approach does not ta!e into consideration the need to obtainletters from attorneys as near the end of field #or! as possible. &f the letters arereceived near the balance sheet date the period from the balance sheet to theend of the auditors field #or! #ill not be included in the attorneys letters. 6isprocedure #ould not obtain the most current information regarding contingentliabilities and #ould not provide adequate information for disclosure of pertinentsubsequent events.

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&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 financialstatements they may require adjustment of the current period financialstatements or disclosure. Auditors of public companies should also be alert forsubsequent changes in internal control over financial reporting.

The subsequent discovery of facts existing at the date of the auditorsreport occurs #hen the auditor becomes a#are that some information included inthe financial statements #as materially misleading after the audited financialstatements 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 bemisleading he or she should request the client to issue a revised set of financialstatements as soon as possible containing a ne# audit report and anexplanation of the reasons for the revisions to the financial statements.

24-1, The #ea!ness in ;a#sons approach is the danger of discovering aninadequacy in one audit area #hich could affect other areas of the audit. orexample if misstatements #ere discovered as part of the tests of controls forsales 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 offixed assets is related to the contracts and notes payable #henever fixed assetsare used as collateral.

Another difficulty #ith ;a#sons approach is that there is nocombining of the misstatements in different audit areas to determine if thecombined misstatements are material. &f the combined misstatements areconsidered material it may be necessary to expand the testing in certain areasor require adjusting entries to some balances.

24-1 The accumulation of audit evidence is crucial to the auditor indetermining #hether the financial statements are stated in accordance #ith

generally accepted accounting principles applied on a basis consistent #ith thepreceding year. The evaluation of the adequacy of the disclosures in financialstatements is made to determine that the account balances on the trial balanceare properly aggregated and disclosed on the financial statements.

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4xamples #here adequate disclosure could depend heavily upon theaccumulation 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 affectthe adequacy of the disclosure are:

5eciding #hether a disposal of equipment should be recorded asan 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 tothe auditor #hich formali"es statements that the client has made about matterspertinent to the audit. Auditing standards /A) 2220 suggest four categories ofitems that should be included in the letter. 7elo# are those four items #ithexamples in each category follo# /refer students to A) 222 for a comprehensivelist0:

,. Financial statements 1anagements ac!no#ledgment of its responsibility for the

fair presentation in the financial statements of financialposition results of operations and cash flo#s in conformity#ith generally accepted accounting principles

1anagement=s belief that the financial statements are fairlypresented in conformity #ith generally accepted accountingprinciples

*. 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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2. Recognition, measurement, and disclosure 1anagement=s belief that the effects of any uncorrected

financial statement misstatements are immaterial to thefinancial statements

&nformation concerning fraud involving /,0 management /*0employees #ho have significant roles in internal control or/20 others #here the fraud could have a material effect onthe financial statements

&nformation concerning related party transactions and amountsreceivable from or payable to related parties

)nasserted claims or assessments that the entity=s la#yer hasadvised are probable of assertion and must be disclosed inaccordance #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 mayaffect 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 auditorto obtain specific representations from management about internal controlover 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 overfinancial reporting.

1anagement=s conclusion about the effectiveness of internalcontrol over financial reporting as of the end of the fiscalperiod.

5isclosure to the auditor of all deficiencies in the design oroperation of internal control over financial reportingidentified as part of management=s assessment includingseparate 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 havea significant role in the company=s internal control overfinancial reporting.

Auditors of public companies may obtain a combinedrepresentation letter for both the audit of the financial statementsand the audit of internal control over financial reporting.

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A management letter is a letter directed to the client to informmanagement of certain recommendations about the business #hich the C%Abelieves #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 allinformation prepared for management or outside users included #ith the basicfinancial statements. 4xamples include detailed comparative statementssupporting control totals in the basic statements supplementary informationrequired by the $4C statistical data such as ratios and trends and specificcomments on the changes that have ta!en place in the financial statements.

The auditor can provide one of t#o levels of assurance for informationaccompanying basic financial statements. The auditor may issue a positiveopinion indicating a high level of assurance or a disclaimer indicating noassurance.

24-10 Auditing standards /A) 88?0 require the auditor to read information inannual reports containing audited financial statements for consistency #ith thefinancial statements and the auditors report. Types of information the auditorexamines include statements about financial condition in the presidents letter

and displays and summaries of statistical financial information.

24-2 A regular audit documentation revie# is the one that is done bysomeone #ho is !no#ledgeable about the client and the unique circumstancesin 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 firms standard of

performance

To counteract the bias that frequently enters into the auditors judgment.

4xamples of important potential findings in a regular auditdocumentation revie# are:

&ncorrect computations &nadequate scope ;ac! of proper documentation for audit decisions

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An independent revie# is one done by a completely independent person#ho has no experience on the engagement. The purpose is to have a competentprofessional from #ithin the firm #ho has not been biased by the ongoingrelationship 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 beenaccumulated 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 #ithgovernance required by auditing standards the $arbanes-Oxley Act expands thesecommunications requirements by also requiring public company auditors to timelyreport 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 #ithmanagement ramifications of the use of such alternativedisclosures and treatments and the treatment preferred by theauditor.

Other material #ritten communications bet#een the auditor andmanagement such as any management letter or schedule ofunadjusted differences.

As the audit of the public company is completed the auditor shoulddetermine that the audit committee is informed about the initial selection of andchanges in significant accounting policies or their application during the currentaudit period. hen changes have occurred the auditor should inform thecommittee of the reasons for the change. The auditor should also communicateinformation about methods used to account for significant unusual transactionsand the effect of significant accounting policies in controversial or emergingareas.

ultiple Choi*e Questions 3rom CPA Eamination

24-22 a. /*0 b. /20 c. /,0

24-2( a. /+0 b. /*0 c. /+0

24-24 a. /20 b. /+0 c. /,0

24-2, a. /+0 b. /20 c. /*0

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"is*ussion Questions And Pro5lems

24-2 a. A contingent liability is a potential future obligation to an outsideparty for an un!no#n amount arising from activities that havealready ta!en place. A commitment is an agreement to commit theentity 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 isextremely important to users of financial statements because theyrepresent the encumbrance of potentially material amounts ofresources during future periods and thus affect the future cashflo#s available to creditors and investors. 7ecause of this generallyaccepted accounting principles require that material contingenciesand commitments be disclosed. The auditor has an obligation todiscover the existence of such items to determine that they areproperly disclosed in order to have complied #ith auditingstandards.

b. ohnson=s tests of controls and substantive tests of transactionsrelated to payments of notes payable and related interest expense#ould provide her information about scheduled debt payments andrelated interest rate terms #hich are required footnote disclosurerelated items. $imilarly substantive tests of transactions #ouldreveal additions and retirements of notes payable #hich bothaffect notes payable disclosures. Tests of details of balances suchas notes payable confirmations #ould provide sufficientappropriate evidence about the existence of ending balances andrelated notes payable terms such as interest rates and requiredcollateral.

c. Three useful audit procedures for uncovering contingenciesthat ohnson #ould li!ely perform in the normal conduct of theaudit even if she had no responsibility for uncoveringcontingencies are:

evie# internal revenue agent reports of income taxsettlements

evie# minutes of meetings of board of directors andstoc!holders

Confirm used and unused balances of lines of credit

d. Three other procedures ohnson is li!ely to perform specifically forthe 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 outsideparty for an un!no#n amount resulting from activities that havealready ta!en place. The most important characteristic of acontingent liability is the uncertainty of the amount9 if the amount#ere !no#n it #ould be included in the financial statements as anactual liability rather than as a contingency.

b. Audit procedures to learn about these items #ould be as follo#s:

The follo#ing procedures apply to all three items:

5iscuss the existence and nature of possible contingentliabilities #ith management and obtain appropriate#ritten representations.

evie# the minutes of directors and stoc!holdersmeetings for indication of la#suits or othercontingencies.

Analy"e legal expense for the period under audit andrevie# invoices and statements of legal counsel forindications of contingent liabilities.

Obtain letters from all major attorneys performing legalservices for the client as to the status of pendinglitigation or other contingent liabilities.

The follo#ing are additional procedures for individual items:

Lawsuit Judgment — no additional procedures9 see abovelist 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 5iscuss specifically any related party

transactions #ith management and includeinformation in letter of representation.

evie# financial statements of affiliate and #here

related party transactions are apparent ma!e directinquiries of affiliate management and perhaps evenexamine records of affiliate if necessary.

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c. 'ature of adjusting entries or disclosure if any #ould be asfollo#s:

,. The la#suit should be described in a footnote to the balance

sheet. &n vie# of the court decision retained earnings maybe restricted for D+?????? the amount of the first courtdecision. Also in vie# of the court decision any reasonableestimate of the amount the company expects to pay as aresult of the suit might be used in lieu of the D+??????. Acurrent liability #ill be set up as soon as a final decision isrendered or if an agreement as to damages is reached. &fliability is admitted to by 1arco and only the amount is indispute a liability can be set up for the amount admitted toby the company #ith a corresponding charge to expense orsho#n as an extraordinary item if the amount is material.

*. The declaration of such a dividend does not create aliability that affects the aggregate net #orth in any #ay. Thedistribution of the dividend #ill cause a reduction in retainedearnings and an increase in capital stoc!. 'o entry isnecessary but an indication of the action ta!en and thatsuch a transfer #ill subsequently be made should be sho#nas a footnote or as a memorandum to etained 4arningsand Common $toc! in the balance sheet.

2. &f payment by 'e#art is uncertain the D,238?? interestliability for the period une * through 5ecember , *??@could be reflected in the 1arco Corporations accountingrecords by the follo#ing entry:

&nterest %ayments for 'e#art Company D,238?? Accrued &nterest %ayable E 'e#art 7onds D,238??

The debit entry should be included as other assets.Collection is uncertain and the 1arco Corporation may nothave a right against the 'e#art Company until all interestpayments have been met and the bonds retired. &f thistreatment is follo#ed the balance sheet should be footnotedto the effect that the 1arco Corporation is contingentlyliable for future interest payments on 'e#art Companybonds in the amount of D**?????.

&f the interest has been paid by the time the audit iscompleted or if for other reasons it seems certain that thepayment #ill be made by 'e#art on anuary ,8 no entryshould be made by 1arco. &n this circumstance a footnotedisclosing the contingent liability of D*2238?? and the factsas to the D,238?? should be included #ith the statements.

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24-2/ a. 2 F Amount should have been determined to be uncollectiblebefore end of field #or! but it #as discovered after the issuanceof the statements. The financial statements should have been!no#n to be misstated on >-,@-?@.

b. + F The amount appeared collectable at the end of the field #or!.

c. , F The uncollectible amount #as determined before end of field#or!.

d. * F The cause of the ban!ruptcy too! place after the balancesheet 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 todo so. ootnote disclosure is necessary because the subsequentevent is material.

e. * F The sale too! place after the balance sheet date but since theloss #as material and #ill affect future profits footnote disclosureis necessary.

f. , F The settlement should be reflected in the <-2?-?@ financialstatement as an adjustment of current period income and not aprior period adjustment.

g. + F The financial statements #ere believed to be fairly stated on

<-2?-?@ and >-,@-?@.

h. * F The cause of the la#suit occurred before the balance sheetdate 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 statementsfor the amount of the expected loss.

i. * F The la#suit originated in the current year but the amount ofthe loss is un!no#n.

24-20 a. The practice of revie#ing the audit files of subordinates on acontinuing basis rather than #hen the audit is completed is a goodone because it enables the auditor to refine the audit approachbased on the information provided from the audit files that arerevie#ed. &n addition since many areas of the audit relate to eachother revie#ing the audit files on a continuing basis gives theauditor a more integrated picture of the companys operations. &tis also an excellent practice from a supervisory point of vie#.

b. &t is acceptable for Adams to prepare the financial statementsprovided he obtained sufficient and appropriate audit evidence to#arrant their fair presentation. This is a common practice on manyaudits because the C%A has greater expertise in financialstatement presentation than the client.

c. 7y not having a revie# of the audit documentation by anotherpartner in the firm there is no chec! against any bias and

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

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24-( a. &t is desirable to have a letter of representation in spite of theaccumulated audit evidence to impress upon management itsresponsibility for the representations in the financial statementsand to formally document the responses from the client to auditorinquiries about various aspects of the audit.

b. The letter of representation is not very useful as audit evidence sinceit is a #ritten statement from a nonindependent source. &n effect theclient being audited ma!es certain representations related to theaudit of itself.

c. $everal categories of information commonly included in a letter ofrepresentation #ith examples in each category follo# /$ee A) 222for a complete list0:

,. Financial statements 1anagements ac!no#ledgment of its responsibility

for the fair presentation in the financial statements of

financial position results of operations and cash flo#sin conformity #ith generally accepted accountingprinciples

1anagement=s belief that the financial statements arefairly presented in conformity #ith generally acceptedaccounting 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 committeesof directors

Absence of unrecorded transactions

2. Recognition, measurement, and disclosure 1anagement=s belief that the effects of any

uncorrected financial statement misstatements areimmaterial to the financial statements

&nformation concerning fraud involving /,0management /*0 employees #ho have significant rolesin internal control or /20 others #here the fraud couldhave a material effect on the financial statements

&nformation concerning related party transactions andamounts receivable from or payable to related parties

)nasserted claims or assessments that the entity=sla#yer has advised are probable of assertion andmust be disclosed in accordance #ith inancial

Accounting $tandards 7oard /A$70 $tatement 'o.8 Accounting for Contingencies

$atisfactory title to assets liens or encumbrances onassets and assets pledged as collateral

Compliance #ith aspects of contractual agreements

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that may affect the financial statements

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24-( )*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 toobtain specific representations from management about internal control overfinancial reporting. $ome of those representations are noted belo#:

8. Internal controls 1anagement=s ac!no#ledgement of its responsibility

for establishing and maintaining effective internalcontrols over financial reporting.

1anagement=s conclusion about the effectiveness ofinternal control over financial reporting as of the endof the fiscal period.

5isclosure to the auditor of all deficiencies in thedesign or operation of internal control over financialreporting identified as part of management=sassessment including separate disclosure of significantdeficiencies and material #ea!nesses.

1anagement=s !no#ledge of any material fraud orother fraud involving senior management or otheremployees #ho have a significant role in thecompany=s internal control over financial reporting.

Auditors of public companies may obtain a combined

representation letter for both the audit of the financialstatements and the audit of internal control.

24-(1 a. $ch#art"s legal and professional responsibility in the issuance ofmanagement letters is only to ma!e sound recommendationsbased on his professional interpretation of the audit evidenceaccumulated and to not omit information of serious systemsdeficiencies. 6e must follo# due care in management letters andmanagement services in the same manner as is required for audits.

b. 1ajor considerations that #ill determine #hether $ch#art" is liable

in this situation are #hether the client installed the systemaccording to $ch#art"s instructions or #hether they deviated fromhis instructions and #hether they could have foreseen thepossibility of the erased master file based on their understanding ofthe system. Another major consideration is the degree to #hich$ch#art" follo#ed due care considering the needs of the client andthe competence of existing employees of Cline holesale Co.

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24-(2 ,. A retroactive pay increase could be uncovered by reading theminutes of the board of directors or stoc!holders meetingsexamining contracts holding discussions #ith managementreading the local ne#spaper and analy"ing internal financialstatements 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 #agesin the year under audit. A liability clearly exists if a union contract#as under negotiation at the balance sheet date but not settleduntil later. &f the retroactive pay increase #as unexpected at thebalance sheet date the expense could be related to the date of thesettlement but even then most auditors #ould require thatretroactive #ages be accrued at the balance sheet date. Theliability and related expense that should be accrued at the balancesheet date is the amount of unpaid #ages existing at the balancesheet date assuming the pay increase is accrued. 'o mention inthe audit report is necessary.

*. The declaration of a stoc! dividend subsequent to the balancesheet date could be uncovered by reading the minutes of the boardof directors or stoc!holders subsequent to the balance sheet dateby confirmation #ith the independent stoc! registrar or throughdiscussion #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 andretained earnings. 'o audit report modification is necessary.

2. 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 ofthe subsequent period or through discussions #ith management.The sale should be disclosed in a footnote and the explanationshould include the amount of the gain and the effect if any on futureoperations of the company. 'o audit report modification isnecessary.

+. An additional tax assessment could be uncovered by examiningsubsequent cash disbursements revie# of the minutes of theboard of directors or stoc!holders examining internal revenueagent 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 expenseand a liability for the year under audit and clearly disclosed if theamount is material. &f the tax assessment is accrued andadequately disclosed no audit report modification is necessary.

8. The antitrust suit may have been uncovered through inquiries ofthe client the client representation letter or letters from clients legal

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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 butdoes not affect the valuation of the current year financialstatements and is not li!ely to be sufficiently material to #arrantdisclosure. &tem + occurred before the balance sheet and istherefore not a subsequent event. &tem 3 does not #arrant

disclosure because the client has merely engaged in a discussion.

b. All seven items can be found by inquires of and discussions #ithmanagement.

&tem , evie# of the sales journal subsequent to the balancesheet obtain a letter of representation and examine salestransactions for larger sales.

&tem * evie# subsequent period minutes of the board ofdirectors obtain a letter of representation and examinetransactions in the cash receipts journal after year-end.

&tem 2 evie# of the acquisitions journal subsequent to the

balance sheet and examine acquisitions transactions forlarger purchases.

&tem + evie# current period minutes of the board of directorsand discussions #ith the credit manager.

&tem 8 evie# subsequent period minutes of the board ofdirectors obtain a letter of representation and examinetransaction in the cash disbursements journal after year-end.

&tem < evie# subsequent period minutes of the board ofdirectors obtain a letter of representation and correspond#ith attorneys.

&tem 3 evie# subsequent period minutes of the board ofdirectors before and after the balance sheet date obtain aletter of representation and read the local ne#spaper.

c. &tem , Adjust the current year financial statements.&tem * &nclude a footnote in the current year financial statements.&tem 2 'o action needed&tem + Adjust the current year financial statements.&tem 8 Adjust the current year financial statements.&tem < &nclude a footnote in the current year financial statements.&tem 3 'o action needed

24-(4 a. &n this situation ;ittle need only send requests for letters tothose attorneys #ho are involved #ith legal matters directlyaffecting the financial statements. The letters should be sentreasonably near to the completion of the field #or! but the follo#-up on nonresponses and unsatisfactory responses should not bedeferred until the last day of field #or!. $he should have examinedthe letters #hen they #ere returned and performed follo#-up #or!at that time. urthermore the third letter should have addressedthe la#suit if the client informed the auditor of its existence.

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24-(4 )*ontinued+

b. The auditor #ould be required to follo# up on the first attorneysletter by sending a second request or calling the attorney tosolicit a response. The second letter #ould not require anyadditional follo#-up due to the nature of the #or! performed by this

attorney. egarding the third attorneys letter it is necessary tohave a conference #ith the attorney client and auditor todetermine the nature and significance of the la#suit.

&t #ould be a serious violation of due care to ignore theinformation in the third attorneys letter. &n rare circumstances adisclaimer of opinion is necessary if the information cannot beobtained.

24-(, a. A typical additional information report includes the financialstatements associated #ith a short-form report plus additionalinformation li!ely to be useful to management and other statementusers. The statements included #ith short form audit reports aredefined by the profession but the additional information included inadditional information reports varies considerably.

b. The purpose of additional information reports is to providemanagement and other users information that is useful for theirdecision ma!ing that has not been included in the basic financialstatements.

c. &t #ould be appropriate to include all of the items as additionalinformation except the follo#ing:

*. The adequacy of insurance coverage. The auditor is notan insurance professional and any comments about theinsurance coverage should be factual. or example it #ouldbe appropriate to state that the insurance coverage is lessthan the recorded boo! value.

2. Adequacy of the allo#ance for uncollectible accounts.Comments that an account balance is correctly stated areinappropriate. The auditor has already issued an auditorsopinion on the statements as a #hole. &f an opinion on aspecific account balance is desired it should be done inaccordance #ith a special report.

8. 1aterial #ea!nesses in internal control. These should beidentified and communicated to management as a part ofthe auditor=s internal control deficiencies letter to thosecharged #ith governance /e.g. the audit committee0.

*+-**

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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 sold

selling 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 opinionon t#e basic financial statements taken as a w#ole$ %#eaccompan!ing information on pages & t#roug# ! is presented for

purposes of additional anal!sis and is not a required part of t#ebasic financial statements$ Suc# information #as not beensub'ected to t#e auditing procedures applied in t#e audit of t#ebasic financial statements, and, accordingl!, we e&press no opinionon it$

Case

24-( a. $ee the G$ummary of %ossible AdjustmentsG on page *+-*, thatfollo#s.

b. Aviarys management may refuse to ma!e some or all of theproposed adjustments because all of the adjustments except /+0reduce net income. 1anagement #ill most li!ely be reluctant to

ma!e any adjustments that #ill ma!e the company loo! lessprofitable. Aviarys management may also refuse to ma!e some orall of the proposed entries because they do not #ant to admit thattheir records contain misstatements.

c. As indicated on the G$ummary of %ossible AdjustmentsH on page*+-*, you should attempt to have Aviarys management record allof the potential adjustments found. 6o#ever at a minimum entries/80 and /<0 should be recorded. One positive #ay for you toconvince Aviarys management to ma!e these entries #ould be tostress 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 adjustingthese accounts. This may help minimi"e managements reluctanceto admit ma!ing a mista!e.

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24-( )*ontinued+

Iou should also stress that it #ould be #ise to adjust theallo#ance accounts in a year #ith substantial net income. Theallo#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 generatesubstantial net income in future years it #ould be best to adjustthe allo#ance accounts in the current year and avoid a substantialreduction to net income in a future year that is not as profitable asthe current year.

d. Iour responsibility related to unadjusted misstatements that managementhas determined are immaterial individually and in the aggregate isto determine for !ourself #hether the combined effect of theseunadjusted misstatements are material for the audit. The combinedeffect of the unadjusted misstatements must be compared tooverall materiality. Assuming that the remaining unadjustedmisstatements are #ell belo# your materiality threshold you do notneed to qualify your audit opinion. Iou should consider having theclient include a summary of this audit schedule in the managementrepresentation letter along #ith management=s representation thatthe uncorrected misstatements are immaterial.

e. Auditors of public companies must evaluate the noted adjustments todetermine their impact on the auditor=s report on internal controlover financial reporting. As discussed in Chapter ,? the audit ofthe financial statements and the audit of internal control overfinancial reporting for a public company are to be integrated. %ublic

company auditors must consider the results of audit proceduresperformed to issue the audit report on the financial statements#hen issuing the audit report on internal control. or example if thepossible adjustments identified by Aviary &ndustries= auditor aredeemed to be material misstatements that #ere not initially identifiedby the company=s internal controls the auditor should consider thisas at least a significant deficiency if not a material #ea!ness forpurposes of reporting on internal control. &n this case the auditor=sreport on Aviary=s financial statements #ould be unqualified aslong as management corrected the misstatement before issuing thefinancial statements. 6o#ever the auditor=s report on internal

control over financial reporting #ould include an adverse opinion ifthe auditor concludes that it is a material #ea!ness.

*+-*+

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24-( )*ontinued+

a.Client 'ame Aviary &ndustries

S$AR6 !3 P!SS%#E A"&$STENTS

Iear-ended 5ecember 2, *??@

"es*riptionA7C "r8

A7C Cr8Total

Amount

Possi5le Ad9ustments - "r )CR+

CurrentAssets

Non-CurrentAssets

Current#ia5ilities

Non-Current

#ia5ilities%eginning

E:uit; n*ome Epenses

/,0 )nrecordedcredit memosJ

$ales KA AL

*<+8,/*<+8,0

*<+8,

/*0 )nrecordedinventorypurchases

%urchases AL%

*8<32/*8<320

*8<32

/20 $ales recordedin #rong period

$ales AL

+,>,+/+,>,+0

+,>,+

/+0 6eld chec!s Cash AL%

+2<3, +2<3,/+2<3,0

/80 ObsoleteinventoryJJ

;oss ALC&nventory Allo#. ALC

,8???/,8???0

,8???

/<0 A5A

understatedJJ

7ad debt exp.

A5A

28???

/28???0

28???

Totals /3+8@+0 /<@2++0 <>*<8 38<32

Conclusions:The net effect of the above items is as follo#s:

or!ing capital D ,+2@2> decreaseTotal assets: D 3+8@+ decrease'et income: D,+2@2> decrease

!pinion as to need <or A&E: %reliminary materiality #as D,?????. 6o#ever revised materialitybased 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 thatall entries be recorded. 6o#ever at a minimum entries /80 and /<0 should be recorded in order to decreasethe effect of the above entries to a level belo# revised materiality of D38?????. 4ntry /,0 or /*0 may alsohave to be recorded in order to have some cushion bet#een the net income misstatement and revisedmateriality after recording entries /80 and /<0.

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

* + - * ,

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nternet Pro5lem Solution= Audit Committee Responsi5ilities

24-1 Audit committees of public companies have many responsibilities intoday=s financial reporting environment. Among those responsibilities are hiringthe company=s external audit firm overseeing the company=s financial reportingprocesses meeting #ith management to understand decisions around

accounting and auditing matters and so forth. 1icrosoft Corporation has madeinformation about its audit committee available on the company=s #ebsitehttp:LL###.microsoft.comLaboutLcompanyinformationLcorporategovernanceLcommitteesLaudit.mspxP. Qisit the #ebsiteand ans#er the follo#ing questions:

,. hat are the committee=s responsibilitiesR

Answer= According to the company=s #ebsite: SThe Audit Committee of the7oard of 5irectors assists the 7oard of 5irectors in fulfilling itsresponsibility for oversight of the quality and integrity of theaccounting auditing and reporting practices of the Company andsuch other duties as directed by the 7oard. The Committeespurpose is to oversee the accounting and financial reportingprocesses of the Company the audits of the Companys financialstatements the qualifications of the public accounting firmengaged as the Companys independent auditor to prepare orissue an audit report on the financial statements of the Companyand the performance of the Companys internal audit function andindependent auditor. The Committee revie#s and assesses thequalitative aspects of financial reporting to shareholders theCompanys processes to manage business and financial ris! and

compliance #ith significant applicable legal ethical and regulatoryrequirements. The Committee is directly responsible for theappointment /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 additionalmeetings occurring as necessary.

2. hat authority does the committee have in carrying out its respon-sibilitiesR

Answer= According to the company=s #ebsite: SThe Committee #ill have theresources and authority necessary to discharge its duties andresponsibilities. The Committee has sole authority to retain andterminate outside counsel or other experts or consultants as itdeems

*+-*<

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*+-*3

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nternet Pro5lem 24-1 )*ontinued+

appropriate including sole authority to approve the firms fees andother retention terms. The Company #ill provide the Committee#ith appropriate funding as the Committee determines for thepayment of compensation to the Companys independent auditor

outside counsel and other advisors as it deems appropriate andadministrative expenses of the Committee that are necessary orappropriate in carrying out its duties. &n discharging its oversightrole the Committee is empo#ered to investigate any matterbrought to its attention. The Committee #ill have access to theCompanys boo!s records facilities and personnel. Anycommunications bet#een the Committee and legal counsel in thecourse of obtaining legal advice #ill be considered privilegedcommunications of the Company and the Committee #ill ta!e allnecessary steps to preserve the privileged nature of thosecommunications.H

+. 6o# do the required auditor communications to those charged #ithgovernance help the audit committee fulfill its responsibilitiesR

Answer= Auditing standards require the auditor to communicate certainadditional information obtained during the audit to those charged#ith governance #hich is generally the audit committee. Thepurpose of this required communication is to !eep the auditcommittee or others charged #ith governance informed aboutsignificant and relevant information for the oversight of the financialreporting process and to provide an opportunity for the audit

committee to communicate important matters to the auditor. Thusthe requirements of auditing standards are designed toencourage t#o-#ay communications bet#een the auditor andthose charged #ith governance. There are four principal purposesof this required communication:

A. To communicate auditor responsibilities in the audit offinancial statements. This communication helps ensure thatthe audit committee /i0 understands the nature of theassurance provided by audited financial statements and /ii0comprehends limitations of an audit of financial statements

/and audit of internal control financial reporting if thecompany is publicly traded0.

7. To overvie# the scope and timing of the audit. The purposeof this required communication is to provide the auditcommittee a high-level overvie# such as the auditor=sapproach to addressing significant ris!s and considerationof internal control and timing of the audit. This information

*+-*>

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helps the audit committee

*+-*@

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nternet Pro5lem 24-1 )*ontinued+

understand !ey ris! areas identified for examination by theauditor #hich increases audit committee oversight of !eyris! areas affecting financial reporting and broader businessris! issues.

C. To provide those charged #ith governance #ith significantfindings arising during the audit. These communicationsmight include discussion of material corrected misstatementsdetected during the audit the auditor=s vie# of qualitativeaspects of significant accounting practices and estimatessignificant difficulties encountered during the auditincluding disagreements #ith management among othermatters. One of the major information sources for an auditcommittee is the external auditor. Thus !no#ledge aboutsignificant findings identified by the auditor is highly relevantto the audit committee in its oversight of financial reporting.

5. To obtain from those charged #ith governance informationrelevant to the audit. The audit committee or others charged#ith governance such as the full board of directors mayshare strategic decisions that may affect the nature andtiming of the auditor=s procedures. These communications #illbe informative to both the auditor and audit committee.

/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

Documents

AEB_SM_CH24_1.pdf