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Chapter 17CHAPTER 17COMPLETING THE ENGAGEMENT

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REVIEW FOR CONTINGENT LIABILITIES

Contingent liabilities are defined as an existing condition, situation, or set of circumstances involving uncertainty as to possible loss to an entity that ultimately will be resolved when some future event occurs or fails to occur.

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SFAS NO. 5 - ACCOUNTING FOR CONTINGENCIES

Probable. The future event is likely to occur.

Reasonably possible. The chance of the future event occurring is more than remote but less than likely.

Remote. The chance of the future event occurring is slight.

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EXAMPLES OF CONTINGENT LIABILITIES

Pending or threatened litigation. Actual or possible claims and assessments. Income tax disputes. Product warranties or defects. Guarantees of obligations to others. Agreements to repurchase receivables that have

been sold.

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AUDIT PROCEDURES FOR IDENTIFYING CONTINGENT

LIABILITIES Reading the minutes of board of directors and other

committees of the board. Reviewing contracts (e.g., loan agreements and

leases). Reviewing income tax liability, tax returns, and IRS

agents' reports. Confirming or otherwise documenting of guarantees

and letters of credit obtained from financial institutions or other lending agencies.

Inspecting other documents for possible guarantees.

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SPECIFIC AUDIT PROCEDURES FOR IDENTIFYING CONTINGENT

LIABILITIES Inquiry of management about policies and

procedures for identifying, evaluating, and accounting for contingent liabilities.

Examination of documents such as correspondence and invoices from attorneys for pending lawsuits.

Obtaining a legal letter.

Obtaining a management representation letter.

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LEGAL LETTERS

A letter of audit inquiry (referred to as a legal letter) sent to the client's attorneys is the primary means of obtaining or corroborating information about litigation, claims, and assessments.

A legal letter should be obtained from the entity's inside counsel if such a position exists.

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COMMON TYPES OF LITIGATION

Breach of contract Patent infringement Product liability Violations of governmental legislation including:

Securities laws, Antitrust. Discrimination based on race, sex, age, and

other characteristics. Income Tax. Environmental protection.

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PRIMARY COMPONENTS OF A LEGAL LETTER (EX 17-2)

List and evaluation of pending or threatened litigation and a discussion of the progress of the case, the action the entity plans to take, the likelihood of unfavorable outcome and the amount of potential loss.

List of unasserted claims that are probable or reasonably possible.

Request to indicate whether the response is limited.

Any unpaid legal fees.

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COMMITMENTS

Companies enter into long-term commitments to purchase raw materials or to sell their product at a fixed price.

The main purposes for entering into such purchase or sales contracts is to obtain favorable pricing arrangements or to secure the availability of raw materials.

Terms are usually disclosed in a footnote; Losses may have to be recognized even though no exchange of goods (e.g. market price < fixed price in contract).

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REVIEW FOR SUBSEQUENT EVENTS

Subsequent events are events or transactions that occur after the balance sheet date, but prior to the issuance of the financial statements and auditor's report, that have a material effect on the financial statements.

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TYPES OF SUBSEQUENT EVENTS

Type I: Events that provide additional evidence about conditions that existed at the date of the balance sheet and effect estimates that are part of the financial statements.

Type II: Events that provide evidence about conditions that did not exist at the date of the balance sheet but arose subsequent to that date.

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EXAMPLES OF TYPE I EVENTS

A loss of an uncollectible account receivable resulting from continued deterioration of its financial condition leading to bankruptcy after the balance sheet date.

The settlement of a lawsuit after the balance sheet date for an amount different from the amount recorded in the year end financial statements.

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EXAMPLES OF TYPE II EVENTS Purchase or disposal of a business.

Sale of a capital stock or bond issue.

Loss of a manufacturing facility or assets resulting from a casualty such as a fire or flood.

Losses on receivables arising from conditions such as a casualty arising subsequent to the balance sheet date.

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DUAL DATING

Must be considered when a subsequent event is discovered after completion of fieldwork but before issuance of financial statements.

Purpose of dual dating is to limit the auditor’s responsibility for events occurring after fieldwork ends.

Can dual date the report “February 15, 2004, except for Note 10, as to which the date is March 1, 2004”; or

Use the date of the subsequent event (March 1, 2004).

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AUDIT PROCEDURES FOR SUBSEQUENT EVENTS

Read interim financial statements available for the period after year end.

Inquire of management about subsequent events.

Read available minutes of meetings of board of directors and other committees.

Inquire of legal counsel concerning litigation, claims, and assessments.

Obtain a representation letter from management.

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FINAL EVIDENTIAL EVALUATION PROCESSES

Perform final analytical procedures. Evaluate the entity's ability to continue as a

going concern. Obtain a management representation letter. Review working papers. Make final assessment of audit results. Evaluate financial statement presentation and

disclosure. Obtain independent review of the engagement.

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PERFORM FINAL ANALYTICAL PROCEDURES

Conduct analytical procedures to assess the conclusions reached on the financial statement accounts.

Auditing standards require that analytical procedures be conducted as an overall review.

Generally involve review of account fluctuations to determine if audit evidence supports the changes.

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EVALUATE GOING CONCERN

Auditing standards state that the auditor has a responsibility to evaluate whether there is substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time, not to exceed one year beyond the date of the financial statements being audited.

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STEPS IN THE GOING CONCERN EVALUATION

Step 1: Consider if the results of all audit procedures performed during the audit indicate whether there is substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time (one year) (Table 17-2 – Page 601).

Step 2: If there is substantial doubt, the auditor should obtain information about management's plans to mitigate the going concern problem and assess the likelihood that such plans can be implemented.

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STEPS IN THE GOING CONCERN EVALUATION

Step 3: If the auditor concludes, after evaluating management's plans, that the entity has a going concern problem, he or she should consider the adequacy of the disclosures about the entity's ability to continue and include an explanatory paragraph in the audit report.

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CONDITIONS THAT MAY INDICATE GOING CONCERN PROBLEMS

Negative financial trends

Other financial difficulties

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CONDITIONS THAT MAY INDICATE GOING CONCERN PROBLEMS

Internal problems

External matters

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CONSIDERATION OF MANAGEMENT'S PLANS

Plans to dispose of assets.

Plans to borrow money or restructure debt.

Plans to reduce or delay expenditures.

Plans to increase ownership equity.

Auditor should evaluate likelihood of success.

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REPRESENTATION LETTER

Auditing standards require that the auditor obtain a representation letter from management.

The representation letter is signed by the CEO and CFO and is dated the same date as the audit report.

Management’s refusal to provide a management letter constitutes a scope limitation.

Exhibit 17-3

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WORKING PAPER REVIEW

Workpapers should be reviewed by an audit team member senior to the person preparing the workpapers.

The reviewer must ensure thatthe audit was properly planned and supervisedthe evidence supports the audit objectives testedthe evidence is sufficient for the type of audit

report issued.

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FINAL ASSESSMENT OF AUDIT RESULTS

The auditor must evaluate the results of the audit tests and be concerned with two issues:

Sufficiency of the audit evidence and

Effects of detected misstatements compared to tolerable misstatement

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EVALUATE FINANCIAL STATEMENT PRESENTATION AND DISCLOSURE

The auditor must ensure

Financial statements comply with GAAP

Proper presentation of accounts and inclusion of all disclosures

Most CPA firms use some type of financial statement disclosure checklist

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INDEPENDENT PARTNER REVIEW

Most firms have a policy requiring that a concurring (or Second) partner review the financial statements for publicly traded companies and those financial statements that are expected to be widely distributed.

Concurring partner should understand the audit approach, findings, conclusion for critical audit areas and should review the audit report, financial statements and footnotes for consistency.

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COMMUNICATIONS WITH THE AUDIT COMMITTEE

Auditing standards (AU 380) requires that the auditor communicate certain matters related to the conduct of the audit to those individuals responsible for oversight of the financial reporting process.

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COMMUNICATIONS WITH THE AUDIT COMMITTEE

The communication should address the following:

The auditor's responsibility under GAAS.

Significant accounting policies.

Significant accounting estimates.

Significant audit adjustments.

The auditor’s judgment about the quality of the entity's accounting principles.

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COMMUNICATIONS WITH THE AUDIT COMMITTEE

(continued) The communication should address the following:

Disagreements with management.

Consultation with other accountants.

Difficulties encountered during the audit.

Fraud involving senior management or fraud that causes material misstatement of the financial statements.

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MANAGEMENT LETTERMakes recommendations to the client based on observations made during the audit and may include areas such as organizational structure and efficiency issues.

Addressed to the Board of Directors, CEO or CFO

Exhibit 17 –5 – Page 608

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SUBSEQUENT DISCOVERY OF FACTS EXISTING AT THE DATE OF

THE AUDITOR'S REPORT An auditor has no obligation to make any inquiries

or conduct any audit procedures after the financial statements and audit report have been issued.

However, facts may come to the auditor's attention after the issuance of the financial statements which may indicate that the financial statements are in error and the audit report is affected.

Most common example: Material misstatements are discovered in financial statements (unintentional or intentional (Exhibit 17-6 – Page 609).

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SUBSEQUENT DISCOVERY OF FACTS

If client refuses to cooperate , the auditor should notify the board of directors and take the following steps: Notify the client that the auditor's report must no

longer be associated with the financial statements.

Notify regulatory agencies having jurisdiction over the client that the auditor report can no longer be relied upon.

Notify each person known to the auditor to be relying on the financial statements. Usually notification to a regulatory agency is the only practical way to provide appropriate disclosure.