What major considerations should the auditor take into account in determining how extensive the review of subsequent events should be?

Completing the Audit

There are four presentation and disclosure-related audit objectives:

A financial statement disclosure checklist is an audit tool that summarizes all disclosure requirements contained in generally accepted accounting principles.  Auditors use the disclosure checklist 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.

The Auditor's Evaluation of Liabilities, Future Purchase Commitments, and Asserted and Unasserted Claims

Definitions:

A contingent liability is a potential future obligation to an outside party for an unknown amount resulting from activities that have already taken place. Some examples would be:

<       Pending litigation

<       Income tax disputes

<       Product warranties

<       Notes receivable discounted

<       Guarantees of obligations of others

<       Unused balances of outstanding letters of credit

An actual liability is a real future obligation to an outside party for a known amount from activities that have already taken place. Some examples would be:

<       Notes payable

<       Accounts payable

<       Accrued interest payable

<       Income taxes payable

<       Payroll withholding liabilities

<       Accrued salaries and wages

 Auditor Actions:

If the auditor is concerned about the possibility of contingent liabilities for income tax disputes, there are various procedures available to use for an intensive investigation in that area. One good approach would be an analysis of income tax expense. Unusual 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 review the general correspondence file for communication with attorneys or internal revenue agents. This might give an indication that the potential for a liability exists even though no actual litigation has begun. Finally, an examination of internal revenue agent reports from prior years may provide the most obvious indication of disputed tax matters.

The auditor would be interested in a client's future commitments to purchase raw 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 raw materials at a fixed price may result in the client paying more or less than the market price at a future time.

The analysis of legal expense is an essential part of every audit engagement because it may give an indication of contingent liabilities which may become actual liabilities in the future and require disclosure in the current financial statements. Since 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 whom payment was made should be considered for letters of confirmation for contingencies (attorney letters).

An asserted claim is an existing legal action that has been taken against the client, whereas 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 lawsuit that would be damaging to the client, and that would otherwise not be filed.

If an attorney refuses to provide the auditor with information about material existing lawsuits or likely material unasserted claims, the audit opinion would have to be modified to reflect the lack of available evidence. This is required by SAS 12 (AU 337), 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 with auditors in obtaining information about contingencies.

Subsequent Events

The first type of subsequent event is one that has a direct effect on the financial statements and requires adjustment. Examples of this type of subsequent event are as follows:

<       Declaration of bankruptcy by a customer with an outstanding accounts receivable balance due to the deteriorating financial condition

<       Settlement of a litigation for an amount different from the amount recorded on the books

<       Disposal of equipment not being used in operations at a price below the current book value

<       Sale of investments at a price below recorded cost

<       Sale of raw 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 which disclosure is advisable. Examples include the following:

<        Decline in the market value of securities held for temporary investment or resale

<        Issuance of bonds or equity securities

<        Decline in the market value of inventory as a consequence of government action barring further sale of a product

<        Uninsured loss of inventories as a result of fire

The major considerations the auditor should take into account in determining how extensive the subsequent events review 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 between the balance sheet date and the completion of the audit

<       Changes in key personnel

 Auditors of public companies should be aware that PCAOB Standard 2 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.

Audit procedures normally performed as a part of the review for subsequent events are:

<       Cutoff and valuation tests of various balances and related transactions; e.g., sales cutoff tests

<       Inquire of management

<       Correspond with attorneys

<       Review internal statements prepared subsequent to the balance sheet date

<       Review records prepared subsequent to the balance sheet date

<       Examine minutes of meetings of board of directors and stockholders subsequent to the balance sheet date

<       Obtain a letter of representation

If 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 when the auditor becomes aware that some information included in the financial statements was materially misleading after the audited financial statements have been issued. Some examples of such facts would be:

<       Subsequent discovery of the inclusion of fraudulent sales

<       Subsequent discovery of the failure to write-off obsolete inventory

<       Omission of an essential footnote

In such cases when 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 new audit report and an explanation of the reasons for the revisions to the financial statements.

Disclosures in the Financial Statements - The Footnotes

The accumulation of audit evidence is crucial to the auditor in determining whether the financial statements are stated in accordance with generally accepted accounting principles, applied on a basis consistent with 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.

Examples where adequate disclosure could depend heavily upon the accumulation of evidence are:

<        The disclosure of declines in inventory values below 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

            Examples where audit evidence does not normally significantly affect the adequacy of the disclosure are:

<       Deciding whether a disposal of equipment should be recorded as an extraordinary item

<       The disclosure of an acquisition as a pooling of interests or a purchase

<       The disclosure of contingencies that the auditor was informed of by the client

Client Representation Letter (Required)

A letter of representation is a written communication from the client to the auditor which formalizes statements that the client has made about matters pertinent to the audit. SAS 85 (AU 333) suggests four categories of items that should be included in the letter. Below are those four items with examples in each category follow (refer students to SAS 85―AU 333―for a comprehensive list):

1.            Financial statements

<       Management's acknowledgment of its responsibility for the fair presentation in the financial statements of financial position, results of operations, and cash flows in conformity with generally accepted accounting principles

<       Management�s belief that the financial statements are fairly presented in conformity with generally accepted accounting principles

2.            Completeness of information

<       Availability of all financial records and related data

<       Completeness and availability of all minutes or meetings of stockholders, directors, and committees of directors

<       Absence of unrecorded transactions

3.            Recognition, measurement, and disclosure

<       Management�s belief that the effects of any uncorrected financial statement misstatements are immaterial to the financial statements       

<       Information concerning fraud involving (1) management, (2) employees who have significant roles in internal control, or (3) others where the fraud could have a material effect on the financial statements

<       Information concerning related party transactions and amounts receivable from or payable to related parties

<       Unasserted claims or assessments that the entity�s lawyer has advised are probable of assertion and must be disclosed in accordance with Financial Accounting Standards Board (FASB) Statement No. 5, Accounting for Contingencies

<       Satisfactory title to assets, liens or encumbrances on assets, and assets pledged as collateral

<       Compliance with aspects of contractual agreements that may affect the financial statements

4.            Subsequent events

<       Bankruptcy of a major customer with an outstanding account receivable at the balance sheet date

<       A merger or acquisition after the balance sheet date

5.         Internal controls

<       Management�s acknowledgement of its responsibility for establishing and maintaining effective internal controls over financial reporting.

<       Management�s conclusion about the effectiveness of internal control over financial reporting as of the end of the fiscal period.

<       Disclosure 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 weaknesses.

<       Management�s knowledge of any material fraud or other fraud involving senior management or other employees who 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.

Management Letter - Not Required

A management letter is a letter directed to the client to inform management of certain recommendations about the business which the CPA believes would be beneficial to the client.

Items that might be included in a management letter are:

<       Recommendation to switch inventory valuation methods

<       Recommendation to install a formal security system

<       Recommendation to prepare more timely bank reconciliations

<       Recommendation to segregate duties

<       Recommendation to have certain types of transactions authorized by specific individuals

Information Accompanying the Financial Statements

Information accompanying basic financial statements is any and all information prepared for management or outside users included with the basic financial statements. Examples include detailed comparative statements supporting control totals in the basic statements, supplementary information required by the SEC, statistical data such as ratios and trends, and specific comments on the changes that have taken place in the financial statements.The auditor can provide one of two 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.

SAS 8 (AU 550) requires the auditor to read information in annual reports containing audited financial statements for consistency with 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.

Audit Documentation Review

A regular audit documentation review is the one that is done by someone who is knowledgeable about the client and the unique circumstances in the audit. The purposes of this review are to:

<        Evaluate the performance of inexperienced personnel

<        To make sure that the audit meets the CPA firm's standard of performance

<        To counteract the bias that frequently enters into the auditor's judgment.

            Examples of important potential findings in a regular audit documentation review are:

<       Incorrect computations

<       Inadequate scope

<       Lack of proper documentation for audit decision

 An independent review is one done by a completely independent person who has no experience on the engagement. The purpose is to have a competent professional from within the firm who has not been biased by the ongoing relationship between the regular auditors and the client perform an independent review. Examples of important potential findings in an independent review are:

<       A number of small adjustments waived that should have been accumulated into an adjusting journal entry due to materiality

<       Too narrow and too biased of a scope in an audit area

<       Inadequate disclosure of contingencies

Required Communications with Company Boards of Directors

In addition to the SAS 114 required communications to those charged with governance, the Sarbanes-Oxley Act expands these communications requirements by also requiring public company auditors to timely report the following items to the audit committee:

<       All critical accounting policies and practices to be used.

<       All alternative treatments of financial information within generally accepted accounting principles that have been discussed with management, ramifications of the use of such alternative disclosures and treatments, and the treatment preferred by the auditor.

<       Other material written communications between 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. When 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.

What are the procedures that an auditor should apply to identify subsequent events up to the date of the auditor's report?

What are the important factors that auditors should consider while carrying out auditing of a company?

Which of the following procedures should an auditor generally perform regarding subsequent events?

What factors should auditors consider in deciding whether to accept or continue the engagement with a particular client?