Completing the Audit

Auditing: A Practical Approach with Data Analytics

Second Edition

Johnson and Wiley

Chapter 15

Completing the Audit

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Learning Objectives

L O 1 Apply the audit procedures used to search for loss contingencies. L O 2 Distinguish between the two types of material subsequent events and evaluate what effect they have on the financial statements, if any. L O 3 Describe engagement wrap-up procedures performed at the conclusion of the audit. L O 4 Evaluate the going concern assumption for a client. L O 5 Discuss what reporting is required to management and those charged with governance.

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Auditing and Assurance StandardsPCAOB AS 1201-1301

• AS 1201 Supervision of the Audit Engagement
• AS 1215 Audit Documentation
• AS 1220 Engagement Quality Review
• AS 1301 Communications with Audit Committees

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Auditing and Assurance StandardsPCAOB AS 2401-2810

• AS 2401 Consideration of Fraud in a Financial Statement Audit
• AS 2415 Consideration of an Entity’s Ability to Continue as a Going Concern
• AS 2505 Inquiry of a Client’s Lawyer Concerning Litigation, Claims, and Assessments
• AS 2801 Subsequent Events
• AS 2805 Management Representations
• AS 2810 Evaluating Audit Results

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Auditing and Assurance StandardsAuditing Standards Board (ASB) AU-C 220-320

• AU-C 220 Quality Control for an Engagement Conducted in Accordance with Generally Accepted Auditing Standards
• AU-C 230 Audit Documentation
• AU-C 240 Consideration of Fraud in a Financial Statement Audit
• AU-C 260 The Auditor’s Communication with Those Charged with Governance
• AU-C 320 Materiality in Planning and Performing the Audit

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Auditing and Assurance StandardsAuditing Standards Board (ASB) AU-C 450-580

• AU-C 450 Evaluation of Misstatements Identified During the Audit
• AU-C 501 Audit Evidence—Specific Considerations for Selected Items
• AU-C 520 Analytical Procedures
• AU-C 560 Subsequent Events and Subsequently Discovered Facts
• AU-C 570 The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern
• AU-C 580 Written Representations

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Audit Procedures for Loss Contingencies

LEARNING OBJECTIVE 1Apply the audit procedures used to search for loss contingencies.

• Every company, no matter how big or how small, faces the risk of events happening today that have consequences in the future.
• What is the proper accounting treatment for a situation like this one, in which the company could still be liable to many different groups over an extended period of time?
• FASB ASC Topic 450, Contingencies, provides accounting guidance for events, or potential events, that create uncertainty for a company.
• FASB defines a loss contingency as an existing condition or situation involving uncertainty as to possible loss that will ultimately be resolved when one or more future events occur or fail to occur.

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Accounting for Loss Contingencies

• FASB ASC Topic 450 classifies the likelihood of loss contingencies into three categories:
• 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.
• If management determines the loss contingency is probable and an amount can be reasonably estimated, then the company must record a liability and a related expense or loss and disclose the relevant details of the event in the notes.
• If the loss contingency is reasonably possible or the amount cannot be reasonably estimated, then only a disclosure in the notes is required.
• If the likelihood of a loss contingency is remote, then nothing needs to be disclosed in the notes.

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Auditing Loss Contingencies

• Auditors should carefully consider the completeness assertion for loss contingencies.
• Management may not be sufficiently objective and could fail to identify loss contingencies or may classify identified contingencies as remote to avoid accruing or disclosing them.
• Failing to identify one or more material loss contingencies is a material misstatement.
• Illustration 15.1 provides examples of audit procedures used during risk assessment and/or risk response that can reveal the potential risk for loss contingencies.

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Illustration 15.1 Risk Assessment and Risk Response Procedures that may Identify Loss Contingencies

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Legal Letter

• Toward the end of the audit, auditors perform an inquiry procedure specifically designed to gather information about loss contingencies arising from litigation, claims, and assessments.
• Auditors will communicate directly with the client’s external legal counsel by sending a letter of inquiry, often referred to as a legal letter.
• The objective of the legal letter is to gather evidence regarding:
• The existence of uncertainties arising from litigation, claims, and assessments.
• The time period in which the cause for the legal action occurred.
• The probability of an unfavorable outcome for the client.
• An estimate of the potential loss.

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Sections of a Legal Letter

• A legal letter used for the Cloud 9 audit is presented in Illustration 15.2, followed by explanations of the bracketed numbers.
• Sections of the letter in Illustration 15.2 are numbered to correspond with the following explanations:
• Client letterhead
• Date of the letter
• Name and address of attorneys
• Request for information
• Response regarding pending or threatened litigation
• Response regarding unasserted claims of assessments
• Time frame for preparing the response
• Signature

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Illustration 15.2 Example of Legal Letter Used for Cloud 9 AuditSections 1 to 4

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Illustration 15.2 Example of Legal Letter Used for Cloud 9 AuditSections 5 to 6

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Illustration 15.2 Example of Legal Letter Used for Cloud 9 AuditSections 7 to 8

Source: AU-C 501.A69 and AS 2505A.

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Subsequent Events

LEARNING OBJECTIVE 2Distinguish between the two types of material subsequent events and evaluate what effect they have on the financial statements, if any.

• The financial statements are prepared by client management on the basis of conditions existing at year-end, which would be December 31 for a calendar-year entity.
• For public companies, the SEC has strict deadlines for the filing of Form 10-K, which is the document that contains the company’s audited annual financial statements.
• Illustration 15.3 summarizes the SEC’s filing deadlines for Form 10-K.

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Illustration 15.3 Public Company Filing Deadlines for Form 10-K

Source: www.sec.gov.

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Accounting for Subsequent Events

• Since auditors usually conduct part of the audit during the 60–90 day period after year-end, they should be alert to certain subsequent events that may occur between the date of the financial statements and the date of the auditor’s report.
• Illustration 15.4 illustrates an example of the subsequent period for a calendar-year client whose audit is completed no more than 60 days after year-end.
• Auditing standards distinguish between two types of subsequent events, as follows:
• Type I subsequent event. Event that provides evidence of conditions that existed at the date of the financial statements.
• Type II subsequent event. Event that provides evidence of conditions that arose after the date of the financial statements.

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Illustration 15.4 Illustration of the Subsequent Period for a Calendar Year Client

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Audit Reasoning ExampleSubsequent Event: Imperial Coffees

• Imperial Coffees, Inc. is a coffee roaster and directly sells its coffee through grocery stores, restaurants, and corporate-owned coffee cafes. For almost a decade, Imperial has experienced explosive growth and has acquired smaller coffee roasters all over the United States and some international locations. Imperial’s most recent fiscal year just ended, and its auditors are completing year-end fieldwork.
• Jorge is an audit manager on the audit team and meets with Stephanie, Imperial’s CFO, one month after year-end. Jorge says, “I know the board of directors just had its monthly meeting. Are the minutes from the meeting available for me to review?” “Yes, I have them right here,” says Stephanie. “I’ll go ahead and tell you the most important item that was discussed. The board has decided to acquire the largest coffee roaster in Nicaragua, Central America. The acquisition process will take several months, but should be completed this year. The board feels this is an excellent strategic move because Nicaragua is the twelfth-largest coffee producer in the world. Having operations in Nicaragua could help form strategic alliances with the coffee growers there, which could lead to reduced costs for some of our coffee supply.”

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Audit Reasoning ExampleSubsequent Event: Type II

• Jorge relays this news to his audit team. Jorge asks Lincoln, a first-year audit associate, if this event impacts the financial statements they are currently auditing. Lincoln says, “Well, it is definitely important news that stakeholders should know about. But since the acquisition hasn’t happened yet, I don’t think it should affect any accounts on the financial statements for the most recent fiscal year. I do think it should be disclosed in the financial statements since the board has made the decision and the financials have not yet been issued. Imperial management should draft a disclosure to include in the notes to the financial statements.”
• “You are correct, Lincoln,” says Jorge. “This is called a Type II subsequent event. Management will draft the disclosure and we will review it.”

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Auditing Subsequent Events

• These audit procedures include:
• Obtaining an understanding of how management identifies subsequent events.
• Inquiring of management and, if necessary, those charged with governance about whether subsequent events have occurred that may impact the financial statements.
• Reading the minutes of manager meetings and/or board of directors’ meetings that have been held after the date of the financial statements.
• Reading the client’s subsequent interim financial statements, if available, and other data, such as budgets and cash flow forecasts.
• Scanning manually, or through the use of audit data analytics, sales and receipts journals or other accounting records relating to transactions that have occurred after the date of the financial statements.
• Inquiring of the client’s legal counsel regarding litigation, claims, and assessments.

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Illustration 15.5 Examples of Inquiries of Management Regarding Subsequent Events

Source: AU-C 560.A6.

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Engagement Wrap-Up

LEARNING OBJECTIVE 3Describe engagement wrap-up procedures performed at the conclusion of the audit.

• After performing audit procedures related to loss contingencies and subsequent events, auditors are in a position to start wrapping up the audit.
• This is the audit team’s last chance to evaluate audit evidence before forming an opinion on the financial statements and determining the appropriate independent auditor’s report to issue.

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Final Analytical Procedures

• Auditing standards require that analytical procedures be used once again near the end of the audit to assist the auditor in forming an overall conclusion about whether the financial statements are consistent with the auditor’s understanding of the entity (AU-C 520.01).
• The actual analytical procedures performed will depend on auditor judgment and may vary by client.
• The final analytical procedures are intended to corroborate audit evidence obtained during the audit and to confirm the financial statements are consistent with the auditor’s revised expectations based on evidence evaluated during the audit.

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Final Evaluation of Audit Findings

• At the conclusion of the audit, auditors:
• Reevaluate materiality decisions made during the audit.
• Reevaluate audit risks based on audit findings, including inherent risk, control risk, and fraud risk.
• Evaluate misstatements found during the audit.

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Final Evaluation of Audit FindingsFinal Evaluation of Materiality

• During execution of the audit, materiality, as a whole or for a specific account or class of transactions, may be revised if auditors become aware of new information that would have caused them to determine a different level of materiality.
• For example, auditors may decide to lower the performance materiality level for the occurrence and accuracy assertions for sales transactions and adjust the nature or extent of their procedures.
• If near the end of the audit it is determined that a lower level of overall materiality is appropriate, auditors would consider if sufficient appropriate evidence has been obtained.
• If the answer is no, they would determine the nature and extent of further audit procedures to perform to obtain more audit evidence.

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Final Evaluation of Audit FindingsFinal Evaluation of Inherent Risk, Control Risk, and Fraud Risk

• Auditors specifically reconsider their assessment of control risk at the entity level when they become aware of significant changes in the client’s system of internal control and after they perform tests of controls.
• Discovery of Misstatements
• When the results of substantive procedures identify misstatements, auditors consider whether the misstatements may indicate the need to reevaluate inherent risk, control risk, or fraud risk.
• Discovery of Fraud
• If it is determined that fraud is the cause of misstatements in an account, class of transactions, or disclosure, it does not matter if the misstatements are material or immaterial because fraud typically does not occur as an isolated incidence.

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Final Evaluation of Audit FindingsEvaluation of Misstatements Identified During the Audit

• The auditor accumulates misstatements in accounts as they are identified during the audit, except for those that are “clearly trivial.”
• Determining if something is clearly trivial is a matter of professional judgment.
• Factual Misstatements are misstatements that are known with certainty.
• Judgmental Misstatements typically involve accounting estimates in which estimation uncertainty, complexity, and subjectivity are inherent risk factors.
• Projected Misstatements are the result of audit sampling.

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Final Evaluation of Audit FindingsEvaluation of Uncorrected Misstatements

• During the final evaluation, auditors evaluate the effect of uncorrected misstatements on the financial statements.
• When evaluating the effect of uncorrected misstatements, both quantitative and qualitative factors are considered.
• Quantitative Factors
• Uncorrected immaterial misstatements should be aggregated to determine if, in total, they exceed the materiality level for the financial statements as a whole or the materiality level for a class of transactions, an account balance, or a disclosure.
• Qualitative Factors
• Even if uncorrected immaterial misstatements do not exceed materiality for the financial statements as a whole or at the class of transactions, account balances, or disclosure level, certain qualitative characteristics may cause auditors to evaluate them as material.

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Illustration 15.6 Analysis of Aggregate Likely Misstatement Working Paper

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Illustration 15.7 Examples of Qualitative Characteristics of Immaterial Misstatements

Source: AU-C 450.A28.

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Completion of Working Paper Review

• All audit documentation will have a preparer and a reviewer or multiple reviewers.
• As procedures are completed and documented in the working papers, the preparer will “sign off” with his or her initials and the date when he or she feels the work is ready for review.
• The work is reviewed by an audit team member with seniority over the team member who did the work.
• The review process is an essential component of ensuring the audit team members maintain professional skepticism.
• Illustration 15.8 provides a list of items an audit team member considers when reviewing the work of another team member.

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Illustration 15.8 Items to Consider When Reviewing Working Papers

Source: AU-C 220.A16 and AS1201.05f.

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Audit Reasoning ExampleWorking Paper Review

• Jacob Bourgeois is a first-year audit associate at TB&I accounting firm. It is his first busy season, and he is assigned to a manufacturing client in Detroit, Michigan. Jacob has completed the audit procedures for tests of details of balances for accounts receivable. He feels very confident about his work and doesn’t think he will have any review comments to address. Jacob tells the audit senior, Maggie, that his work is ready to be reviewed.
• The next day, Maggie says to Jacob, “Overall, you have done a good job and I can tell that you understand the purpose of the audit procedures you have completed. However, there are a few instances in which you have not sufficiently documented your follow-up procedures. For example, to gather evidence about the client’s past due accounts, the procedures from the audit program are:
• Examine evidence of collectibility, such as correspondence with customers and outside collection agencies, credit reports, and customers’ financial statements.
• Inquire about collectibility of accounts with appropriate management personnel.

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Audit Reasoning ExampleWorking Paper Review: Corroborate

• You notated in the working papers that you examined the client’s correspondence with customers who had large overdue balances. However, you did not put a copy of the correspondence in the working papers to substantiate that your examination procedure was completed. You also documented that you spoke with an accounts receivable clerk about the status of overdue accounts. It is more appropriate to inquire of the accounts receivable manager, someone with more authority, regarding the status of the overdue accounts. You need to schedule a meeting with the accounts receivable manager today, and be sure you take good notes so you can thoroughly document your discussion in the working papers. Also, remember that inquiry alone is not sufficient. You will need to corroborate any discussions with additional evidence.”

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Engagement Quality Review

• To ensure the audit team has conducted the audit in accordance with standards and gathered sufficient appropriate evidence to support the audit conclusions, an engagement quality control reviewer will review selected areas of working papers prior to the issuance of the audit report.
• The engagement partner discusses with the engagement quality control reviewer the significant findings and other issues encountered during the audit.
• Ultimately, the reviewer evaluates the conclusions reached in determining if the financial statements are fairly presented and ensures the proposed auditor’s report is appropriate based on the audit team’s work.

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Completion of Documentation

• The working papers are the property of the firm and act as support for the auditor’s opinion.
• The working papers do not have to be completely assembled and archived before the audit report release date.
• However, auditing standards do provide a deadline for the complete assembly of the audit file and a time frame for how long the audit file should be retained by the firm.
• Illustration 15.9 summarizes the time frames for assembly and retention of the audit file for both public and private company audits.

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Illustration 15.9 Assembly and Retention of Audit Documentation

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Going Concern

LEARNING OBJECTIVE 4Evaluate the going concern assumption for a client.

• The going concern assumption is a fundamental principle in the preparation of the financial statements.
• Under the going concern assumption, an entity is viewed as continuing in business for the foreseeable future with neither the intention nor the need for liquidation.
• As a result, assets and liabilities are recorded on the basis that the entity will realize its assets and pay its liabilities in the normal course of business.

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Management Responsibility

• Management is responsible for evaluating its status as a going concern in accordance with the applicable financial reporting framework.
• GAAP (FASB ASC 205-40 Presentation of Financial Statements—Going Concern) requires management to make an assessment of the entity’s ability to continue as a going concern for the future period of one year beyond the issuance date of the financial statements.
• Illustration 15.10 provides a timeline example to illustrate management’s responsibility.

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Illustration 15.10 Management’s Going Concern Evaluation Period

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Auditor Responsibility

• Auditors have a responsibility to gather evidence regarding:
• Management’s process for evaluating the going concern status.
• The appropriateness of management’s conclusions regarding it.
• If management does not have a formal process in place, it could be considered a deficiency in internal control.
• Auditors also draw their own conclusions about whether there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time.
• The PCAOB defines a reasonable period of time as one year from the date of the financial statements (AS 2415.02).

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Audit Procedures to Evaluate Going Concern

• Audit procedures that are performed throughout the audit as part of risk assessment and risk response should identify events or conditions that could signify going concern issues.
• Illustration 15.11 provides a list of procedures and examples of the types of going concern issues that may be identified through the performance of routine audit procedures.
• Auditors perform procedures to gather evidence about the mitigating factors and consider whether the plans can be effectively implemented.
• After considering management’s plans, if auditors determine there is substantial doubt about the entity’s ability to continue as a going concern, the next steps are to consider the possible effects on (1) the financial statements and (2) the auditor’s report.
• Auditors consider modifying the auditor’s report to further emphasize the substantial doubt about the entity’s ability to continue as a going concern.
• The final step is to communicate with those charged with governance.

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Illustration 15.11 Audit Procedures that may Identify Going Concern Issues

Source: AU-C 570.A7 and .A28.

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Management Representation and Communication with Those Charged with Governance

LEARNING OBJECTIVE 5Discuss what reporting is required to management and those charged with governance.

• Throughout the entire audit, auditors communicate often with management and other client personnel in the process of gathering evidence.
• As the audit draws to a conclusion, some required communications must take place with management and those charged with governance, and the communications must be documented.
• The remainder of this section will explain the management representation letter and the required communications with those charged with governance.

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Management Representation Letter

• A written representation is a written statement by management provided to the auditor to confirm certain matters or to support other audit evidence (AU-C 580.07).
• The responses to the inquiries are documented in the auditor’s working papers. As supplemental evidence to the inquiries, auditors are required to obtain a management representation letter as a final piece of audit evidence.
• A management representation letter:
• Is addressed to the auditor and signed by management
• Acknowledges management’s responsibility for the preparation of the financial statements
• Details verbal representations made by management during the course of the audit.

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Sections of Management Representation Letter

• Illustration 15.12 contains a management representation letter for the Cloud 9 audit. Since Cloud 9 is a public company, the letter has been prepared using the example provided in the PCAOB standard.
• Sections of the management representation letter in Illustration 15.12 are numbered to correspond with the following explanations:
• Client letterhead
• Date
• Address
• Identification of audit
• Materiality
• List of items that management is confirming
• Subsequent events statement
• Signatures

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Illustration 15.12 Management Representation Letter for Cloud 9 AuditSections 1 to 4

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Illustration 15.12 Management Representation Letter for Cloud 9 AuditSections 5 to 6.5

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Illustration 15.12 Management Representation Letter for Cloud 9 AuditSections 6.6 to 6.10

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Illustration 15.12 Management Representation Letter for Cloud 9 AuditSections 6.11 to 6.13

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Illustration 15.12 Management Representation Letter for Cloud 9 AuditSections 7 to 9

Source: AS 2805.16.

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Communication with Those Charged with Governance

• Governance structures will vary by client.
• Public companies will have a board of directors with an audit committee, and large private companies may also have a board of directors.
• For medium and smaller companies, governance responsibility may fall upon owners, partners, trustees, or a committee of upper management.
• In very small companies, one person may be in charge of governance, such as the owner-manager.

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Communication with Those Charged with GovernanceCommunication at the Start and Throughout the Audit

• Communication with those charged with governance, with management, and with third parties, when applicable, is covered in auditing standards.
• Here are a few examples of situations that should be communicated:
• Identification of fraud or information that indicates the existence of a fraud.
• Identification of material noncompliance with laws and regulations.
• Significant findings or issues arising during the audit in connection with the entity’s related parties.
• Auditors normally communicate these items during the course of the audit as the issues arise.

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Communication with Those Charged with GovernanceCommunication at the End of the Audit

• Toward the end of the audit, auditors communicate significant findings or issues from the audit to those charged with governance.
• This communication should take place before the audit report is issued.
• The communication may be oral or written, but either way it must be documented in the working papers.
• Illustration 15.13 lists the matters to be communicated with those charged with governance near the end of the audit.

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Illustration 15.13 Matters to be Communicated With Those Charged With Governance (1-5)

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Illustration 15.13 Matters to be Communicated With Those Charged With Governance (6-9)

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Illustration 15.13 Matters to be Communicated With Those Charged With Governance (10-13)

Source: AU-C 260.12–.14, .A25–.A42.

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Communication with Those Charged with GovernanceUnique Communications for Public Company Audits

• For a public company audit, the items in Illustration 15.13 should be communicated with the audit committee of the board of directors.
• In addition, the PCAOB standard specifies that critical accounting policies and practices and critical accounting estimates must be communicated to the audit committee.
• An entity’s critical accounting policies and practices are most important for the portrayal of the company’s financial condition and results, and require management’s most difficult, subjective, or complex judgments (AS 1301.A4).
• Auditors must discuss their assessment of management’s application of and disclosure of the critical accounting policies and practices, including any recommended modifications that management did not make.

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Copyright

Copyright ©2022 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 19 76 United States Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

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