Graded Forum - 070921 Financial Statement Reporting

1. What is the purpose of a client representation letter and what representations would you
request management to make in a client representation letter with regards to receivables,
inventories, minutes of the meeting, and subsequent events?

One objective of representation letters is to remind the client officers of their primary and
personal responsibility for the financial statements. Another is to document in the audit
working papers the client's responses to the significant questions asked by the auditors during
the engagement.

Written representations from management should be obtained for all financial statements and
periods covered by the auditor's report.

 In certain circumstances, the auditor may want to obtain written representations from
other individuals. For example, he or she may want to obtain written representations
about the completeness of the minutes of the meetings of stockholders, directors, and
committees of directors from the person responsible for keeping such minutes. 

 Receivables (Receivables have been recorded in the financial statements) - Receivables

have been recorded in the financial statements. Receivables recorded in the financial
statements represent valid claims against debtors for sales or other charges arising on
or before the balance-sheet date and have been appropriately reduced to their
estimated net realizable value.

 Inventories (Excess or obsolete inventories exist) - Provision has been made to reduce
excess or obsolete inventories to their estimated net realizable value.

2. What are the two types of subsequent events and in which ways are they treated
differently in the financial statements?

Subsequent events are events that occur after a company’s year-end period but before the
release of the financial statements. Depending on the situation, subsequent events may require
disclosure in a company’s financial statements.

1. Adjusting events

An event that provides additional information about pre-existing conditions that existed on the
balance sheet date. The financial statements are adjusted to reflect this additional information.

2. Non-adjusting events

A subsequent event that provides new information about a condition that did not exist on the
balance sheet date. For subsequent events that are new events and thus do not provide
additional information about pre-existing conditions that existed on the balance sheet, these
events are not recognized in the financial statements. However, a subsequent event footnote
disclosure should be made so that investors know the event occurred.

3. Describe why and how an auditor compares misstatements to materiality and tolerable
misstatement.

Auditing is expressing an opinion as to the fairness of financial statement presentation. It

provides reasonable assurance that the financial statements are free from MATERIAL
misstatements. It does not assure that the financial statements are totally free from errors.
When an auditor discovers an error or misstatement on one of the accounts being audited, he
will assess if the error is material enough to warrant an adjustment. If it is not material, it will
be considered a tolerable misstatement and will no longer be adjusted. So whether a
misstatement will be adjusted or not depends on the materiality of the amount involved. It is
considered material if it will affect decision making. The materiality of an amount depends on a
lot of factors like size of the firm, total assets, etc.

A tolerable misstatement is the amount by which a financial statement line item can differ from
its true amount without impacting the fair presentation of the entire financial statements. The
concept is used by auditors when designing audit procedures to examine the financial
statements of a client.

The tolerable misstatement that an auditor allows is a judgment call, based on the proportion
of planning materiality for an audit. If the perceived risk level is high, the tolerable
misstatement will be a smaller percentage of the planning materiality, such as 10-20%.
Conversely, if the perceived risk level is low, the tolerable misstatement can be a much higher
percentage of the planning materiality, such as 70-90%.

It is possible that there are tolerable misstatements in several financial statement line items.
When combined, these misstatements in aggregate could result in a material misstatement of
the financial statements. This is especially likely when management is engaged in financial
statement fraud, so that a number of individually tolerable misstatements are all in the same
direction, rather than offsetting each other.

4. What responsibility does an auditor have on discovering the omission of an audit

procedure considered necessary at the time of the audit engagement?

When the auditor concludes that an auditing procedure considered necessary at the time of the
audit in the circumstances then existing was omitted from his audit of financial statements, he
should assess the importance of the omitted procedure to his present ability to support his
previously expressed opinion regarding those financial statements taken as a whole. A review
of his working papers, discussion of the circumstances with engagement personnel and others,
and a re-evaluation of the overall scope of his audit may be helpful in making this assessment.
Also, subsequent audits may provide audit evidence in support of the previously expressed
opinion.

5. In forming an opinion on the financial statements, what factors should the auditor consider
in concluding whether the financial statements as a whole are free from material
misstatements, whether due to fraud or error?

When evaluating whether the financial statements as a whole are free of material
misstatement, the auditor should evaluate the qualitative aspects of the company's accounting
practices, including potential bias in management's judgments about the amounts and
disclosures in the financial statements.
The following are examples of forms of management bias:

 The selective correction of misstatements brought to management's attention during

the audit.
 The identification by management of additional adjusting entries that offset
misstatements accumulated by the auditor.

 Bias in the selection and application of accounting principles

 Bias in accounting estimates