CHAPTER EIGHT

COMPLETING THE AUDIT

Objectives:
After studying this chapter, you should be able to:
1. Conduct a review for contingent liabilities and commitments.

2. Obtain and evaluate letters from the client's attorneys.

3. Explain the purpose of a subsequent events review.

4. Discuss the procedures to be undertaken in performing subsequent events review.

5. Define and discuss the significance of the concept of going concern.

6. Explain the importance of and the need for going concern reviews.

7. Explain the respective responsibilities of auditors and management regarding going

concern.

8. Discuss the procedures to be applied in performing going concern reviews.

9. Discuss the disclosure requirements in relating to going concern issues.

10. Understand the purposes and content of management representation letters.

11. Discuss the quality and reliability of management representations as audit evidence.

12. Discuss the circumstances where management representations are necessary and the
matters on which representations are commonly obtained.

13. Discuss the importance of the overall review of evidence obtained.

14. Identify the auditor's responsibilities when facts affecting the audit report are
discovered after its issuance.
Introduction

This chapter covers several activities that complete the audit. Applying basic analytical
procedures to the income statement detail may bring to light unexpected results for which
the auditor has yet obtained sufficient competent evidence. The auditor must make sure that
the disclosures are adequate. The auditor should review information that becomes available
after the balance sheet date but prior to issuing the audit report to see if amounts should be
revised or additional disclosure made. The auditor should make a final assessment of the
risk of a material misstatement having gone undetected by the procedures that were
performed during the audit.

Review for contingent liabilities and commitments

A loss contingency may be defined as a possible loss, stemming from past events that will
be resolved as to existence and amount by some future event. Central to the concept of
contingent is the idea of uncertainty as to both the amount of loss and whether, in fact, any
loss has been incurred. This uncertainty is resolved when some future event occurs or fails
to occur. Most loss contingencies may also appropriately be called contingent liabilities.

Contingent liability is a potential future obligation to an outside party for an unknown

amount resulting from activities that have already taken place. An actual liability is a real
future obligation to an outside party for a known amount from activities that have already
taken place.

SFAS No.5,”accounting for contingencies,” provides the standard for accruing and
disclosing three categories of contingent loss: those for which an unfavorable outcome is
(1) probable, (2) reasonably possible, and (3) remote. It requires the accrual and disclosure
of probable contingent loss that can be reasonably estimated. It also requires the disclosure
of probable contingencies that are not accrued, those that are reasonably possible, and those
remote contingencies that are disclosed because of common practice, such as the guarantee
of another company’s debt. Contingencies include the following:

Collectability of receivables and loans

Product warranty liability
Litigation, claims, and assessments
 Guarantees of debts to others
Agreements to repurchase receivables that have been sold
Purchase and sale commitments

Responsibilities related to contingencies: management is responsible for designing and

maintaining policies and procedures to identify, evaluate, and account for contingencies.
Auditors are responsible for determining that the client has properly identified, accounted for,
and disclosed material contingencies. Contingencies are not just for footnote disclosure. If a
contingency is probable and reasonably capable of estimation, it meets the criteria for financial
statement recording. Recall that not everything in the financial statements requires precise
estimates before they are booked. For example, most financial institutions do not know
precisely how much of their loans will not be collectible, but that does not stop them from
making a “best estimate.” The same concept is true of other contingencies.

Sources of evidence of contingencies: the primary source of information concerning

contingencies is the client’s management. The auditor should obtain the following from
management:

 A description and evaluation of contingencies that existed at the balance sheet date
or that arose prior to the end of the fieldwork and the lawyer(s) consulted.

 Assurance in the management representation letter that the accounting and

disclosure requirements of SFAS No.5 have been met.

The auditor should also examine related documents in the client’s possession, such as
correspondence and invoices from lawyers. Additional sources of evidence are the corporate
minutes, contracts, correspondence from governmental agencies, and bank confirmations. In
performing an examination in accordance with generally accepted auditing standards, the
independent auditor must obtain appropriate audit evidence pertaining to litigation, claims, and
assessments.
Review documents: the auditors should ask management about pending litigation or possible
future litigation and about controls adopted to identify, evaluate, and account for such items.
In conjunction with these inquires the auditor should also review appropriate documents.
Those documents could include:

1. Minutes of meetings of stockholders, board of directors, and other executive committees;

2. Correspondence and invoices from lawyers; and
3. Contracts, loan agreements, loan guarantees, leases, and correspondence from taxing
authorities.

Specific inquiry in to litigation: if it comes to the auditor’s attention that the entity is
involved in litigation or is threatened with litigation, the auditor should inquire regarding:

1. The nature of the matter, including the period of occurrence;

2. The progress of the case to date, including management’s intended response;
3. The degree of probability of an unfavorable outcome; and

4. The amount or estimate of potential loss.

Note: it is management’s responsibility to identify and account for litigation, claims, and
assessments through the policies adopted by management for such purposes. The
management representation letter should indicate that management has disclosed to the
independent auditor all such relevant information.

Letter of audit inquiry; the primary source of corroborative evidence concerning litigation,
claims, and assessments is the client’s legal counsel. The auditor should ask the client to send
a letter of audit inquiry to their legal counsel asking their legal counsel to confirm
information about asserted claims and those claims that are probable of assertion. There must
be a direct letter of inquiry to the client’s attorneys. In this letter, management details any
pending or threatened litigation matters. The letter is signed by the client and sent by the
auditors to the attorneys.

a. Response by attorneys: the attorneys in turn send their replies directly to the
independent auditor. In these replies, attorneys give their evaluation concerning
litigation matters within their knowledge or control.
b. Limitation on response: the lawyer’s response to the letter of inquiry should include a
professional opinion on the expected outcome of any lawsuit and the likely outcome of
any liability, including court costs.

c. “Substantial Attention” limitation: lawyers may limit their replies to matters to which
they have given substantial attention. Responses may also be limited to material matters
if an understanding has been reached between the lawyer and the auditor as to what
amount be considered material.

d. Confidentiality limitation: in some cases, it may be unwise for a lawyer to disclose

certain confidential information. An example of this may be knowledge of a patent
violation, if the disclosure of violation in the financial statements could bring about a
lawsuit. Attorneys are hesitant to provide much information to auditors. They know that
the auditors will document that information in most states, and the information is not
protected by privileged communication. Information that is not privileged can be
subpoenaed by a court of law and serve as evidence against the client. Attorneys usually
have privileged communication with their clients. The letter of audit inquiry should
include:

 Identification of the company, its subsidiaries, and the date of the audit
 Management’s list (or a request by management that the lawyer prepare a list) that
describes and evaluates the contingencies to which the lawyer has devoted
substantial attention.
 A request that the lawyer furnish the auditor with the following:
i. a comment on the completeness of management’s list and evaluations
ii. for each contingency
 A description of the nature of the matter, the progress to date and the
action the company intends to take.
 An evaluation of the likelihood of an unfavorable outcome and an
estimate of the potential loss or range of loss, if possible
iii. Any limitations on the lawyer’s response, such as not devoting substantial
attention to the item or the amounts are not material
 e. Refusal to respond; a lawyer’s refusal to respond to a letter of inquiry where the lawyer
has devoted substantial attention to litigation matters is a limitation in the scope of an
independent auditor’s examination, sufficient to preclude an unqualified opinion.

f. Refusal to permit inquiry; a client’s refusal to permit inquiry of the attorneys generally
will result in disclaimer of opinion.

g. Inherent uncertainties: in some cases, inherent uncertainties may make it difficult for a
lawyer to form conclusions regarding pending litigation. If the auditor is satisfied
financial disclosure is adequate, no modification to the opinion would be required.

Effect of contingency on audit report: a lawyer’s refusal to furnish the requested information
either orally or in writing is a scope limitation precluding an unqualified opinion. How ever, the
lawyer may be unable to form a conclusion on the likelihood of an unfavorable outcome or the
amount of potential loss because of inherent uncertainties. Such a response is not considered a
scope limitation. If the effect of the matter could be material to the financial statements, the
auditor may choose to emphasize the matter by adding an explanatory paragraph to the audit
report.

Adequacy of disclosures: the auditor’s report covers the basic financial statements, which
include the balance sheet, income statement, statement of cash flows, a statement of changes in
stockholders' equity or retained earnings, and the related footnotes. According to the third
standard of reporting, “Informative disclosures in the financial statements are to be regarded as
reasonably adequate unless otherwise stated in the report.”

Disclosures can be made on the face of the financial statements in the form of classifications or
parenthetical notations and in the footnotes. Placement of the disclosure should be dictated by
the clearest manner of presentation. In many cases, industry practice has evolved to indicate
acceptance of one method versus the other. The auditor must be sure that the disclosures are
adequate, but not as extensive or wordy as to hide the importance matters. Confidential
information should not be disclosed without the client’s permission unless it is required to be
disclosed by accounting or auditing standards or is considered necessary for fair presentation.
The auditor should consider matters for disclosure while gathering evidence during the course of
the audit, not just at the end of the audit. While auditing cash, fore example, evidence should be
gathered concerning compensating balances or any other restrictions on the use of cash.

During the audit of receivables, the auditor should be aware of the need to separately disclose
receivables from officers, employees, or other related parties, and the pledging receivables as
collateral for a loan.

One of the key disclosures is a summary of significant accounting principles used by the
company. In evaluating this summary, the auditor is guided by the evolving nature of business as
opposed to simply reviewing IASB. As an example, the method of revenue recognition may be
the most important disclosure for the new breed of internet companies, but the FASB has not
issued authoritative statements mandating specific disclosures.

Subsequent events

The auditor should consider the effect of subsequent events on the financial statements and on
the auditor’s report. This section presents three situations relating to events occurring after the
balance sheet date that require special audit attention:

Review of events occurring prior to issuance of the audit report, a normal part of each
audit.
Subsequent discovery of facts existing at the date of the auditor’s report
Consideration of omitted procedures after the report date

Events occurring up to the date of the auditor’s report

The auditor should perform audit procedures designed to provide sufficient appropriate audit
evidence that all material subsequent events up to the date of the auditor’s report that may
require adjustment of, or disclosure in, the financial statements have been identified, properly
accounted for or adequately disclosed.

Facts discovered after the date of the auditor’s report but before the financial
statements are issued
When, after the date of the auditor’s report but before the financial statements are issued, the
auditor becomes aware of a fact, which may materially affect the financial statements, the auditor
should consider whether the financial statements need amendment, should discuss the matter
with management, and should take the action appropriate in the circumstances.

When management does not amend the financial statements in circumstances where the auditor
believes they need to be amended (and the audit report has not been released to the entity), the
auditor should express a qualified or adverse opinion.

Facts discovered after the financial statements have been issued

When, after the financial statements have been issued, the auditor becomes aware of a fact which
existed at the date of the auditor’s report and which, if known at that date, may have caused the
auditor to modify the auditor’s report, the auditor should consider whether the financial
statements need revision, should discuss the matter with management, and should take action
appropriate to the circumstances.

The new auditor’s report should include an emphasis of matter paragraph referring to a note in
the financial statements that more extensively discusses the reason for the revision of the
previously issued financial statements and to the earlier report issued by the auditor.

Audit procedures to identify subsequent events

a. Review the procedures management has established to ensure that subsequent events
are identified.

b. Read minutes of the meetings of shareholders, those charged with governance,

including established committees such as relevant executive committees and the audit
committee, held after the date of the financial statements and enquire about matters
discussed at meetings for which minutes are not yet available.

c. Read the entity's latest available interim financial statements and, as considered
necessary and appropriate, budgets, cash flow forecasts and other related management
reports.
 d. Enquire, or extend previous oral or written enquiries, of the entity’s legal counsel
concerning litigation and claims.

e. Enquire of management as to whether any subsequent events have occurred which

might affect the financial statements. On the other hand, inquire of management
concerning:

 Any significant changes noted in the interim statements.

 The existence of significant contingent liabilities or commitments at the balance sheet

date or date of inquiry, which should be near the end of fieldwork

 Any significant changes in working capital, long-term debt, or owners’ equity.

 The status of items for which tentative conclusions were drawn earlier in the audit.

 Any unusual adjustments made to the accounting records after the balance sheet date.

(f) Obtain a management representation letter.

Going-concern

When planning and performing audit procedures and in evaluating the results thereof, the
auditor should consider the appropriateness of management’s use of the going concern
assumption underlying the preparation of the financial statements.

Under the going concern assumption, an entity is ordinarily viewed as continuing in business
for the foreseeable future with neither the intention nor the necessity of liquidation, ceasing
trading or seeking protection from creditors pursuant to laws or regulations.

Management’s assessment of the entity’s ability to continue as a going concern should cover
a period of at least 12 months after period end.

In obtaining an understanding of the entity, the auditor should consider whether there are
events or conditions and related business risks which may cast significant doubt on the
entity’s ability to continue as a going concern.
Based on the audit evidence obtained, the auditor should determine if, in his judgment, a
material uncertainty exists related to events or conditions that alone or in aggregate, may cast
significant doubt on the entity’s ability to continue as a going concern.

Examples of events or conditions, which may cast significant doubt on the going concern
assumption include:

Financial
Net liability or net current liability position
Fixed-term borrowings approaching maturity without realistic prospects of
renewal or repayment; or excessive reliance on short-term borrowings to
finance non-current assets
Indications of withdrawal of financial support by debtors and other creditors
Negative operating cash flows indicated by historical or prospective financial
statements
Adverse key financial ratios
Substantial operating losses or significant deterioration in the value of assets
used to generate cash flows.
Arrears or discontinuance of dividends
Inability to pay creditors on due dates
Inability to comply with the terms of loan agreements
Change from credit to cash-on-delivery transactions with suppliers.
Inability to obtain financing for essential new product development or other
essential investments
Operational
Loss of key management without replacement
Loss of a major market, franchise, license, or principal supplier
Labor difficulties or shortages of important supplies

Other

Non-compliance with capital or other statutory requirements

 Pending legal or regulatory proceedings against the entity that may, if
successful, result in claims that are unlikely to be satisfied.
Changes in legislation or government policy expected to adversely affect the
entity.

Relevant audit procedures may include:

a. Analyzing and discussing cash flow, profit and other relevant forecasts with
management

b. Analyzing and discussing the entity’s latest available interim financial statements.

c. Reviewing the terms of debentures and loan agreements and determining whether
any have been breached.

d. Reading minutes of the meetings of shareholders, those charged with governance

and relevant committees for reference to financing difficulties.

e. Enquiring of the entity’s lawyer regarding the existence of litigation and claims and
the reasonableness of management’s assessments of their outcome and the estimate
of their financial implications

f. Confirming the existence, legality and enforceability of arrangements to provide or

maintain financial support with related and third parties and assessing the financial
ability of such parties to provide additional funds.

g. Considering the entity’s plans to deal with unfilled customer orders

h. Reviewing events after period end to identify those that either mitigate or otherwise
affect the entity’s ability to continue as a going concern.

When analysis of cash flow is a significant factor in considering the future outcome of events
or conditions the auditor considers:
 The reliability of the entity’s information system for generating such
information, and

Whether there is adequate support for the assumptions underlying the forecast.

In addition, the auditor compares:

The prospective financial information for recent prior periods with historical
results, and

The prospective financial information for the current period with results
achieved to date.

The auditor will form his opinion on the going concern status of the company based on the
outcome of the above.

Mitigating factors: if the auditor concludes that there may be a going concern problem,
management’s plans to overcome this problem should be identified and assessed.
Management may plan to sell non-essential assets, borrow money or restructure existing
debt, reduce or delay unnecessary expenditures, and /or increase owner investments. The
auditor should identify those factors that are most likely to resolve the problem and gather
independent evidence to determine the likely success of such plans. For example, if financial
projections are an integral part of the solution, the auditor should ask management to provide
that information and the underlying assumptions. The auditor should then consider the
adequacy of support for the major assumptions.

Effects on the financial statements: If the auditor continues to believe that, there is
substantial doubt about the client continuing as a going-concern for a reasonable period of
time, not to exceed one year beyond the date of the financial statements being audited. Such
disclosures might include the conditions causing the going-concern doubt, management’s
evaluation of the significance of those conditions and its plans to overcome the problem, and
information about the effect on amounts and classification of assets and liabilities. When the
auditor believes that management’s plans are likely to alleviate the problem, disclosure of the
conditions that initially led to the going-concern doubt should be considered.

Management representations
 The auditor should obtain appropriate representations that management acknowledges its
collective responsibility for the fair presentation of the financial statements in
accordance with the applicable financial reporting framework, and has approved the
financial statements

 The auditor should obtain written representations from management on matters material
to the financial statements when other sufficient appropriate audit evidence cannot
reasonably be expected to exist.

Purpose: The purposes of the management representation letter are as follows:

It reminds management of its responsibility for the financial statements.

It confirms oral responses obtained by the auditor earlier in the audit and the
continuing appropriateness of those responses.
It reduces the possibility of misunderstanding concerning the matters that are the
subject of the representations.

Audit evidence

The representations should relate to matters where they are critical to obtaining sufficient
appropriate audit evidence. Representations cannot be a substitute for other audit evidence
that auditors expect to be available.

They should be restricted to matters where the auditor is unable to obtain independent
corroborative evidence and could not reasonably expect it to be available. For example,

 Where knowledge of facts confined to management, like management's intentions

 Where the matter is principally one of judgment, example, whether a receivable is a

doubtful debt or not

Procedures

a. Agree procedures at early stage (e.g. letter of engagement).

b. Discuss the letter with client first.
c. Usually signed by senior executive officer and senior financial officer on behalf of
board
 d. Should be minuted.
e. Dated – after all other audit work completed but before signing of the auditor’s
report.

If the client refuses to sign

a) Auditor should write letter setting out his understanding and ask for management
confirmation.
b) If management does not reply, auditor should follow up to ascertain that his understanding
is correct.
c) If management refuses to provide a representation, that the auditor considers necessary,
this constitutes a scope limitation and the auditor should express a qualified opinion or
disclaimer of opinion.

Effects on the audit report: an explanatory paragraph should be added to the auditor’s
report when the auditor concludes that substantial doubt remains about the client’s ability to
continue as a going-concern for a reasonable period of time. The paragraph describing the
auditor’s concern should be added to the standard unqualified audit report. It should include
reference to a footnote in which management describes the financial problem in more detail.
A qualified audit report would normally be issued if the auditor believes the client’s
disclosure is inadequate.

Review of major estimates

An accounting estimate is an approximation of a financial statement element, item, or

account. Estimates are used because either data about past events cannot be accumulated in a
timely, cost-effective manner or because measurement of some accounts is dependent upon
the outcome of future events. It is the responsibility of management to make reasonable
estimates and include them in the financial statements.

Some companies “manage” earning by creating hidden reserves in unusually good years that
can be issued in years when real profits do not meet expectations. Many of the SEC’s
criticisms of the accounting profession in the past few years have focused on account
balances for which estimates are used extensively. The auditor is responsible for providing
reasonable assurance that:
  Management has an information system to develop estimates that could be material to
the financial statements.
 Those estimates are reasonable. In evaluating reasonableness, the auditor focuses on
assumptions that are significant to the estimate, sensitive to variations, and deviations
from historical patterns, or subjective and susceptible to misstatement/bias.
 The estimates are presented in conformity with GAAP.
 Assess management's written policies and practices regarding the development and use
of estimates

Examples of accounting estimates include net realizable value of inventory and receivables;
property and casualty insurance loss reserves; revenues from contracts accounted for by the
percentage of completion method; warranty expenses; depreciation and amortization
methods, useful lives and residual values of productive facilities, natural resources and
intangibles; valuation and classification of financial instruments; pensions and other post-
retirement benefits, and compensation in stock option plans and deferred plans.

Accounting estimates are based on management’s knowledge and experience about past and
current events, as well as its assumptions about conditions that it expects to exist and courses
of action it expects to take. Estimates are based on subjective as well as objective factors.
There is potential for bias in both factors.

In evaluating the reasonableness of an estimate, the auditor normally concentrates on key

factors and assumptions that are:

 Significant to the accounting estimate

 Sensitive to variations
 Deviations from historical patterns
 Subjective and susceptible to misstatement and bias
 Inconsistent with current economic trends

The auditor should consider the historical experience of the entity in making past estimates.
How ever, changes in facts, circumstances, or any entity’s procedures may cause factors
different those considered in the past to become significant to the estimate. For example,
economic changes may occur that increase or decrease the ability of customers to make
timely payments; or the company may have changed its credit policies, providing for a longer
or shorter time before payment is due or higher or lower sales discount rates.

Procedures:

In evaluating the reasonableness of an estimate, the auditor must first obtain an

understanding of how management developed its estimate. The auditor would then perform
one or a combination of the following procedures:

1. Review and test the procedures used by management to develop the estimate.

2. Develop an independent estimate of the item for comparative purposes.

3. Review subsequent events and transactions (occurring prior to the date of the auditor's
report) that corroborate the value of the estimate

Communicating with the audit committee: There are several items that the auditor should
discuss with the audit committee. Such communication is intended to help the audit
committee fulfill its responsibility to oversee the financial reporting process of the entity. The
following items should be discussed with the audit committee:

 The processes used by management in making sensitive accounting estimates, and any
concerns the auditor has about those process results.
 Significant audit adjustments, even if management readily agrees to make them
 Major accounting and reporting disagreements with management, even if eventually
resolved
 Managements discussion with other public accounting firms regarding the treatment of
potentially controversial accounting issues
 Difficulties encountered in performing the audit
 Significant fraud or other illegal acts
 Significant deficiencies in the design and/or operation of internal controls(reportable
conditions)
 Any issues that may have led someone to question the auditor’s independence.