AUDITING THEORY
Red Sir ug COMPLETING THE A UDIT
Character istics of the procedures perfor med in completing the audit: a. The procedures are required to be performed b. The procedures are performed near the end of the audit (on or near the last day of fieldwork) c. The procedures do not per tain to specific transaction cycles or accounts d. The procedures are usually performed by audit managers or other senior members of the audit team who have extensive audit experience with the client e. The procedures involve many subjective judgments by the auditor AUDIT PROCEDURES IN COMPLETING THE A UDIT: 1.
Search for unrecorded liabilities The auditor examines cash disbursements made subsequent to balance sheet date. The purpose is to verify if those disbursements for purchases or expenses incurred as of the balance sheet date were properly accrued and recorded as liabilities in the current year. Search for unrecorded liabilities addresses the completeness assertion (to provide assurance that amount owed to others are recor ded by the entity).
2.
Review related party transactions (to ensure that they have been properly identified, recorded and disclosed in the financial statements)
Related party – a party related to an entity because of any of the following: Control, common control, significant influence, joint control – w hether direct or indirect Associate A fellow venturer A member of the key management personnel Close member of the family A post-employment benefit plan Related party transaction – transfer of resources, ser vices or obligations between related parties, regardless of whether a price is changed Management responsibility: Management is responsible for identification and disclosure of related par ties and related party transactions. Auditor’s responsibility: a. To ensure that related par ties and related par ty transactions have been properly identified, recorded and disclosed in the financial statements. b. To review information provided by those char ged with governance and management identifying the names of all know n related parties and transactions with such par ties. c. To obtain a written representation from management concerning: (1) Completeness of information on identification of related parties; and (2) Adequacy of disclosure in the financial statements An audit cannot be expected to detect all related party transactions.
Audit procedures to identify related parties: Performing detailed tests of transactions and balances Reviewing minutes of meetings of shareholders and those charged with governance Reviewing accounting records for large or unusual transactions and balances, paying particular attention to transactions recognized at or near the end of the reporting period. Reviewing confirmations of loans receivable and payable and confirmations from banks (such review may indicate guarantor relationship and other related party transactions) Reviewing investment transactions (for example, purchase or sale of an equity interest in a joint venture or other entity) Audit those 1. 2. 3. 4.
procedures to determine completeness of related party infor mation prov ided by charged with governance and management: Reviewing prior year’s working papers for names of know n related parties Review the entity’s procedures for identification of related parties Inquire as to the affiliation of those charged with governance and officers with other entities Review shareholder recor ds to determine the names of principal shareholders or, if appropriate, obtain a listing of principal shareholders from the share registrar 5. Review minutes of meetings of shareholders and those char ged with governance and other relevant statutory recor ds such as the register of director’s interest 6. Inquire of other auditors currently involved in the audit, or predecessor auditors, as to their knowledge of additional related par ties 7. Review the entity’s income tax returns and other information supplied to regulator y agencies (such as SEC filings)
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Indicators of existence of related party transactions: Transactions w hich have abnormal terms of trade, such as unusual prices, inte rest rates, guarantees, and repayment terms. Transactions w hich lack an apparent logical business reason for their occurrence. Transactions in which substance differs from form. Transactions processed in an unusual manner. High volume or significant transactions with certain customers or suppliers as compared with others. Unrecor ded transactions such as the receipt or provision of management services at no charge. Minimum disclosures regarding related party transactions: Amount of the transaction Amount of outstanding balances, their terms and conditions, whether secured or unsecured, and the nature of consideration to be provided in settlement Provision for doubtful accounts (related to the outstanding balances) Expense recognized during the period in respect of doubtful accounts due from related parties 3.
Ident ify and evaluate contingencies (arising from litigation, claims, and assessments) and commit ments Contingency – an existing condition/situation/circumstances involving a possible gain or loss to an entity the ultimate outcome of which depends on the occurrence or non-occurrence of one or more uncertain future events Examples of loss contingencies: 1. Pending or threatened lawsuit/litigation 2. BIR assessment of prior years’ taxes 3. Guarantees of obligation of others Commit ment – represent future cash flow requirements (such as a purchase commitment) a.
Procedures to identify litigation and claims: Inquir y of management (and, w here applicable, others within the entity, including in- house legal counsel) Reviewing minutes of meetings of those char ged with governance (BOD and audit committee) and correspondence between the entity and its external legal counsel Reviewing legal expense accounts (such as examining invoices for legal expenses) Using information obtained through risk assessment procedures Management should adopt policies and procedures to identify, evaluate, and account for litigations, claims, and assessments as a basis for the preparation of financial statements in accordance with applicable financial reporting framewor k. Thus, the auditor’s primary source of information about litigation, claims, and assessments is the client’s management.
b.
Seek direct communication with the entity’s external legal counsel (through a letter of inquiry ) when litigation or claims have been identified or when the auditor believes they may exist
The auditor should corroborate the information furnished by client’s management by sending a letter of inquiry to lawyers with w hom the client has consulted regar ding litigation, claims, and assessments. Direct communication with the entity’s legal counsel assists the auditor in obtaining sufficient appropriate audit evidence as to whether potent ially material lit igat ion and claims are known and management’s estimates of the financ ial implications, including costs, are reasonable. The letter of inquir y should be prepared by management and sent by the auditor, requesting the entity’s external legal counsel to communicate directly with the auditor. Management’s refusal to permit the a uditor to communicate with the entity’s lawyer or the lawyer’s refusal to reply to the letter of inquiry w ould be considered a scope limitation that would or dinarily lead to either qualified or disclaimer of opinion.
(1) Letter of specific inquiry – this letter of inquir y would ordinarily include: (a) A list of litigation and claims (b) Management’s assessment of the outcome of the litigation or claim and its estimate of the financial implications, including costs involved; and (c) A request that the entity’s legal counsel confirm the reasonableness of management’s assessments and provide the auditor with further information if the list is considered by the entity’s legal counsel to be incomplete or incorrect. (2) Letter of general inquiry – requests the entity’s external legal counsel to inform the auditor of: (a) Any lit igat ion and claims that the counsel is aware of (b) Assessment of the outcome of the litigation and claims, and (c) An estimate of the financial implications, including costs c.
Discuss with the entity’s external legal counsel the likely outcome of litigation and claims where:
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(1) The auditor determines that the matter is a significant risk (2) The matter is complex (3) There is disagreement between management and the entity’s external legal counsel Ordinarily, such meetings with enti ty’s exter nal legal counsel require management’s per mission and are held with a representative of management in attendance. 4.
Review subsequent events that may require adjust ment of, or disclosure in the financial statements Subsequent events (post-balance sheet events ) refer to events occurring between period end (balance sheet date) and the date of the auditor’s report that may affect the financial statements and the auditor’s report. Subsequent events may also refer to facts discovered after the date of the auditor’s repor t. Subsequent period is the period between the date of the financial statements (balance sheet date) and the date of the auditor's report. During this period, the auditor should investigate subsequent events that would require adjustment or disclosure in the financial statements because his responsibility to search for subsequent events is up to the date of the auditor’s report. Types of subsequent events: 1. Those requiring adjust ment – events that provide further evidence of conditions that existed at the date of the financial statements Examples: Settlement of litigation in excess of amount recorded Loss on uncollectible accounts resulting from customer’s continued deteriorating financial condition leading to bankruptcy (declaration of bankruptcy is incidental to an already existing insolvency of a debtor) 2. Those requiring disclosure – events that are indicative of conditions that arose after the date of the financial statements Examples: Issuance of bonds/stocks after the balance shee t date Major purchase of a business Loss on inventor y due to fire that occurred in the subsequent period Loss of plant due to flood Loss on uncollectible receivable because of a major catastrophe suffered by the customer after the balance sheet date a.
b. 5.
Procedures to identify subsequent events (1) Reviewing procedures established by entity’s management to ensure that subsequent events are identified (2) Inquiring of management as to w hether any subsequent events have occurred which might affect the financial statements Examples of inquiries of management on specific matters are: 1. Current status of items that were accounted for on the basis of preliminar y or inconclusive data 2. New commitments, borrowings or guarantees 3. Sales or acquisition of assets that have occurred or are planned 4. Issue of new shares or debentures or an agreement to merge or liquidate that is made or planned 5. Any assets that have been appropriated by government or destroyed, for example, by fire or flood 6. Any developments regar ding risk areas and contingencies 7. Any unusual accounting adj ustments made or contemplated 8. Any events that have occurred or are likely to occur w hich will bring into question the appropriateness of accounting policies used in the financial statements (such as goingconcern issues). (3) Reading minutes of the meetings (of shareholders, those charged with governance, audit and executive committees) including those held after period end and inquiring about matters discussed at meetings for w hich minutes are not yet available. (4) Reading the entity’s latest available interim financial statements as well as budgets and cash flow forecasts and other related management reports; compare them with the financial statements under audit. (5) Obtaining representation letter from management regar ding w hether a ny events occurred during the subsequent period that require adjustments to or disclosure in the financial statements. Consider whether material subsequent events are properly accounted for and adequately disclosed in the financial statements
Assess the appropr iateness of management’s use of the going concer n assumpt ion in the preparation of the financial statements Going concern assumption is a fundamental principle in the preparation of financial statements. Going concern means an entity is ordinarily viewed as continuing in business for the
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foreseeable future with neither the intention nor the necessity of liquidation, ceasing trading or seeking protection from creditors pursuant to laws and regulations. Financial statements are ordinarily prepared based on going concern basis (contrary to the quitting concern basis) in the absence of information to the contrary. This means that the assets and liabilities are recorded on the basis that the entity will be able to realize its assets and discharge its liabilities in the normal course of business. Management’s responsibility: Assessment. Management should assess the entity’s ability to continue as a going concern by making a judgment about the future outcome of uncertain events or conditions (for a period of one year from balance sheet date). a. Disclosure. Management should disclose going concern problem, if any. Auditor’s responsibility: a. Overall evaluation of the appropriateness of management’s use of the going concern assumption in the preparation of the financial statements b. Identifying material uncer tainties about the entity’s ability to continue as a going concern that need to be disclosed in the financial statements c. Whether such events or conditions are adequately disclosed in the financial statements d. Consider report modification because of these events or conditions e. If conditions or events such as those identified previously create substantial doubt as to the ability of the entity to continue as a going concern, the auditor should consider whether management has feasible plans (plans for and the ability to implement alternative means of maintaining adequate cash flows)
Audit procedures to ident ify conditions and events that may cast doubt about an ent ity’s ability to cont inue as a going concern: Analytical procedures Subsequent events review Review of compliance with debt and loan agreements Reading minutes of meetings Inquir y of legal counsel Confirmation with related and third parties of arrangements for financial support The auditor has no responsibility to predict future events or conditions that may cause an entity to cease to continue as a going concern. Thus, auditors are not required to design audit procedures solely to detect going concer n problems. Examples of event or condit ions that may s ignify existence of a material going concer n uncertainty Events or conditions that may give rise to business risks, that individually or collectively, may cast doubt about the entity’s ability to continue as a going concern: Financial events and condit ions: Net liability or net current liability position Maturing fixed-term borrowings without realistic prospects of renewal or repayment Indications of withdrawal of financial support by debtors and other creditors Negative operating cash flows Adverse key financial ratios Substantial operating losses Significant deterioration in 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 or o ther statutor y requirements Change from credit to cash-on-deliver y transactions with suppliers Inability to obtain financing for essential new product development or other essential investments Operating events and condit ions: Loss of key management without replacement Loss of a major mar ket, franchise, license, or principal supplier Labor difficulties or shor tages of important supplies Other events and condit ions: Noncompliance with capital or 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 gover nment policy expected to adversely affect the entity Mit igating Factors There are factors that can mitigate the adverse effects of identified material going concern uncertainty. The auditor should consider whether management has plans for and the ability to implement alternat ive means of maintaining adequate cash flows to mitigate events and conditions that may cast doubt about the entity’s ability to continue as a going concern.
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Examples of mit igat ing factors: When there is a history of profitable operations and a ready access to financial resources Management has plans and ability to maintain adequate cash flows by alternative means, such as: Disposal of assets (including disposal of operations producing negative cash flows) Borrowing money or restructuring debt Leasing (instead of purchasing) of PPE items Renewal or, extension or rescheduling of loan repayments Reducing or delaying or postponing expenditures Obtaining additional capital Reducing or postponing dividend payments Availability of alternative source of supply in case of loss of a principal supplier Disclosure requirements if the financial statements are not prepared on a going concern basis: a. The fact that financial statements are not prepared on a going concer n basis b. The basis on which the financial statements are prepared, and c. The reasons why the entity is not regarded as a going concern 6.
Obtain written representations from management (on matters material to the financial statements) Management representation letter is a letter from the management confirming its responsibility and its oral representations. The auditor’s responsibility is to obtain written representation, whereas the management’s responsibility is to provide written representations (this responsibility is included in the engagement letter that sets out the terms of an audit engagement). The auditor’s responsibility on representations relating to matters that are material to the financial statements: a. Seek corroborative audit evidence from sources inside or outside the entity; b. Evaluate whether the representations made by management appear reasonable and consistent with other audit evidence obtained, including other representations; and c. Consider whether the individuals making the representations can be expected to be well informed on the particular matters. Purposes of a management representation letter: a. Main/ primary: To emphasize or impress upon management its ultimate responsibility for the financial statements b. Other purposes: To confirm oral representations made by management during the audit To reduce the possibility of misunderstanding between the auditor and the client concerning the matters tha t are the subject of the representations To document management’s acceptance acknowledgment of its responsibility for fair presentation of the financial statements To provide corroborative evidence when audit evidence may not be reasonably expected to be available (for example, audit evidence to corroborate management’s intention to hold a specific investment for long-term appreciation or to discontinue a line of business) To complement, but not replace or substitute, other audit procedures or other audit evidence that the auditor could reasonably expect to be available Basic elements of a management representation letter: a. Addressee: Should be addressed to the auditor b. Contents: Should contain the specified infor mat ion c. Date: Should be appropriately date d (ordinarily coincides with date of the auditor’s report) d. Signatory: Should be appropriately signed by the members of management who have primary or overall responsibility for financial and operating aspects of the entity Appropriate signatory of a management representation letter: Owner-manager Chief/senior executive officer Chief/senior financial officer Other members of management For ms of management representations: Management representations may be verbal, w hether solicited or unsolicited, or wr itten, whether explicitly such as contained in a management representation letter or implicitly such as contained in financial information pr ovided. Written representations are better audit evidence than oral representation. Written representations incl ude: A representation letter from management – known as the management representation letter or client’s representation letter A letter from the auditor ( confirmatory letter ) – outlining the auditor’s understanding of
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management’s representations, duly acknowledged and confirmed by management Relevant minutes of meetings (of the board of directors or similar body) Signed copy of the financial statements Matters communicated in discussions or electronically such as e-mails or telephone messages. Schedules, analyses, and repor ts prepared by the entity, and management’s notations and comments therein
Limitat ions of management representations: Although management representations are considered part of evidential matter, they (are): Not a substitute for performing other audit procedures or a means to reduce the auditor’s responsibility Not as the sole source of evidence on significant audit matters Cannot be substitute for other audit evidence that the auditor could reasonably expect to be available Cannot reduce the auditor’s responsibility Applicat ion of materiality: 1. Representations may be limited to matters that are considered either individually or collectively material to the financial statements 2. Materiality limits would not apply when obtaining written client representation on: a. Fraud or irregularities involving management b. Availability of minutes of meetings Effect if management refuses to provide the necessary wr itten representations: Refusal by management to provide a written representation requested by the auditor that the auditor deems necessary constitutes a scope limitation and would result in a qualified opinion or a disclaimer of opinion. In such circumstances, also consider: a. Any reliance placed on other representations made by management dur ing the audit; and b. Any additional implications of the refusal on the auditor’s report. When management representation is contradicted by other audit evidence: The auditor should investigate the circumstances and, when necessary, reconsider the reliabi lity of other representations made by management
Specific matters included in a management representation letter: Management’s acknowledgement of its responsibility for the fair presentation of the FS Management’s acknowledgement of its responsibility for the design and implementation of internal control to prevent and detect error Availability of all financial records and related data and minutes of meetings (of shareholders, board of directors, and committee of directors) Irregularities involving management or employees Confirmation on the completeness of the information pr ovided regarding the identification of related par ties That the FS are free of material misstatements, including omissions Compliance or noncompliance with aspects of contractual agr eements or requirements of regulator y that could have a material effect on the FS in the event of noncompliance. Plans or intentions that may materially alter the carrying value or classification of assets and liabilities Plans to abandon lines of product or other plans or intentions that will result in any excess or obsolete inventory, and no inventory is stated at an amount in excess of net realizable value Satisfactory title on assets and liens or encumbrances on the company’s assets Communications from regulatory agencies concerning noncompliance with/or deficiencies in financial reporting practices Information or recording and/or disclosure of: The identity of, and balances and transactions with, related par ties Losses arising from sale and purchase commitments Agreements and options to buy back assets previously sold Assets pledged as collateral All liabilities, both actual and contingent Formal or informal compensating balance arrangements or other arrangements involving restrictions on cash balances and credit line or similar arrangements Subsequent events requiring adjustment of or disclosure in the FS Claims and assessments in connection with litigation Capital stock repurchase options and agreements, and capital stock reserved for options, warrants, conversions and other requirements Example of a management representation letter: The following letter is not intended to be a standard letter. Representations by management will vary from one entity to another and from one period to the next.
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(Entity Letter head) (To Auditor) (Date) This representation letter is provided in connection with your audit of the financial statements of ABC Company for the year ended December 31, 19X1 for the purpose of expressing an opinion as to whether the financial statements present fairly, in all material respects, the financial position of ABC Company as of December 31, 19X1 and of the results of its operations and its cash flows for the year then ended in accordance with (indicate applicable financial repor ting framework). We acknowledge our responsibility for the fair presentat ion of the financial statements in accordance with (indicate applicable financial reporting framewor k). We confirm, to the best of our knowledge and belief, the following representations: There have been no irregularities involving management or employees who have a significant role in internal control or that could have a material effect on the financial statements. We have made available to you all books of account and suppor ting documentation and all minutes of meetings of shareholders and the board of directors (namely those held on March 15, 19X1 and September 30, 19X1, respectively). We confirm the completeness of the information provided regarding the identification of related parties. If required, add “On behalf of the boar d of directors (or similar body).” The financial statements are free of material misstatements, including omissions. The Company has complied with all aspects of contractual agreements that could have a material effect on the financial statements in the event of noncompliance. There has been no noncompliance with requirements of regulatory authorities that could have a material effect on the financial statements in the event of noncompliance. The following have been properly recorded and, w hen appropriate, adequately disclosed in the financial statements: The identity of, and balances and transactions with, related par ties. Losses arising from sale and purchase commitments. Agreements and options to buy back assets previously sold. Assets pledged as collateral. We have no plans or intentions that may materially alter the carrying value or classification of assets and liabilities reflected in the financial statements. We have no plans to abandon lines of product or other plans or intentions that will result in any excess or obsolete inventor y, and no inventory is stated at an amount in excess of net realizable value. The Company has satisfactory title to all assets and there are no liens or encumbra nces on the company’s assets, except for those that are disclosed in Note X to the financial statements. We have recor ded or disclosed, as appropriate, all liabilities, both actual and contingent, and have disclosed in Note X to the financial statements all guarantees that we have given to third parties. Other than . . . described in Note X to the financial statements, there have been no events subsequent to period end w hich require adjustment of or disclosure in the financial statements or Notes thereto. The . . . claim by XYZ Company has been settled for the total sum of XXX which has been properly accrued in the financial statements. No other claims in connection with litigation have been or are expected to be received. There are no formal or informal compensating balance arrangements with any of our cash and investment accounts. Except as disclosed in Note X to the financial statements, we have no other line of credit arrangements. We have properly recorded or disclosed in the financial statements the capital stock repurchase options and agreements, and capital stock reserved for options, warrants, conversions and other requirements. Yours truly, _____________________ (Senior Executive Officer) _____________________ (Senior Financial Officer) 7.
Perfor m final analyt ical procedures Purpose: The purpose of performing analytical procedures in the overall review stage of the audit is to assist the auditor when forming an overall conclusion as to whether the financial statements are consistent with the auditor’s understanding of the entity. Such procedures assist in arriving at the overall conclusion as to the reasonableness of the financial statements. Audit focus: Auditor’s focus when performing analytical procedures in the overall review stage:
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a.
b.
Identifying unusual fluctuations or transactions or unexpected account balances that were not previously identified Once identified, they would require investigation, adequate explanation and appr opriate corroborative evidence by per forming additional tests o f details. Assessing the validity of the conclusions reached and evaluating the overall financial statements presentation
Analytical procedures involve analysis of significant ratios and trends including the resultant investigation of fluctuations and relationships that are inconsistent with other relevant information or expectation. Analytical procedures are required to be performed during the planning and overall review stages.
8.
Evaluate audit findings Throughout the course of the audit, the auditors will propose adj usting entries for all material misstatements (whether caused by error or fraud) that are discovered in the client’s financial records. Any material misstatement that the auditors have detected must be corrected; otherwise, they cannot issue an unqualified opinion on the financial statements. Unrecorded misstatements are combined as total likely misstatement in the financial statements and considered.
9.
Review of audit wor king papers (audit documentation) The review is usually performed by manager, par tner, and possibly a second partner review performed by a partner who is not otherwise involved in the engagement but to provide an independent review of the wor k performed. The review process helps provide assurance that audit risk is an appropriately low level, working paper documentation is adequate, and that the evidence suppor ts the opinion being rendered.
10. Obtain approval of the client regarding disclosures and adjust ments made to the financial statements 11. Evaluate the overall financial statement presentation Review adequacy of disclosures using a disclosure checklist that lists all specific disclosures required by GAAP and the SEC, if appropriate 12. Review of other infor mation or documents that contain the audited financial statements and ascertain their consistency 13. Communicate with management and those charged with governance regarding the scope of the audit and other matters of interest to the client Reporting to audit committee Report on internal control using a management letter Such management letter contains: a. Reportable conditions which refer to significant deficiencies in the design or operation of the internal control structure that could adversely affect the financial statements b. Recommendat ions for improvement in the existing internal control structure SUBSEQUENT DISCOVERY OF OMITTED PROCEDURES A FTER SUBMISSION OF THE A UDIT REPORT:
Omitted audit procedures may be discovered (after the audit report has been submitted) during a firm's internal inspection program or during peer review. Auditor’s action: a. The auditor should assess the impor tance of the omitted procedures to his ability to support the audit opinion. b. The auditor should determine whether other audit procedures that were applied tend to compensate for the omitted audit procedures. If so, no further action is necessary. c. If, on the other hand, the omitted audit pr ocedures impair the auditor's ability to support the previously issued opinion, and there are people relying (or likely to rely) on the repor t, then the auditor should promptly undertake to a pply the omitted procedures or the corresponding alternative pr ocedures. d. If, after applying the omitted procedures, the auditor determines that the financial statements are materially misstated and that the auditor's repor t is inappropriate, the auditor should discuss the matter with the management and take steps to prevent future reliance on the repor t.
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