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Chapter 18 Completing the Audit Concept Check Questions C18-1 Why are contingent liabilities difficult to identify? One of the key audit steps for locating contingent liabilities is discussion with management or others charged with governance of the organization. If management does not disclose the ...

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Chapter 18 Completing the Audit Concept Check Questions C18-1 Why are contingent liabilities difficult to identify? One of the key audit steps for locating contingent liabilities is discussion with management or others charged with governance of the organization. If management does not disclose the contingent liability to the auditors, then it is difficult to detect. C18-2 When reviewing legal expenses, which transactions should the auditor examine, and why? The auditor should review all legal expense transactions by tracing to source documents since they could indicate potential lawsuits. The lawyers’ invoices will provide details of what claims they had been providing legal advice. C18-3 List three audit techniques that could be used to identify relevant subsequent events. Note: Three examples are provided. Others are possible. 1. Review legal letter received from law firms. 2. Review subsequent internal financial statements. 3. Examine minutes of board and shareholder meetings after the date of the balance sheet. C18-4 Why is partner examination of final analytical review important? The partner in charge of the engagement has broad experience with the client and other businesses that facilitates the identification of unusual relationships that may require the conduct of additional audit procedures. C18-5 Describe management’s and the auditor’s responsibilities with respect to the goingconcern assumption Management is required to clearly disclose the financial position of the entity, including its ability to function as a going concern, in the financial statements. The auditor’s responsibilities are to assess management’s conclusions. This is a difficult area to audit since the auditor is assessing management’s future plans (which may be overly optimistic). Where the auditor believes that managements’ disclosures are not sufficient, the auditor may be required to provide additional information in an Other Matters Paragraph in the auditor’s report. The auditor may also need to provide an Emphasis of Matter Paragraph to highlight the potential going concern problem in the auditor’s report.

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Instructor’s Solutions Manual for Auditing, Fourteenth Canadian Edition

C18-6 What method does the auditor use to determine whether sufficient appropriate audit evidence has been collected? Audit evidence is assessed in relationship to the risks identified during the planning stage of the audit, in relationship to risks by audit objectives and assertions, and to address any problem areas that were discovered during the audit. C18-7 What is the purpose of the engagement quality control review? The engagement quality review is unbiased risk-based review, with the reviewer paying particular attention to significant judgments made by the engagement team and the conclusions reached in formulating the report. C18-8 What are some procedures used for the engagement quality control review? Some common procedures that should be performed are:  Evaluating the procedures performed by the engagement team to evaluate team and firm independence;  Evaluating the engagement team’s assessment of and responses to significant risks, including fraud risks;  Evaluating whether significant matters noted in the engagement were satisfactorily resolved;  Reviewing financial statements and cross-checking for completeness of significant issues;  Reviewing the proposed audit report and evaluating whether it aligns with engagement outcomes C18-9 List two examples of information that must be communicated by the auditor to the audit committee. Note that two examples are provided; more are possible. Information that must be communicated by the auditor to the audit committee could include the following: 1. Material weaknesses in internal control. 2. All misstatements, except those that are clearly trivial. C18-10 Why would an auditor submit a management letter to the client? A management letter would be submitted to provide recommendations for improving the client’s business (i.e., for more efficient operations) and to maintain a positive working relationship with the client.

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Chapter 18: Completing the Audit

Review Questions 18-1 There are four groups of presentation and disclosure-related audit objectives (seven individual objectives): PRESENTATION AND DISCLOSURE-RELATED AUDIT OBJECTIVES (1) Occurrence and (2) rights and obligations (3) Completeness (4) Accuracy and (5) valuation (6) Classification and (7) understandability

DESCRIPTION Account-related information as described in the footnotes exists and represents the rights and obligations of the company. All required disclosures are included in the financial statement footnotes. Footnote disclosures are accurate and valued correctly. Account balances are appropriately classified and related financial statement disclosures are understandable.

18-2 A financial statement disclosure checklist is an audit tool that summarizes all disclosure requirements contained in accounting standards. Auditors use the disclosure checklist to determine that all required disclosures are completely presented and disclosed in the financial statements and accompanying footnotes. This helps the auditor obtain sufficient appropriate evidence about the completeness objective for the presentation and disclosure-related audit objective. 18-3 A contingent liability is a potential future obligation to an outside party for an unknown amount resulting from activities that have already taken place. Some examples would be:  pending litigation  income tax disputes  product warranties An actual liability is a real future obligation to an outside party for a known amount from activities that have already taken place. Some examples would be:  notes payable  accounts payable  accrued interest payable Note that there are numerous terms for different types of liabilities, depending upon the financial accounting framework in use. The instructor could review each of those terms when discussing the nature of different types of liabilities. 18-4 Being concerned about the possibility of contingent liabilities for income tax disputes, there are various procedures you could use for an intensive investigation in that area. One good approach would be an analysis of income tax expense. Unusual or nonrecurring amounts should be further investigated to determine if they represent situations of potential tax liability. Another helpful procedure in uncovering potential tax liabilities is to review the general correspondence file for communication with law firms or Canada Revenue Agency. This might give an indication that the Copyright © 2019 Pearson Canada Inc. 18-3

Instructor’s Solutions Manual for Auditing, Fourteenth Canadian Edition

potential for a liability exists even though no actual litigation has ensued. Finally, an examination of Canada Revenue Agency reports from prior years may provide the most obvious indication of disputed tax matters. 18-5 The analysis of legal expense is an essential part of every audit engagement because it may give indication of contingent liabilities that may become actual liabilities in the future and require disclosure in the current financial statements. Since any single contingency could be material, it is important to verify all legal transactions, even though the amount may be small. After the analysis of legal expense is completed, the law firms to whom payment was made should be considered for letters of confirmation for contingencies (communications with law firms/ lawyer’s letters). 18-6 Pyson should determine the materiality of the lawsuits by requesting from Merrill’s lawyers an assessment of the legal situations and the probable liabilities involved. In addition, Pyson may have his own legal counsel assess the situations. Proper disclosure in the financial statements will depend on the lawyers’ evaluations of the probable liabilities involved. If the evaluations indicate highly probable, material amounts, disclosure will be necessary in the form of a footnote, assuming the amount of the probable material loss cannot be reasonably estimated. If the client refuses to make adequate disclosure of the contingencies, a qualified or adverse opinion may be necessary. 18-7 If a law firm refused to provide the auditor with information about material existing lawsuits or likely material possible (unasserted) claims, the audit opinion would have to be modified to reflect the lack of available evidence. This is required by the CICA Assurance Handbook, and has the effect of requiring management to give its law firms permission to provide contingent liability information to auditors and to encourage law firms to cooperate with auditors in obtaining information about contingencies. 18-8 1. Subsequent events requiring adjustment: those that have a direct effect on the financial statements. Examples: (i) the declaration of bankruptcy due to the deteriorating financial condition of a customer with a large outstanding accounts receivable balance and (ii) the settlement of a litigation for an amount different from the amount recorded in the books. 2. Subsequent events requiring disclosure: those that have no direct effect on the financial statements. Examples: (i) the decline in market value of securities held for temporary investment or resale, (ii) the issuance of bonds or equity securities, and (iii) the declaration of bankruptcy by a customer (with a large outstanding accounts receivable balance) who was inadequately insured and lost everything due to a fire subsequent to the auditor’s report date. 18-9 The auditor would be interested in a client’s future commitments to purchase raw materials to ensure that this information is properly disclosed in the financial statements. The commitment may be of interest to an investor as it is compared to the future price movements of the material. A future commitment to purchase raw material may result in the client paying more or less than the market price at a future time. In the former case, it may be appropriate for the client to recognize a loss in the current year rather than when the raw material is actually purchased. Copyright © 2019 Pearson Canada Inc. 18-4

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18-10 The major considerations the auditor should take into account in determining how extensive the subsequent events review should be are:  the financial strengths and stability of earnings  the effectiveness of the company’s internal control  the number and significance of the adjustments proposed by the auditor  the length of time between the balance sheet date and the completion of the audit  changes in key personnel 18-11 The accumulation of audit evidence is crucial to the auditor in determining whether the financial statements are stated in accordance with an acceptable financial reporting framework, applied on a basis consistent with the preceding year. The evaluation of the adequacy of the disclosures in financial statements is made to assure that the account balances on the trial balance are properly aggregated and disclosed on the financial statements. Three examples where adequate disclosure could depend heavily upon the accumulation of evidence are:  the disclosure of declines in inventory values below cost  the separation of current and non-current receivables  the disclosure of contingent liabilities of whose existence, the auditor has not been informed Three examples where audit evidence does not normally significantly affect the adequacy of the disclosure are:  deciding whether a disposal of equipment should be recorded as an extraordinary item  the disclosure of an acquisition as a pooling of interests or a purchase  the disclosure of contingencies of whose existence the auditor was informed by the client 18-12 This statement implies that the auditor should consider, as part of his or her audit procedures, if there is a serious risk of the company being unable to realize assets and discharge liabilities in the normal course of business for the foreseeable future. A number of conditions that may cast doubt on the ability of the enterprise to continue as a going concern such as:  recurring operating losses  serious deficiencies in operating capital  an inability to obtain financing sufficient for continued operations  an inability to comply with terms of existing loan agreements  the possibility of an adverse outcome of one or more contingencies  insufficient funds to meet liabilities  a plan to significantly curtail or liquidate operations  external factors that could force an otherwise solvent enterprise to cease operations Based on the auditor’s assessment of these factors, the auditor must determine if the accounting treatment, presentation, and disclosure by the entity is appropriate. If so, no reservation is required.

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18-13 A management representation letter is a letter from management that documents management’s most important oral representations during the audit. A management letter is one directed to the client to inform him or her of certain recommendations about the business that the public accountant believes would be beneficial to the client. Five items that might be included in a management representation letter are:  existence or non-existence of litigation  evaluation of inventory stock as obsolete  the adequacy of the disclosure of actual liabilities  existence or non-existence of unused letters of credit  the recognition that the auditor is not primarily responsible for the detection of fraud Five items that might be included in a management letter are:  recommendation to switch inventory valuation methods  recommendation to institute a formal security system  recommendation to prepare more timely bank reconciliations  recommendation to segregate duties in a particular area  recommendation to have certain types of transactions authorized by specific individuals 18-14 A regular working paper review is the one that is done by someone who is knowledgeable about the client and the unique circumstances in the audit. An independent review is one done by a completely independent person who has had no experience on the engagement. The purpose is to have a competent professional from within the firm who has not been biased by the ongoing relationship between the regular auditors and the client, perform an independent review. Two examples of important potential findings in a regular review are:  incorrect computations  inadequate scope Three examples of important potential findings in an independent review are:  a number of small amount adjustments waived that should be accumulated into a real adjustment.  too narrow and biased a scope in a particular area.  inadequate disclosure of contingencies.

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Chapter 18: Completing the Audit

18-15 CAS 260 par 14 to 17 itemizes requirements to report. In addition to the required communications to those charged with governance required by auditing standards, in the U.S., the Sarbanes-Oxley Act expands these communications requirements by also requiring public company auditors to timely report the following items to the audit committee:  All critical accounting policies and practices to be used.  All alternative treatments of financial information within generally accepted accounting

principles that have been discussed with management, ramifications of the use of such alternative disclosures and treatments, and the treatment preferred by the auditor.  Other material written communications between the auditor and management, such as any management letter or schedule of unadjusted differences. As the audit of the public company is completed, the auditor should determine that the audit committee is informed about the initial selection of and changes in significant accounting policies or their application during the current audit period. When changes have occurred, the auditor should inform the committee of the reasons for the change. The auditor should also communicate information about methods used to account for significant unusual transactions and the effect of significant accounting policies in controversial or emerging areas. Multiple Choice Questions 18-16

(1)

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(2)

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(3)

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(3)

18-20 Subsequent Event 1 – Defective chemicals a. The following are audit procedures that the auditor should consider to corroborate the event and to make the conclusion as to the appropriate financial statement treatment:     

Review quality control reports to assess whether this event was the only case of defective inventory as there could potentially be other inventory that requires writing down. Inquire of management and quality control if any other instances of defective inventory Inspect supporting documentation (such as cost data or production records) to verify that the chemicals were produced prior to October 31st to ensure that a write-down is necessary. Inquire management as to how they determined the scrap value of $100 000. Agree the scrap value amount to supporting documentation.

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b) (1) – when taken with the other unadjusted amounts, net income is materially overstated by $300,000 ($250 000 + 50 000) – which is greater than $280,000. Subsequent Event 2 c) The following are audit procedures that the auditor should consider to corroborate the event and to make the conclusion as to the appropriate financial statement treatment:  Obtain a schedule of the damaged property, plant and equipment and agree to the net book value in the PPE subledger.  Obtain an inventory listing to determine the amount of inventory stored at the time – further amounts may need to be disclosed in the financial statements.  Given that the inventory stored was chemicals, inquire if there are necessary site clean-up costs and, if so, obtain management’s estimate of those costs.  If there are site clean-up costs, agree management’s estimate to supporting documentation  Obtain client representation letter regarding estimated costs as well as whether in compliance with applicable regulations.  Ask management about insurance coverage and inspect insurance documentation (such as policies, any correspondence regarding the recent fire). d) (2) – the impact is material; however, the event happened after year-end. Therefore, note disclosure is required with no adjustment to the financial statements. Discussion Questions and Problems 18-21 a. Contingent liabilities are potential future obligations for an unknown amount arising from activities that have already taken place. A commitment is an agreement to commit the firm to a set of fixed conditions in the future, regardless of what happens to profits or the economy as a whole. Knowledge of both contingencies and commitments is extremely important to users of financial statements because they represent the encumbrance of potentially material amounts of resources during future periods, and thus affect the future cash flows available to creditors and investors. Because of this, generally accepted accounting principles require that material contingencies and commitments be disclosed. The auditor has an obligation to discover the existence of such items to assure that they are properly disclosed in order to have complied with generally accepted auditing standards. b. Kathy’s tests of controls and substantive tests of transactions related to payments of notes payable and related interest expense would provide her information about scheduled debt payments and related interest rate terms, which are required footnote disclosure related items. Similarly, substantive tests of transactions would reveal additions and retirements of notes payable, which both affect notes payable disclosures. Tests of de...