Chapter 14

3 categories of misstatements:

1. known misstatements
2. projected misstatements
3. judgemental misstatements

known misstatements:

-those that the auditor has specifically identified and that have no doubt
-factual misstatements

projected misstatements:

auditor's best estimate of the total misstatements in a given population

judgemental misstatements:

those that arise from material differences in judgements of the auditor and client management

summary of unadjusted audit differences (SUAD):

schedule used by audit firms to accumulate the known and projected misstatements as well as the carryover effects of prior year uncorrected misstatements

what is the SUAD used for?

-used to determine which misstatements the client will correct, waive, etc.
-done at the end of the audit

can clients waive material misstatements?

no, only immaterial

equation for total misstatements:

known + projected misstatements

the materiality of a misstatement is made up of what?

both qualitative and quantitative factors

if a client is publicly traded, does an auditor have to take action upon discovery of an illegal act even if its immaterial?

yes

when auditors detect an intentional misstatement, they: (3)

1. reconsider client's level of audit risk
2. consider revising the nature, timing, and extent of audit procedures
3. evaluate whether to resign from the audit engagement

British petroleum case:

pg. 745

what does an intentional misstatement likely signal?

-internal control material weakness
-control environment deficiencies

what could bias management's willingness to correct detected material misstatements?

incentives

what's more important to an auditor: long term reputation or immediate satisfaction of client?

long term reputation

relationship between misstatements in prior periods and current periods:

misstatements that were immaterial in prior periods may be material in the current period

dual approach:

-simultaneous application of both the rollover method and the iron curtain method
-if a misstatement is material under EITHER method, the client must correct the misstatement in the current period

how to auditors deal with the idea that misstatements which were immaterial in prior periods may be material in the current period?

by applying the dual approach

rollover method:

-focuses on the materiality of current year misstatements and the reversing effect of prior year misstatements on the income statements
-this method may allow misstatements to accumulate on the BS

iron curtain method:

-focuses on accuracy of year end BS
-doesn't consider the impact of prior year uncorrected misstatements reversing in later years

auditors usually decide on their own estimate by:

1. testing the client's methodology for reaching their estimate
2. developing their own model to come up with an estimate and then comparing it to client's estimate

who is responsible for designing/maintaining policies and procedures to identify loss contingencies?

management

who is responsible for ensuring that the client properly identified/accounted for loss contingencies?

auditor

3 categories of loss contingencies:

1. probable
2. reasonably probable
3. remote

what organizations provide the standard for accruing/disclosing loss contingencies?

-Accounting Standards Codification
-FASB

examples of loss contingencies:

-litigation, claims, assessments
-guarantees of debts of others
-purchase and sale commitments

regarding loss contingencies, auditors should obtain the following from management:

-description/evaluation of contingencies that existed at the BS date or that arose prior to the end of fieldwork
-assurance that the accounting and disclosure requirements concerning contingent liabilities have been met
-info about major contracts in whic

what is a primary source of evidence concerning loss contingencies?

client management

what is the main source of corroborative evidence concerning litigation, claims, and assessment?

client's legal counsel

letter of audit inquiry:

-sent from client to its legal counsel
-document that asks legal counsel to confirm info about asserted claims and those claims that are probable of assertion

the letter of audit inquiry should include:

-ID of the company, its subsidiaries, and the date of the audit
-management's list that describes/evaluates the contingencies to which the lawyer has devoted substantial attention
-a request for the lawyer to provide auditor with certain things (in separa

the letter of audit inquiry will request the lawyer to provide the auditor with what 3 things?

1. a comment on the completeness of management's list and evaluations
2. description of each contingency
3. any limitations on the lawyer's response

who should the lawyer respond to in a letter of audit inquiry?

directly to the auditor

what if a lawyer refuses to comply with a letter of audit inquiry?

its considered a scope of limitation and auditor wouldn't be able to issue an unqualified audit opinion

where can disclosures be made?

either on the face of the statements or within the notes

when assessing the adequacy of disclosures, auditor should have reasonable assurance that:

-disclosed events/transactions have occurred and pertain to the organization
-all disclosures that should've been included are included
-disclosures are understandable to users
-info is accurately disclosed and at appropriate amounts

to review and assess the adequacy of disclosures, auditor will:

-read the client's disclosures for each line item and associated disclosures in the footnotes
-obtain evidence to determine whether disclosures follow GAAP
-consider alternative or enhanced disclosures that may be helpful to users

disclosure checklist:

-helps ensure a quality audit
-helps guide audit planning around management's assertions in various disclosures

are disclosure checklists all the same?

no, they're often industry specific or specific to a set of reporting standards

noncompliance:

acts of omission or commission by the entity, either intentional or unintentional, which are contrary to the prevailing laws and regulations

inherent limitations in an auditor's ability to detect material misstatements relating to a client's compliance with laws/regulations:

-laws/regulations often relate to operational issues that don't necessarily relate to the financials
-management may act to conceal noncompliance or may override controls
-legal implications of noncompliance are a matter for legal authorities

to review for potential noncompliance, auditor should:

1. obtain understanding of internal controls
2. gain knowledge of the laws/regulation relevant to client's business
3. search for indications of noncompliance

corruption perception index (CPI):

-created by Transparency International
-a ranking of countries according to the extent to which people believe corruption exists

what does 0 mean on the CPI?

highly corrupt

what does 100 mean on the CPI?

clean, no corruption

important provision of the Foreign Corrupt Practices Act (FCPA):

companies that have securities listed on the US markets must make and keep financial records that accurately/fairly reflect company transactions

what is the objective of review analytical procedures?

to determine whether the financials are consistent with the auditor's understanding of the entity

typical review analytical procedures:

-ratio analysis
-common size analysis
-analysis of the dollar and percentage changes in each income statement item over the previous year

going concern:

a business that is assumed will meet its financial obligations when they fall due

is an audit opinion a guarantee that a business is a going concern?

no, auditors will only issue an opinion on a going concern ASSUMPTION

going concern assumption:

assumption in which auditor evaluates the likelihood of each client continuing as a going concern for a reasonable period of time

what is the assessment of the going concern assumption based on?

based on info obtained from typical audit procedures (no separate procedures necessary)

why are auditors reluctant to issue a going concern modification?

-could be a self fulfilling prophecy that company will go bankrupt
-its simply very difficult to determine

potential indicators of going concern problems:

-negative trends
-internal matters (employee strikes, outdated procedures, etc.)
-external matters (new legislation, loss of customer, etc.)
-other misc. matters (violation of regulation, inability to pay, etc.)
-significant changes in the competitive mar

what is a good way to estimate the likelihood of bankruptcy?

by using bankruptcy prediction models

popular bankruptcy prediction model:

combining two Altman Z scores

what bankruptcy prediction model is used for publicly owned manufacturing companies?

5 ratio model

what bankruptcy prediction model is used for privately owned non manufacturing companies?

4 ratio model

under a 5 ratio model, what z score constitutes a high potential for bankruptcy?

z score < 1.81

under a 5 ratio model, what z score constitutes a low potential for bankruptcy?

z score > 2.99

under a 4 ratio model, what z score constitutes a high potential for bankruptcy?

z score < 1.1

under a 4 ratio model, what z score constitutes a low potential for bankruptcy?

z score > 2.6

how could management resolve the issue of an invalid going concern assumption?

-sell non essential assets
-borrow money or restructure
-reduce unnecessary expenditures
-increase owner investments
etc.

period A:

period between the BS date and the audit report date

period B:

period between the audit report date and the report release date

period C:

anything that occurs after the report release date

BS date, audit report date, and report release date: put in chronological order:

1. BS date
2. audit report date
3. report release date

during which period does an auditor have ongoing responsibilities?

during Period A

does an auditor have responsibility during period B and C?

no

two types of events that happen in period A:

-Type I subsequent events
-Type II subsequent events

subsequent events:

those that occur between the date of the financial statements and the date of the auditor's report

subsequent events review:

auditor's review of events occurring in period A to determine their possible effect on the financial statements

procedures auditors usually use related to subsequent events:

-read the minutes of board/stockholder meetings
-read interim financial statements
-inquiry of management

Type I subsequent events:

-provide evidence about conditions that existed at the BS date
-financial statement numbers should be adjusted to reflect these events

examples of Type I events:

-a major customer files for bankruptcy during the subsequent period
-client settles a lawsuit for a different amount than what was accrued
-stock dividend or split that occurs during subsequent period
-sale of inventory < carrying value

Type II subsequent events:

-indicate conditions that did not occur at the BS date but that may require disclosure
-financial statement balances shouldn't be adjusted

examples of Type II subsequent events:

-something causes a customer's bankruptcy during the subsequent period
-customer initiates a lawsuit relating to an incident that occurred after the BS date
-losing a major facility due to a natural disaster
-major decision made during the subsequent peri

when auditor becomes aware of an event that occurs during period B, what are their two options for dating the audit report?

1. use the date of this event as the audit report date
2. dual date the report using the dates of the original report and the date of the event

which option for dating an audit report gives the auditor LESS responsibility?

dual dating

if events that occur in period C would've been investigated had they been found earlier, the auditor should determine:

-the reliability of new info
-whether event had occurred by the report date
-whether users are likely to still be relying on the statements
-whether the audit report would've been affected had the facts been known to the auditor at the report date

what if a client doesn't cooperate with auditor's advice on how to handle events in period C?

auditor should notify any regulatory agent with jurisdiction and any users that shouldn't rely on the audit report anymore

management representation letter:

-letter that is obtained by the auditor at the end of each audit
-addressed to the auditor, signed by the CEO and CFO

purposes of the management representation letter:

-reminding management of its responsibility for the financial statements
-confirming oral responses obtained by the auditor earlier in the audit
-reducing the possibility of misunderstanding

what does it mean if management refuses to sign the management representation letter?

it would imply that they were not being truthful in their representation (enough to prevent auditor from issuing an unqualified opinion)

management letter:

-used by auditor to make operational and control recommendations to management
-not required

when is the engagement quality review performed?

performed before the audit opinion is issued

is an engagement quality review required?

usually for publicly held firms, not explicitly required for privately held firms

engagement quality review:

risk based review where the review evaluates the significant judgements/conclusions made by the engagement team

qualities that a reviewer should have when performing an engagement quality review:

-experienced
-not a part of the engagement team
-competent
-independent
-objective
-has integrity

purpose of an engagement quality review:

to provide reasonable assurance that the audit and audit documentation are complete and support the audit opinion on statements and controls

some procedures that a review should perform during an engagement quality review:

-discuss with audit team any significant matters
-evaluate judgements about materiality
-review evaluation of client's independence
-review audit documentation

audit committee:

independent sub committee of client's board of directors

relationship between auditor and audit committee:

they should have constructive and detailed dialogue between them