Audit Exam 4

Other Financial Difficulties

- Default on loans - Dividends in arrears - Restructuring of debt - Denial of trade credit by suppliers - No additional sources of financing

External Matters

- Legal proceedings - Loss of a major customer or supplier - Loss of a key franchise, license, or patent

Examples of Type II events or conditions are:

- Purchase or disposal of a business by the entity after the balance sheet date. - Sale of a capital stock or bond issue by the entity after the balance sheet date - Loss of the entity's manufacturing facility or assets resulting from a casualty such as a fore or flood occurring after the balance sheet date. - Losses on receivables arising from conditions such as a casualty arising subsequent to the balance sheet date.

Financial Conditions

- Recurring operating losses - Current-year deficit - Accumulated deficits - Negative net worth - Negative working capital - Negative cash flow - Negative income from operations - Inability to meet interest payments

Examples of the control events or conditions (relating to both before and after the reporting period) are:

- Relevant internal audit reports (or similar functions, such as loan review in a financial institution) issued during the subsequent period. - Independent auditor reports (if other than the primary auditor's) of significant deficiencies or material weakness. - Regulatory agency reports on the company's internal control over financial reporting - Information about the effectiveness of the company's internal control over financial reporting obtained through other engagements (AS5)

Internal Matters

- Work stoppages - Uneconomic long-term commitments - Dependence on the success of one particular project

Examples of Type I events or conditions are:

- an uncollectible account receivable resulting from continued deterioration of a customer's financial condition leading to bankruptcy after the balance sheet date, where the bankruptcy is the event that reveals the customer's poor financial condition at the balance sheet date. -The settlement of a lawsuit after the balance sheet date for an amount different from the amount recorded in the year-end financial statements.

The two types of subsequent events that require consideration by management and evaluation by the auditor relevant to the audit of internal control over financial reporting (ICFR) are:

1.) Control events that reveal information about a material weakness that existed as of the end of the reporting period. If the event reveals information about a material weakness, the auditor should issue an adverse opinion regarding the effectiveness of the company's financial reporting. If the auditor is unable to determine the effect of the subsequent control event on the effectiveness of the company's internal control, the auditor should disclaim an opinion. 2.) Control events that create or reveal information about a new condition that did not exist as of the end of the reporting period. If the information has a material effect on the company, the auditor should include an explanatory paragraph describing the event and its effects or directing the reader's attention to the event and its effects as disclosed in management's report.

What four major categories of events or conditions may indicate going concern problems?

1.) Financial conditions 2.) Other financial difficulties 3.) Internal Matters 4.) External Matters

Define what is meant by contingent liability. What three categories are used to classify a contingent liability? Give four distinct examples of contingent liabilities.

A contingent liability is defined as an existing condition, situation, or set of circumstances involving uncertainty as to possible loss to an entity that ultimately will be resolved when some future event occurs or fails to occur. FASB ASC Topic 450, "Contingencies," classifies uncertainties into three categories: 1.) Probable: the future event is likely to occur. 2.) Reasonably possible: the chance of the future event occurring is more than remote but less than likely. 3.) Remote: the chance of the future event occurring is slight. Examples of contingent liabilities include: - pending or threatened litigation - actual or possible claims and assessments - income tax disputes -product warranties or defects - guarantees of obligations to others - agreements to repurchase receivables that have been sold

Auditing standards primarily encourage which of the following conversations between the auditor and another party about the financial reporting?

A conversation with those charged with governance to discuss matters pertaining to financial reporting.

Describe the purposes of an independent engagement quality review by quality review partner.

A quality review partner is generally not associated with the details of the engagement and is expected to provide an independent review of the audit. The quality review partner can protect the firm from an inappropriate or non-independent relationship between the audit partner and the client. The engagement quality control reviewer performs an objective evaluation of the significant judgments made by the engagement team and the conclusions reached in formulating the auditor's report. He or she discusses significant findings or issues with the engagement partner and reads the financial statements and the proposed auditor's report. The engagement quality reviewer reviews selected audit documentation relating to the significant judgments the engagement team made and the related conclusions it reached, and evaluates the conclusions reached in formulating the auditor's report. Finally, he or she considers whether the proposed auditor's report is appropriate.

Describe what is meant when it is said that an auditor is "associated with" a set of financial statements.

An auditor is associated with financial statements when he or she has consented to the use of his or her firm's name in a document such as an annual report.

Give examples of a client-imposed and a condition-imposed scope limitation. Why is a client-imposed limitation generally considered more serious?

An example of a client-imposed scope limitation is where a client requests that the auditor not confirm accounts receivable because of concerns about creating conflicts with customers. An example of a circumstances -imposed scope limitation is when the auditor is not engaged to conduct the audit until after year-end. Under such circumstances, the auditor may not be able to observe inventory. Auditors should be particularly cautious when a client places a limit on the scope of the engagement letter because the client may be trying to prevent the auditor from discovering material misstatements. Auditing standards suggest that when restrictions imposed by the client significantly limit the scope of the engagement, the auditor should disclaim an opinion on the financial statements.

Are analytical procedures required as part of the final overall review of the financial statements? What is the purpose of such analytical procedures?

Auditing standards (AU-C 520, PCAOB No. 2810), require that the auditor perform analytical procedures at the final review stage of the audit. The objective of conducting final analytical procedures near the end of the engagement is to help the auditor assess the conclusions reached on the financial statement components and to help the auditor evaluate the overall financial statement presentation

Which of the following audit procedures is most likely to assist an auditor in identifying conditions and events that may indicate substantial doubt about an entity's ability to continue as a going concern?

Review compliance with the terms of debt agreements.

Which of the following matters should an auditor communicate to those charged with governance?

Significant audit adjustments - Yes Management's consultations with other accountants - Yes

An auditor should request that an audited entity send a letter of inquiry to those attorneys who have been consulted concerning litigation, claims, or assessments. The primary reason for this request is to provide:

Corroboration of the information furnished by management concerning litigation, claims, and assessments.

Which of the following procedures would an auditor most likely perform to obtain evidence about the occurrence of any changes in internal control that might affect financial reporting between the end of the reporting period and the date of the auditor's report?

Examine relevant internal audit reports issued during the subsequent period.

List four bases for special purpose financial statements. Why is it important that the audit report clearly identify the basis of accounting used in the preparation of the financial statements?

Four bases for special purpose financial statements are: - regulatory basis - tax basis - cash (or modified cash) basis - contractual basis it is important that the financial statements and the audit report clearly identify which basis of accounting is being used so that the financial statements are not confused with financial statements prepared on a GAAP basis

What types of events would generally require restatement of the issued financial statements? What procedures should the auditor follow when the entity refuses to cooperate and make the necessary disclosures?

Generally, when previously issued financial statements contain material misstatements due to unintentional or intentional actions by management, the financial statements will require revision. If the client refuses to cooperate and make the necessary disclosures, the auditor should notify the board of directors and take the following steps, if possible: 1.) Notify the client that the auditor's report must no longer be associated with the financial statements 2.) Notify any regulatory agencies having jurisdiction over the client that the auditor's report can no longer be relied upon 3.) Notify each person known to the auditor to be relying on the financial statements. Usually, notification to a regulatory agency, such as the SEC, is the only practical way to provide appropriate disclosure

If the auditor determines that other information contained with the audited financial statements is incorrect and the client refuses to correct the other information, what actions can the auditor take?

If the auditor determines that other information contained with audited financial statements is incorrect, the auditor should request that the client correct the other information. If the other information is not revised, the auditor should include an explanatory (or other-matter) paragraph in the audit report, withhold the report, or withdraw from the engagement. The auditor should communicate the material inconsistency to the client and the audit committee in writing and consider getting legal advise as to any further appropriate action.

An auditor would be most likely to identify contingent liability by obtaining a(n):

Letter from the entity's general legal counsel

An auditor issued an audit report that was dual dated for a subsequent event occurring after the date on which the auditor has obtained sufficient appropriate audit evidence but before issuance of the financial statements. The auditor's responsibility for events occurring subsequent to the date on which the auditor has obtained sufficient appropriate audit evidence was:

Limited to the specific event referenced

Final analytical procedures are generally intended to:

Provide the auditor with a final, overall evaluation of the relationships among financial statement balance.

In which of the following situations would an auditor ordinarily issue an unqualified/unmodified financial statement audit opinion with no explanatory (or emphasis-of-matter/other-matter) paragraph?

The auditor decides not to refer to the report of another auditor as a basis, in part, for the auditor's opinion.

What are the auditor's responsibilities for other information included in an entity's annual report?

The auditor has not responsibility beyond the financial information contained in the report, and he or she has no obligation to perform any audit procedures to corroborate the other information. However, auditing standards (AU-C 720) requires that the auditor read the other information and consider whether such information is consistent with the information contained in the audited financial statements.

Why does the auditor obtain a representation letter from management?

The auditor obtain a representation letter in order to corroborate significant oral representations made to the auditor and to document the continued appropriateness of those representations. The representation letter also reduces the possibility of misunderstanding between management and the auditor.

What information does the auditor ask the attorney to provide on pending or threatened litigation?

The auditor requests that the attorney provide the following information on pending or threatened litigation: - a list and evaluation of any pending or threatened litigation to which the attorney devoted substantial attention. The client may provide the list. - a listing of unasserted claims and assessments considered by management to be probable of assertion and reasonably possible of unfavorable outcome. - a description and evaluation of the outcome of each pending or threatened litigation. This should include the progress of the case, the action the entity plans to take, the likelihood of unfavorable outcome, and the amount or range of potential loss. - identification of any pending or threatened litigation or claims not included in management's list or a statement that the list is complete - comments on unasserted claims where his or her views differ from management's evaluation. - indication if his or her response is limited and the reasons for such limitations

In 2017, your firm issued an unmodified report on Tosi Corporation, a private company. During 2018, Tosi entered its first lease transaction, which you have determined is material but not pervasive. Tosi Corporation's management chooses to treat the transaction as an operating lease, without adopting the requirements of the new FASB leasing standard. What types of reports would you issue on the corporation's comparative financial statements for 2017 and 2018?

The auditor should issue an unmodified report on the 2017 financial statements and a qualified report on the 2018 financial statements because the current year is not in conformity with GAAP. The non-GAAP accounting for the lease transaction should be disclosed in the audit report. The opinion on the 2018 financial statements would not be adverse because, while the misstatement is material, it is not pervasive.

How does the materiality of a departure from GAAP affect the auditor's choice of financial statement audit reports?

The concept of materiality plays a major role in the auditor's choice of audit reports. If the departure from GAAP is immaterial, the auditor issues an unqualified/unmodified opinions. If the departure from GAAP is material but not pervasive, the auditor issues a qualified ("except for") opinion. If the departure is so pervasive that it effects are highly material, the auditor issues an adverse opinion. For example, suppose that a client accounts for leased assets as operating leases when proper accounting requires that the leases be capitalized. If a client has only one small piece of equipment that is accounted for inappropriately , the auditor will probably issue an unqualified/unmodified opinion because the item is not material. However, if the client has many significant leased assets that are accounted for as operating leases instead of capitalized leases, the auditor will normally issue a qualified or adverse opinion, depending on the magnitude of the problem.

Which of the following events occurring after the issuance of a set of financial statements and the accompanying auditor's report would be most likely to cause the auditor to make further inquiries about the financial statements?

The discovery of information regarding a contingency that existed before the financial statements were issued.

List the four overall steps in the auditor's going concern evaluation process.

The four overall steps in the going concern evaluation process are as follows: 1.) Independently evaluate whether the results of audit procedures performed during the planning, performance, and completion of the audit indicate whether there is substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time not the exceed one year from the issuance of the financial statements. 2.) If there is substantial doubt, the auditor should obtain information about management's plans to mitigate the going concern problem and assess the likelihood that such plans can be implemented. 3.) Conclude, in light of management's plans, whether it is probable that the entity will be able to continue as a going concern; if not, consider the adequacy of the disclosures about the entity's ability to continue and include a separate section in the auditor's report disclosing the going-concern issue under the heading "Substantial Doubt About Entity's Ability to Continue as a Going Concern" 4.) Assess management's going-concern evaluation and related disclosures.

What items should be included in the auditor's communication with those charged with governance (i.e., the audit committee or similar group)?

The items to be communicated are organized into three categories: appointment and retention of the auditor, obtaining information relevant to the audit and communicating the audit strategy, and communicating the results of the audit. Note: The auditor's communication with those charged with governance would normally take place at or near the end of the engagement. However, if a significant event occurs, such as fraudulent activities by senior management, the auditor would normally contact those charged with governance immediately.

What are the types of subsequent events relevant to financial statement audits? Give one example of each type of subsequent event that might materially affect the financial statements.

The two types of subsequent events that require consideration by management and evaluation by the auditor relevant to financial statement audits are: - Type I: Events that provide additional evidence about conditions that existed at the date of the balance sheet and affect the estimates that are part of the financial statement preparation process. These types of events require adjustment of the financial statements - Type II: Events that provide evidence about conditions that did not exist at the date of the balance sheet but arose subsequent to that date. These types of events usually require disclosure in the notes to the financial statements. In some instances, where the effect of the event or transaction is very significant, pro forma financial statements may be necessary in order to prevent the financial statements from being misleading.

A public entity changed from the straight-line method to the declining balance method of depreciation for all newly acquired assets. This change has no material effect on the current year's financial statements but is reasonably certain to have a substantial effect in later years. The client's financial statements contain no material misstatements and the auditor concurs that this change is justified. If the change is disclosed in the notes to the financial statements, the auditor should issue a report with a(n):

Unqualified opinion

An auditor includes a separate paragraph in an otherwise unmodified financial statement audit report to emphasize that the entity being reported upon had significant transactions with related parties. The inclusion of this separate paragraph:

is appropriate and would not negate the unmodified opinion