ACC 450 Exam 3
Third Party Lawsuits Against Auditors
Investors, creditors , and other users of the financial statements. They can only cite the law of torts. Needs to prove duty (can not act with gross negligence), breach of contract, loss, and proximate cause
Restatements
The changing of previously issued financial statements
Unasserted Claims Examples
The client is dumping hazardous material in a nearby lake. This is likely to cause health consequences sometime in the near future which will generate lawsuits
Loss (plaintiff has to prove)
The client suffered loss
Communicate with the Audit Committee Form
The communication should be in writing when, in the auditor's professional judgment, oral communication would not be adequate. (Often, a formal presentation to the audit committee will be involved, plus written reports.) When communicated orally, the auditor should document them in the working papers.
Communicate with the Audit Committee Timing
Must be on a timely basis. For example: The auditor may communicate planning matters early in the audit, and significant difficulties as soon as practicable after they occur.
Iron Curtain and Roll Over Methods
Must use BOTH when evaluating materiality, and if either one of them come up as material, then it is a material misstatement that needs to be fixed
Type II Subsequent Event Example
Natural Disasters Accounts receivable issues that originates after fiscal year end Lawsuits that start and get settled after balance sheet date (Rare)
Independence
Not being swayed by the actions or needs of the client Only required for for auditing and other attestation services
Procedures to Find Subsequent Events
Obtain understanding of management's procedures to ensure that subsequent events are identified. Management inquiry. Read minutes. Read interim financial statements.
When to Use Big "R" Restatements
Old financial statements are materially misstated
Asserted Claims
Ongoing lawsuits that are already in progress. Lawyers will share information on how likely the client is to lose the case
Inquiry of Client's Lawyers Recipient
Outside legal counsel
Critical Audit Matters
PCAOB - Public Companies
AICPA Code of Professional Conduct Structure
Part 1: Members in public practice (most stringent set of rules) Part 2 members in business Part 3: other members (retired people and people in academics)
Proportionate Liability
Payment by an individual defendant based on the degree of fault of the individual. 20% liable, inly pay 20% of damages
What Circumstances Lead to Qualified Reports
Pervasive scope limitation and scope limitation
Omitted Procedures
The inadvertent failure of auditors to perform necessary audit procedures prior to the audit report release date
Report for Departures from GAAP
The opinion is modified to either a qualified opinion or adverse opinion.
Qualified Opinion
The opinion states that the financial statements are presented fairly in conformity with GAAP "except for" the effects of some matter. The effects, while material, are not considered pervasive
What would cause a Group Audit?
The parent company and subsidiary are in different countries. Even if the auditor is the same company, since they're in different countries they are considered legally distinct (separate) companies
Insurance Value of the Audit
If you're an investor, part of the value of hiring a firm is that when there are lawsuits the auditing firm will be there to pay any damages
Quantitative Considerations
Income, EPS, Total assets, Owners' equity
Key Position (with the client)
Individual with primary responsibility for accounting functions, preparing financial statement, ability to influence contents of financial statements.
Other Matter Paragraghs
Inserted in the audit report that highlight information for readers that is not in the financial statements and are always optional.
Unmodified Opinions
"clean opinion" that may be issued when (1) financial statements presented in conformity with GAAP, (2) audit was performed in accordance with GAAS (or PCAOB standards, for publicly traded companies), including no scope limitations so significant as to prevent the auditors from gathering the evidence necessary to support their opinion and (3) when no conditions resulting in explanatory language exist.
Under Ultramares Approach, third parties can cover for ordinary losses when:
(1) the primary purpose of the audit is for the third party's benefit and (2) the identity of the third party.
Why are Auditors Responsible for Predicting the Going Concern Assumption?
1. Going concern is foundational for the financial statements 2. Regulators believe that auditors are in a prime position to make this assumption
What must be included in Critical Audit Matters/ Key Audit Matters
1. Identification of the matter. 2. Description of the principal considerations that led the auditor to determine that the matter is a CAM (KAM). 3. Description of how the CAM (KAM) was addressed in the audit. 4. Reference to the relevant financial statement accounts and disclosures that relate to the CAM (KAM).
Third Party Beneficiary
A person named in a contract or intended by the contracting parties to have definite rights and benefits under the contract.
Legal Strategies (to mitigate lawsuits)
1. Improve the quality of auditing. 2. Increasing insurance coverage (e.g., www.cpaprotectorplan.com). 3. Reporting more conservatively. 4. Lobbying legislators for legal reform. 5. Being more selective in obtaining and retaining clients. 6. Get out of audit practices altogether to reduce liability exposure.
Research Articles
Big picture theme: as litigation risk gets larger auditors will act more conservatively and that has opportunity cost for investors
Management Representation Letter
Auditor obtains from the client a written letter of representations summarizing the most important oral representations made during the year. CEO and CFO signs it. Management MUST sign
Common Law - Liability to Clients
1. Most frequent lawsuits against CPA's 2. $ amount is generally small 3. Little publicity 4. Breach of contract vs. tort (to gain standing) 5. Burden of proof?
Auditor's Responsibility for Omitted Procedures
Auditor should go back and perform the omitted procedure If the auditor can not perform the procedure then they must do alternative procedures If the auditor can not gather enough alternative evidence then the auditor needs to reissue the auditor's opinion
Re-Issue Opinion
Auditors take previous year opinions done by another companies and put them into the current year's audit
Details in an Auditor's Reports
1. What the auditor did 2. Management's responsibilities 3. Auditor's responsibilities 4. Standards used (GAAP or GAAS) 5. Something about internal controls 6. Opinion on the financial statements
Intrinsic Motivation
A desire to perform a behavior for its own sake. This is what we need in auditing
extrinic motivation
A desire to perform a behavior to receive promised rewards or avoid threatened punishment
Not Reasonably Estimated Contingency Loss
A disclosure is required
Reasonably Possible Contingency Loss
A disclosure is required
Breach of Contract
A failure to perform, as promised, at the time the performance was due. Civil common law., privity, you have to do what you agree to
Joint and Several Liability
A legal concept that makes each partner in a partnership legally liable for all the debts of the partnership. 20% liable can pay up to 100% if other defendants don't have money.
Common Law
A legal system based on custom and court rulings
Rollover Method of Evaluating Materiality
A method used to determine materiality that focuses on the current year's misstatement and compares that number to the tolerable misstatement level Created for the income statement and statement of cash flows because that statement focuses on the current years activity
Iron Curtain Method of Evaluating Materiality
A method used to determine materiality that focuses on the total or cumulative effect of a misstatement between current and previous years and compares that number to the tolerable misstatement level Created for the balance sheet because those accounts do not close and carry balances for a long time
Uncertainties
A situation where conclusive audit evidence will not exist until the future.
Ordinary Negligence
A violation of a legal duty to exercise a degree of care that an ordinarily prudent person would exercise under similar circumstances. Often, people refer to ordinary negligence simply as "negligence." Acting carelessly
Tort
A wrongful act or an infringement of a right (other than under contract) leading to civil legal liability. Civil-Common law, if you hurt/damage someone you should pay for it
Qualitative Considerations
A. Effect on trends, particularly profitability B. Changes loss to income C. Effect on compliance with loan covenants and contracts. D. Increases management's compensation E. Sensitivity of circumstances—Fraud, illegal acts, violation of contract. F. Motivation of management G. Effect on segment information H. Likelihood of being material in future I. Misstatements that are almost quantitatively material
Key Audit Matters (KAMS)
AICPA - Non-public companies
Adverse Opinion
An adverse opinion states that the financial statements are NOT presented fairly in conformity with GAAP. Auditors issue an adverse opinion when the departures from GAAP are both material and pervasive.
Independence in Fact
An auditor's mental attitude and impartiality with respect to the client
Unmodified with an Emphasis of Matter Paragraph
An emphasis of matter paragraph is included that refers to a matter appropriately presented or disclosed in the financial statements. In certain circumstances an emphasis of matter paragraph is required. In other circumstances an emphasis of matter paragraph is included at the auditor's discretion.
Contingencies
An existing condition, situation, or circumstance involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur
Covered Member
An individual on the audit engagement team, an individual in a position to influence the audit engagement, or a partner in the office in which the lead audit engagement partner primarily practices in connection with the audit engagement.
Unmodified with an Other Matter Paragraph
An other matter paragraph is included in the auditor's report that refers to a matter other than those presented or disclosed in the financial statements that, in the auditor's judgment, is relevant to users' understanding of the audit, the auditor's responsibilities, or the auditor's report.
Management, Discussion, and Analysis (MDNA)
Area where the CEO of the company just gets to talk about the results for the year and their interpretation of the results, and whether the company did well or did poorly, and what their plans are for the future. In a separate section from the footnote disclosures Gets a lower level of testing. It's more of a review and read by the auditor
Projected Misstatements
Arise from sample results projection to population. Rare to get to the end of an audit and still have these.
Type I Subsequent Event Examples
Audit client has a bunch of A/R and one of the people who owed our company money had no ability to pay but no one knew aout it yet. Subsequent to the balance sheet date that company goes bankrupt. Now we have eveidencce to write off the receivable. We need to make an adjusted journal entry to write the receivable off. Settlement of a lawsuit that is ongoing during current year and settle after balance sheet date
Audit Partner Rotation in Europe
Audit firm rotation after 10 years.
Audit Partner Rotation in the US
Audit partner rotation after 5 years.
Management Representation Letter Date
Audit report date
Management Representation Recipient
Auditor
Auditor's Responsibility During Report Preparation Period
Auditor is only responsible for subsequent events that come to their attention
Auditor's Responsibility During Subsequent Period
Auditor is responsible for performing procedures to actively search for subsequent events
Ultramares Approach (1931) (Primary Beneficiaries)
Auditor not liable for ordinary negligence to a third party who was not in contractual privity, unless the third party was a third party beneficiary.
Management Representation Signers
CEO & CFO
Substantial Doubt for Going Concern
Cash shortages, recurring losses and natural disasters
Inquiry of Client's Lawyers Signers
Client
Most Frequent Lawsuits against CPA's
Common Law-Liability to Clients
Management Representation Purpose
Confirm oral representation given to auditor.
Opportunity Cost
Cost of the next best alternative use of money, time, or resources when one choice is made rather than another
Scienter
Deliberately or knowingly
Privity
Describes who is involved in a contract
Rosenblum Approach (Fosrseeable Third-Party)
Details of what is meant by "foreseeable" have never been determined. But the basic idea is that a "foreseeable third party" should be able to recover for ordinary negligence.
Judgement Misstatements
Differences arising from judgments or estimates of management that the auditor consider incorrect.
Type II Subsequent Event (How to Handle)
Disclosure in the financial statements
When to Use Little "R" Restatement
Do this when prior years misstatements aren't material but the mistake would make current year statements materially misstated These generally get ignored and are fairly common
Disclaimer of Opinion
Due to a significant scope limitation (or very major uncertainties, including going concern uncertainties) the auditor was unable to obtain sufficient appropriate audit evidence (a scope limitation) on which to base the opinion, and the auditor concludes that the possible effects on the financial statements of undetected misstatements, if any, could be both material and pervasive. A disclaimer is not an opinion; it simply states that the auditor does not express an opinion on the financial statements.
Review the Minutes of Meetings
During meetings, someone is always taking notes. This procedure is reading/ reviewing those notes. Advantage: (1) Final catch all to see if there are any additional problems to review before audit is finished, (2) Helps with identifying subsequent events
Rules of Conduct
Enforceable ethical standards
Type I Subsequent Event
Events that provide additional evidence as to conditions that existed at the date of the balance sheet and affect the estimates inherent in the process of preparing financial statements.
Type II Subsequent Event
Events that provide evidence with respect to conditions that did not exist at the date of the balance sheet being reported on but arose subsequent to that date.
Group Audit Rarity
Extremely common
Aggregate Misstatement Types
Factual, Judgemental, Projected
Report for GAAP Inconsistencies
If properly handled, unmodified opinion with an emphasis of a matter paragraph. If improperly handled, either qualified or adverse.
Other Information
Financial and non-financial information that is included in a document that contains audited financial statements. Examples of such information include a report by management discussing the year's operating results, financial summaries, employment data, planned capital expenditures, financial ratios, and names of officers and directors.
Communicate with the Audit Committee
Fraud and illegal acts, communication of control related matters, significant findings
Unasserted Claims Problem
GAAP mandates that these contingent liabilities be included in the financial statements, but this information is extremely hard to get
Big "R" Misstatement (Non-Reliance Restatement)
Go backwards and change old statements. 8k announcement that states you should not rely on old statements and provides new ones. These are rare.
When to Issue an Unmodified Opinion with an Emphasis of Matter Paragrapgh
Going concern question, GAAP not consistently used *change in accounting method), and Uncertainties
Burden of Proof in a Criminal Case
Guilty beyond a reasonable doubt
Emphasis of Matter Paragrapghs
Highlight information that is in the financial statements and can be either required or optional.
Engagement Completion Document
Identifying significant findings or issues, actions taken to address them (including additional evidence obtained), and the basis for the conclusions reached in connection with each engagement. Only required for public companies.
Management Representation Letter Importance
It outlines the difference in what the auditors job is and what the management's job is
Gross Negligence
Lack of even slight care, indicative of a reckless disregard for one's professional responsibilities. Substantial failures on the part of an auditor to comply with GAAS might be interpreted as gross negligence. Acting recklessly
Statutory Law
Law passed by the U.S. Congress or state legislatures
Class Action Lawsuit
Lawsuit brought on behalf of many plaintiffs Makes the cost of suing manageable when there are many plaintiffs with small individuals claims but large claims in total
Uncertainties Examples
Lawsuits or changes in a law
Unasserted Claims
Lawsuits that have not started yet.
Dual Dating
Leave audit report date the same but where the audit report date is listed, for subsequent events, add an additional sentence that states when a subsequent date was found.
Proximate Cause (plaintiff has to prove this)
Legal cause; exists when the connection between an act and an injury is strong enough to justify imposing liability.
Inquiry of Client's Lawyers Content Restraints
Material matters to which lawyer gave substantial attention during the year.
Uncertainties and Matter Paragraphs
Matter paragraphs are optional when it comes to uncertainties
Management Representation Content Restraints
Matters individually or collectively material to F/S.
Burden of Proof in a Civil Case
Preponderance of the evidence (51%)
Inquiry of Client's Lawyers Purpose
Primary means of verifying assertions about LCA.
Type I Subsequent Event (How to Handle)
Recognize the subsequent event with an adjusted journal entry
Reasonably Estimated Contingency Loss
Recognize with a journal entry
Perform Final Analytical Procedures
Required Things change since the beginning of the audit so this ensures that all information is good and that the financial statements are as good as possible
Auditor Responsibility for After Report Subsequent Events
Restatement is required
Accounts That Often Get Key Audit Matters/ Critical Audit Matters Disclosures
Revenue, Allowance for Doubtful Accounts, and Taxes
Inquiry of Client's Lawyers Failure to Obtain or Receive Response
Scope limitation that may preclude issuance of standard audit report.
Management Representation Failure to Obtain or Receive Response
Scope limitation that may preclude issuance of standard audit report.
Restatement of Torts Approach (Foreseen Third Party)
Similar to Ultramares approach in that auditor knew the primary purpose of the audit was for the third party's benefit, but different in that the auditor need not be aware of the specific identity of the third party.
Letter of Inquiry
Similar to a confirmation letter, but for contingent liabilities, that are sent to our clients legal team We have to get permission from the client in order to do this. If refused then we will discontinue the audit. The legal team does not have to respond
Factual Mistatements
Specific misstatements identified during the course of the audit for which there is no doubt.
Audit Report for Non-Public Companies
Standard unmodified report
Audit Report for Public Companies
Standard unqualified report
Significant Findings or Issues
Substantive matters that are important to the procedures performed, evidence obtained, or conclusions reached, and include, but are not limited to, the following: Audit adjustments, disagreements, changes in assessed level of risk, modification in auditor's report
What standards does every state accountancy board follow for code of ethics?
The AICPA guidelines
Duty (plaintiff has to prove)
The CPA accepted a duty of care to exercise skill, prudence, and diligence. This is ordinarily easy to prove since by accepting an engagement a CPA assumes a responsibility to exercise due care.
Going Concern
The accounting assumption that a business is expected to operate in the future (1 year).
Management Letter
The auditor uses the management letter to make recommendations to the client based on observations during the audit. This is optional *Different from management representative letter
Independence in Appearance
The auditor's ability to maintain an unbiased viewpoint in the eyes of others
Group Audits
The situation where there is a parent company and a subsidiary who is getting an audit by a legally distinct (separate) auditing company
Preponderance of the Evidence
The standard of proof in a civil case in which a judge or jury must believe the plaintiff's story and evidence is stronger than the defendant's version.
PCAOB vs AICPA Audit Report Details Differences
The standards used during the audit and an opinion on internal controls
Subsequent Period
The time between balance sheet date and date of the audit report.
Contingency Gains
These are just ignored
Footnotes
These get audited and are verified
What do Auditors do?
They provide reasonable assurance that financial statements are free of material misstatement whether due to error or fraud
Subsequent Events
Things that happen after balance sheet date but before financial statements are generated U.S. GAAP topic Two types: Type I and Type II
Remote Contingency Loss
This can just be ignored
Right of Subrogation
This is a situation in which the third party "steps into the shoes of the client" recovery wise and can recover for ordinary negligence. This most often occurs when for one reason or another that third party reimburses the client for losses.
Fraud
This is intentional
Unmodified on Group Financial Statements
This unique circumstance involves situation in which two or more CPA firms are involved in the audit of components of group financial statements (e.g., a component auditor may audit one subsidiary of an organization structured as a parent company with 5 subsidiaries). The key to this opinion is whether the group auditor chooses to (or not to) take responsibility for the work of the component auditor
Report Preparation Period
Time between date of the audit report and report release date
Key Audit Matters/ Critical Audit Matters
To be considered a CAM (or KAM), the matter: 1. Arises from the audit and communicated or required to be communicated to the audit committee. 2. Relates to accounts or disclosures that are material to the financial statements. 3. Involved especially challenging, subjective, or complex auditor judgment. These areas might include accounting estimates such as allowance for sales returns, loan loss provisions, goodwill impairment, accounting for acquisitions, going concern assessments, hard to value financial instruments, etc.
Objectivity
Treating facts without influence from personal feelings or prejudices Always required
The Public Interest (Principle of Professional Ethics)
Ultimate responsibility is to serve the public (the people who use the financial statements)
Report for Uncertainties
Unmodified opinion, or unmodified opinion with an emphasis of matter paragraph, or disclaimer of opinion.
Report for Going Concern
Unmodified with emphasis of matter paragraph or disclaimer of opinion.
Report for Group Audits
Unmodified, with modifications added to the different paragraphs when the group auditor does not take responsibility for the work of the component auditor. Standard unmodified when the group auditor takes responsibility for the work of the component auditor.
Updating Opinion
Update all audit opinions for all of the years presented in the financial statements
Evaluation of Audit Findings to Support an Opinion
Used for determining opinion at the end of the audit. An auditor aggregates misstatements to determine whether there is a material misstatement of the financial statements. Includes both quantitative and qualitative considerations.
General Risk Contingencies
Used to describe all things that could ever possibly happen to a client. These are ignored
Breach of Contract (plaintiff has to prove)
Went against the agreed upon contract Most commonly defended against by the defendant (auditor)
Expectation Gap
What the public thinks accountants should do and what accountants think they can do
Impaired Independence
When independence is effectively extinguished. That, is when an auditor's independence is impaired, that auditor is not independent.
Little "R" Restatement (Amendment/ Revision)
When you don't change the old statements you just change the previous years column in new statements
Moral Hazard Issue
When you take away the consequences of a bad action you'll then get more of that bad actions
Justified Departure from GAAP
You are allowed to break GAAP if it leads to misleading information
Specifically Enforceable
You have t o follow the rules or you will get in trouble