Chapter 16: Auditing Operations and Completing the Audit

Contingent loss relies on ___. Uncertain as to both the ___ and whether the __ __.

Uncertainty Amount and whether the loss occured

Loss contingencies can also be called __ __. Loss contingencies encompasses the possible __ of __ and the possible __ of __. Because of the uncertainty factor, loss contingencies mostly do __ appear in accounting records

Contingent Liabilities Possible impairment of assets and the possible existence of liabilities DO NOT APPEAR

Commitments (Def.) Examples

Contractual obligation to enter into transactions in the future Ex: Inventory purchase commitments, commitment to sell merchandise at a certain price, employee stock option plans

Recognition of the loss involves recognition of ___ or a __ of an __. When accrued, __ of contingency and __ of loss needs to be disclosed.

Creation of liability or a reduction of an asset Nature of contingency and any exposure of loss

Dana Corp Example

Historically slow to pay off AR to certain company --> 300,000 of receivables that are aging out and not being paid --> should be considered bad debt --> auditors found out that dana had filed bankruptcy after year end --> Type I subsequent event Have to go back and make audit adjustment to write off AR since Dana would never be able to pay off the receiveable

Income Tax Disputes Uncertainty exists with prior year income taxes payable especially if they dispute the payable with the ___. Resulting in a time lag for the __.

IRS Payable

2) Determine the amount of difference from the expectation that can be accepted without investigation - how?

Materiality shows us what is a significant difference

Classification of expenses can effect __ __. SGA expenses are deducted from __ in the period __ while manufacturing overhead costs are carried forward as part of ___ cost.

Net Income Revenue, occured, inventory cost

Disclosure of loss contingencies is __ __ if possibility is ___. UNLESS ITS A __ __ and __ __

Not required, remote NR Discounted and gurantee endorsements

Auditor's report should __ be dated prior to the date they have gathered sufficient ___. Auditors are on the __ for any __ events up until the ___ of the report.

SHOULD NOT, sufficient evidence Hook, for any subsequent events, date

1) Search for unrecorded liabilities

Search for unrecorded liabilities deals with checking subsequent cash receipts after year end Designed to detect ommitted liabilities

Unasserted Claims (Def.)

When individual or org has not yet taken legal action against client Probable that a claim will be asserted and reasonably possible that a loss will be incurred

AR assigned with recourse means:

A gurantee of collectibility is given

General Risk Contingencies (Def.) Examples

A loss that might occur in the future Ex: Consumer boycott, natural catastrophe, raw materials price increase,

SGA expenses should be further scrutinized Analytical Procedures - (4)

1) Develop an expectation of the account balance 2) Determine the amount of difference from the expectation that can be accepted without investigation 3) Compare company's account balance with the expected account balance 4) Investigate significant deviations from the expected account balance

Loss Contingency (Def.)

A possible loss, stemming from past events, that will be resolved by some future event

Guarantees or endorsements Endorsement of notes seldom reflected in __, but are reflected in __ __. Officers, partners, and sole proprietors are inquired about __ received to keep business alive and about __ of contingent liabilities.

Accounts, director meetings Collateral, sources

What are Auditing Operations?

Additional procedures performed to audit the income statement beyond what has already been done

These items may be effectively identified using __ __ to investigate __ __.

Analytical techniques Unusual fluctuations

3) Compare company's account balance with the expected account balance

Can reveal significant differences

Confirmation by __ __ with purchaser or assignee is necessary for any receivables ___ or ___.

Direct Communication Sold or assigned

Loss contingencies that DO NOT MEET BOTH CRITERIA should be ___ in a note if there is at least a __ __ the loss has __. Disclosure should describe __ of contingency and provide an __ of the loss if possible.

Disclosed in a note Reasonable possibility the loss has occured Nature of contingency and provide an estimate of the loss

All businesses face potential losses from __ __ __.

General Risk Contingencies

3) Final analytical procedures (similar to preliminary analytical procedures)

Help auditors assess the validity of the conclusions reached and the opinions issued Auditors required to determine whether these procedures were performed as substantive procedures or used to find a previously unrecognized risk

Most common lost contingency stems from actual or pending ___. Need to discuss legal matters with in-___ ___ counsel.

Litigation in-house legal counsel

FASB __ ___ since it is not consistent with ___. Financial statements should be ___.

Rejects conservatism Not consistent with neutrality Neutral

Need to further scrutinize Miscellaneous Income (Why?)

There could be events recorded here that belong in other accounts "Where dead bodies are buried"

Conservatism in the valuation os liabilities

When two or more reasonable alternative values are indicated, the accountant will choose the higher amount

Conservatism in the valuation of assets

When two or more reasonable alternative values are indicated, the accountant will choose the lowest amount

Type 2 examples

a. Ex: Sell business after year end --> do not have to go back in financial statements --> but have to disclose that the business was sold b. Ex: Major drug in R&D --> drug gets rejected by FDA after year end

Obtain analyses of selected accounts - what are the most considered accounts?

1) Advertising 2) Research and Development 3) Legal expenses and Professional Fees 4) Repairs and Maintenance 5) Rents and Royalties

1) Develop an expectation of the account balance Consider factors such as: (5)

1) Budgeted amounts 2) Prior year audited balances 3) Industry averages 4) Relationships among financial data 5) Relevant nonfinancial data

Items that might be improperly included in Miscellaneous Income: (5)

1) Collections on previously written off AR or NR, should increase allowance for uncollectible notes 2) Write offs of outstanding checks or unclaimed wages, should be credited as liability since these revert to the state 3) Proceeds from sale of scrap, should reduce COGS 4) Rebates or refunds of insurance premiums, refunds should be offset against related expense or unexpired insurance 5) Proceeds from ssales of assets, should be used for gain or loss determination from sale

Obtain analyses of selected accounts - Professional Fees (3)

1) Could be a potential going concern issue 2) Could be a legal liability not yet recorded 3) Identify unknown issues by looking at invoices

4) Investigate significant deviations from the expected account balance Example

1) Inquiry management 2) Ex: If utilities have increased dramatically --> get invoices for the year from the energy provider to see if balances are close --> if that fails then we have to go directly to energy company

Many income statement accounts have already been tested in conjunction with the audit of balance sheet accounts - examples? How is this usually done? - (7)

1) Interest Expense - Debt 2) COGS (Inventory) - Recalculate sample using FIFO, LIFO, or WA 3) Sales and Bad Debt Expense - for AR we send out confirmations and look at subsequent cash receipts, for Sales we send out confirmations to confirm total sales balances 4) Depreciation expense, gains / losses, repairs & maintenance - fixed assets (Recalculate depreciation expense) 5) Interest / investment income - investments / loans receivable (Recalculate interest income) 6) Commissions expense, payroll, warranty costs, etc. - accruals 7) Amortization expense and royalty income - intangible assets

Why should additional steps be taken to audit the income statement beyond the audit of the balance sheet and testing already performed?

1) More important since company value is tied to income earnings 2) Dozens of estimates effect the income statement

FASB says that loss contingencies should be reflected in the accounting records when two requirements are met:

1) Probable that a loss was sustained before balance sheet date 2) Amount of loss can be reasonably estimated

1) Develop an expectation of the account balance Examples - (3)

1) Rent expense (common SGA expense) --> how long is lease for? What is monthly payment? --> leads to expectation 2) Sales commissions (function of sales, variable costs) --> 5% of sales for examples --> Take total sales x 5% to get expectation 3) Utilities (common SGA account) --> expect expenses to double based on yearly changes --> ex: natural gas price spikes, etc.

Certain audit procedures cannot be completed before the end of the audit

1) Search for unrecorded liabilities 2) Review or re-review board minutes 3) Final analytical procedures (similar to preliminary analytical procedures) 4) Identification of loss contingencies (e.g. contingent liabilities)

Identification of subsequent events

1) Type 1 2) Type 2

Review journals and ledgers for unusual items that may be indicative of misstatements - Looking for what? (3)

1) Unusually large entries - especially if its in round amounts 2) Entries from unusual sources 3) Entries with unusual timing - entries on the last day of the year

Effective __ program allows management to have __ __, so it reduces the risk of __ __. Control over budgeting is effective --> auditors can rely on good __ __ for __ ___

Budgeting program, expected expenses, material misstatement Good expected amounts for analytical procedures

Environmental Issues Resource, Conservation, and Recovery Act and various __ air and __ water acts create potential liability for companies.

Clean air and clean water

Doctrine of __ has a large influence over decisions dealing with __ and __.

Conservatism Revenues and Expenses

General risk contingencies ordinarily do __ __ to be __. __ __ __ is a general risk contingency.

DO NOT NEED TO BE DISCLOSED Lack of insurance

This process needs to be done near the __ of the auditor report so the auditors have the latest __ ___.

Date of the auditor report Available information

Auditors need to directly communicate to client's __ __ through a letter of __. They ask legal counsel to reply near the date of the __ __ to have the most current info.

External counsel through a letter of inquiry Audit report

Auditors have considerable respect for conservatism since:

Financial statements that understate financial position and operating almost never lead to legal action against auditors

Comparison of expenses and revenue accounts with __ and __ __ can bring light to things that need ___.

Industry and nonfinancial data, investigating

2. Letter of ___ (e.g., legal representation letter)- external counsel (need a ___ of all ___lawsuits and ___ lawsuits that haven't been filed yet) Summary involves: a. ___ of legal ___ b. ___ of outcomes c. ___ of potential losses d. ___ claims

Letter of Inquiry (Summary, current lawsuits, upcoming lawsuits) Status of legal cases Probability of outcomes Amount of potential loses Unasserted claims

When conservatism is applied to the income statement, it results in a __ or __ income figure.

Low or conservative income figure

2) Review or re-review board minutes

Reviewing minutes of meetings of stockholders, directors, audit committee, and investment committee Includes minutes held throughout date of audit report, also need written representation from management that they provided all minutes

Type 1 (Def.)

Subsequent events that take place that provide additional evidence about conditions that existed at the date of the financial statements

Type 2 (Def.)

Subsequent events that take place which are unrelated to conditions existing at the date of the financial statements