Chapter 17
Define what is meant by contingent liability.
-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.
Examples of Other financial difficulties
• Default on loans • Dividends in arrears • Restructuring of debt • Denial of trade credit by suppliers • No additional sources of financing
An auditor would be most likely to identify a *contingent liability* by obtaining a(n) a. Accounts payable confirmation. b. Bank confirmation of the entity's cash balance. c. Letter from the entity's general legal counsel. d. List of subsequent cash receipts.
c. Letter from the entity's general legal counsel.
Management letter.
A letter from the auditor to management making recommendations to the entity based on observations during the audit; the letter may include topics relating to organizational structure and efficiency issues.
Representation letter.
A letter that corroborates oral representations made to the auditor by management or by other auditors and documents the continued appropriateness of such representations.
Closest reasonable estimate.
A range of acceptable amounts or a precisely determined point estimate for an estimate (e.g., uncollectible receivables), if that is a better estimate than any other amount.
Engagement quality review.
A review by a quality review partner of the financial statements and audit report to ensure the audit was properly conducted and an appropriate report issued.
What types of events would generally require restatement of the issued financial statements?
Generally, when previously issued financial statements contain material misstatements due to unintentional or intentional actions by management, the financial statements will require revision.
The following represents a series of unrelated statements, questions, excerpts, and comments taken from various parts of an auditor's working paper file. What is the most likely source? It is our opinion that the possible liability to the company in this proceeding is nominal in amount.
Lawyer's response to audit inquiry letter.
The following represents a series of unrelated statements, questions, excerpts, and comments taken from various parts of an auditor's working paper file. What is the most likely source? In planning the sampling application, was appropriate consideration given to the relationship of the sample to the assertion and to planning materiality?
Partner's engagement review notes.
The following represents a series of unrelated statements, questions, excerpts, and comments taken from various parts of an auditor's working paper file. What is the most likely source? Our use of professional judgment and the assessment of audit risk and materiality for the purpose of our audit mean that matters may have existed that would have been assessed differently by you. We make no representation as to the sufficiency or appropriateness of the information in our working papers for your purposes.
Predecessor auditor's communication with successor auditor.
Why does the auditor obtain a representation letter from management?
The auditor obtains 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.
Auditing standards primarily encourage which of the following conversations between the auditor and another party about *financial reporting*? a. A conversation with those charged with governance to discuss matters pertaining to financial reporting. b. A conversation with only management to discuss matters pertaining to financial reporting. c. A conversation with the head of the entity's internal audit department and those charged with governance to discuss matters pertaining to financial reporting. d. A conversation in which those charged with governance report on management's views on matters pertaining to financial reporting.
a. A conversation with those charged with governance to discuss matters pertaining to financial reporting.
Describe the purposes of an independent engagement quality review by a 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. 1) 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. 2) He or she discusses significant findings or issues with the engagement partner and reads the financial statements and the proposed auditor's report. 3) 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. 4) Finally, he or she considers whether the proposed auditor's report is appropriate.
Type I Event or Conditions
-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. 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.
Type II Events or Conditions
-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. 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 fire 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.
The following represents a series of unrelated statements, questions, excerpts, and comments taken from various parts of an auditor's working paper file. What is the most likely source? Indicate in the space provided below whether this information agrees with your records. If there are exceptions, please provide any information that will assist the auditor in reconciling the difference.
Accounts receivable confirmation request.
Legal letter.
An audit inquiry sent to the entity's attorneys in order to obtain or corroborate information about litigation, claims, and assessments.
Subsequent event.
An event or transaction that occurs after the balance sheet date but prior to the issuance of the financial statements and the auditor's reports that may materially affect the financial statements.
Contingent liability.
An existing condition, situation, or set of circumstances involving uncertainty as to possible loss to an entity that will ultimately be resolved when some future event occurs or fails to occur.
The following represents a series of unrelated statements, questions, excerpts, and comments taken from various parts of an auditor's working paper file. What is the most likely source? In connection with an audit of our financial statements, please furnish to our auditors a description and evaluation of any pending or probable litigation against our company of which you are aware.
Audit inquiry letter to legal counsel.
Are analytical procedures required as part of the final overall review of the financial statements?
Auditing standards (AU 520, PCAOB AS No. 14), require that the auditor perform analytical procedures at the final review stage of the audit.
The following represents a series of unrelated statements, questions, excerpts, and comments taken from various parts of an auditor's working paper file. What is the most likely source? During the year under audit, we were advised that management consulted with Gonzales & Ramirez, CPAs. The purpose of this consultation was to obtain another CPA firm's opinion concerning the company's recognition of certain revenue that we believe should be deferred to future periods. Gonzales & Ramirez's opinion was consistent with our opinion, so management did not recognize the revenue in the current year.
Auditor's communication to those charged with governance (other than with respect to significant deficiencies and material weakness).
The following represents a series of unrelated statements, questions, excerpts, and comments taken from various parts of an auditor's working paper file. What is the most likely source? The timetable set by management to complete our audit was unreasonable considering the failure of the company's personnel to complete schedules on a timely basis and delays in providing necessary information.
Auditor's communication to those charged with governance (other than with respect to significant deficiencies and material weakness).
The following represents a series of unrelated statements, questions, excerpts, and comments taken from various parts of an auditor's working paper file. What is the most likely source? Blank checks are maintained in an unlocked cabinet along with the check-signing machine. Blank checks and the check-signing machine should be locked in separate locations to prevent the embezzlement of funds.
Auditor's communications on significant deficiencies and material weakness.
The following represents a series of unrelated statements, questions, excerpts, and comments taken from various parts of an auditor's working paper file. What is the most likely source? During our audit we discovered evidence of the company's failure to safeguard inventory from loss, damage, and misappropriation.
Auditor's communications on significant deficiencies and material weakness.
The following represents a series of unrelated statements, questions, excerpts, and comments taken from various parts of an auditor's working paper file. What is the most likely source? Several employees have disabled the antivirus detection software on their PCs because the software slows the processing of data and occasionally rings false alarms. The company should obtain antivirus software that runs continuously at all system entry points and that cannot be disabled by unauthorized personnel.
Auditor's communications on significant deficiencies and material weakness.
The following represents a series of unrelated statements, questions, excerpts, and comments taken from various parts of an auditor's working paper file. What is the most likely source? The company has insufficient expertise and controls over the selection and application of accounting policies that are in conformity with GAAP.
Auditor's communications on significant deficiencies and material weakness.
Analytical procedures.
Evaluations of financial information made by an analysis of plausible relationships among both financial and nonfinancial data.
Give four distinct examples of contingent liabilities.
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
Give examples of other procedures undertaken for different purposes that might also disclose litigation, claims, and assessments
Examples of other procedures undertaken for different purposes that might also disclose litigation, claims, and assessments are the following: • Read minutes of stockholders, directors, and appropriate committee meetings held during and subsequent to the period being examined. • Read contracts, loan agreements, leases, and correspondence from taxing or other governmental agencies, and similar documents. • Obtain information concerning guarantees from bank confirmation forms. • Inspect other documents for possible guarantees by the client.
Give examples of control events or conditions relating to both before and after the reporting period
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).
The following represents a series of unrelated statements, questions, excerpts, and comments taken from various parts of an auditor's working paper file. What is the most likely source? As discussed in Note 4 to the financial statements, the company experienced a net loss for the year ended July 31, 2015, and is currently in default under substantially all of its debt agreements. In addition, on September 25, 2015, the company filed a prenegotiated voluntary petition for relief under Chapter 11 of the U.S. Bankruptcy Code. These matters raise substantial doubt about the company's ability to continue as a going concern.
Explanatory paragraph of an auditor's report on financial statements.
What three categories are used to classify a contingent liability?
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.
*WORD PROBLEM* Namiki, CPA, is auditing the financial statements of Taylor Corporation for the year ended December 31, 2015. Namiki plans to complete the fieldwork and sign the auditor's report about March 10, 2016. Namiki is concerned about events and transactions occurring after December 31, 2015, that may affect the 2015 financial statements. Required: a. What general types of subsequent events require Namiki's consideration and evaluation?
For the financial statement audit, the two types of subsequent events that require Namiki's consideration and evaluation are: • Events that provide additional evidence concerning conditions that existed at the balance sheet date and affect the estimates inherent in the process of preparing financial statements. This type of subsequent event requires that the financial statements be adjusted for any changes in estimates resulting from the use of such additional evidence. • Events that provide evidence concerning conditions that did not exist at the balance sheet date but arose subsequent to that date. Such events result in financial statement disclosure.
a1) What two types of subsequent events might the audit consider if Taylor were a public company?
If Taylor is a public company, the audit of internal control over financial reporting includes two types of subsequent events that the auditor must consider: 1) Control events that reveal information about a material weakness which 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 on the effectiveness of internal control over 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 any opinion. 2) Control events that create or reveal information about a new condition which 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 procedures should the auditor follow when the entity refuses to cooperate and make the necessary disclosures?
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.
The following represents a series of unrelated statements, questions, excerpts, and comments taken from various parts of an auditor's working paper file. What is the most likely source? The company believes that all material expenditures that have been deferred to future periods will be recoverable.
Management representation letter.
The following represents a series of unrelated statements, questions, excerpts, and comments taken from various parts of an auditor's working paper file. What is the most likely source? The company considers the decline in value of equity securities classified as available-for-sale to be temporary.
Management representation letter.
The following represents a series of unrelated statements, questions, excerpts, and comments taken from various parts of an auditor's working paper file. What is the most likely source? The company has no plans or intentions that may materially affect the carrying value or classification of assets and liabilities.
Management representation letter.
The following represents a series of unrelated statements, questions, excerpts, and comments taken from various parts of an auditor's working paper file. What is the most likely source? There have been no communications from regulatory agencies concerning non-compliance with or deficiencies in financial reporting practices.
Management representation letter.
*WORD PROBLEMS* During an audit engagement, Harper, CPA, has satisfactorily completed an examination of accounts payable and other liabilities and now plans to determine whether there are any loss contingencies arising from litigation, claims, or assessments. Required: What audit procedures should Harper follow with respect to the existence of loss contingencies arising from litigation, claims, and assessments? Do not discuss reporting requirements. (AICPA, adapted)
Since the events or conditions that should be considered in the financial accounting for and reporting of litigation, claims, and assessments are matters within the direct knowledge, and often, control of management of an entity, management is the primary source of information about such matters. Accordingly, Harper's audit procedures with respect to the existence of loss contingencies arising from litigation, claims, and assessments should include the following: • Inquire and discuss with management the policies and procedures adopted for identifying, evaluating, and accounting for litigation, claims, and assessments. • Obtain from management a description and evaluation of litigation, claims, and assessments that existed at the date of the balance sheet being reported on, and during the period from the balance sheet date to the date the information is furnished, including an identification of those matters referred to legal counsel. • Examine documents in the client's possession concerning litigation, claims, and assessments, including correspondence and invoices from lawyers. • Obtain assurance from the client, ordinarily in the form of a representation letter, that it has disclosed all unasserted claims which the lawyer has advised the client are probable of assertion and must be disclosed in accordance with generally accepted accounting principles (FASB ASC 450). • The auditor should request the client's management to send a letter of inquiry to those lawyers with whom management consulted concerning litigation, claims, and assessments.
b. What auditing procedures should Namiki consider performing to gather evidence concerning subsequent events?
The auditing procedures Namiki should consider performing to gather evidence concerning subsequent events include the following: • Compare the latest available interim statements with the financial statements being audited. • Ascertain whether the interim statements were prepared on the same basis as the audited financial statements. • Inquire whether any contingent liabilities or commitments existed at the balance sheet date or the date of inquiry. • Inquire whether there was any significant change in the capital stock, long-term debt, or working capital to the date of inquiry. • Inquire about the current status of items in the audited financial statements that were accounted for on the basis of tentative, preliminary, or inconclusive data. • Read or inquire about the minutes of meetings of stockholders or the board of directors. • Inquire of the client's legal counsel concerning litigation, claims, and assessments. • Obtain a management representation letter, dated as of the date of Namiki's audit report, as to whether any subsequent events would require adjustment or disclosure. • Make such additional inquiries or perform such additional procedures Namiki considers necessary and appropriate. • Examine and/or inquire about findings included in internal audit reports completed after year end.
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 has 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.
Under what circumstances would the auditor dual date an audit report?
The auditor would consider dual dating the audit report when a subsequent event is recorded or disclosed in the financial statements after the date on which the auditor has obtained sufficient appropriate audit evidence but before the issuance of the financial statements
Working papers.
The auditor's record of the work performed and the conclusions reached on the audit.
Dual dating.
The auditor's report is dual dated when a subsequent event occurs after the date on which the auditor has obtained sufficient appropriate audit evidence but before the financial statements are issued.
What four major categories of events or conditions may indicate going concern problems?
The four major categories of events or conditions that may indicate going concern problems and examples of each are 1) Financial conditions 2) Other financial difficulties: 3) Internal matters 4) External matters
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: 1) Appointment and retention of the auditor, 2) obtaining information relevant to the audit and communicating the audit strategy, and 3) 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 is the purpose of analytical procedures as part of the final overall review of the financial statements?
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.
What are the types of subsequent events relevant to financial statement audits?
The two types of subsequent events that require consideration by management and evaluation by the auditor relevant to financial statement audits are: *Type I* *Type II*
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 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 internal control over 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.
List the three overall steps in the auditor's going concern evaluation process.
Three overall steps in the going concern evaluation process are as follows: 1. Consider 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 to exceed one year. 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 there is substantial doubt about the ability of the entity to continue as a going concern; if substantial doubt exists, consider the adequacy of the disclosures about the entity's ability to continue and include an explanatory paragraph in the audit report
Provide two examples of commitments.
Two examples of long-term commitments are the purchase of raw materials or the sale of products at a fixed price.
Under what conditions do such commitments result in a decrease in Other Comprehensive Income?
When the fair market value of the good is less than the purchase price included in the purchase contract, the entity will have to recognize a loss on a long-term commitment even though there has been no exchange of goods.
An auditor issued an audit report that was *dual dated* for a subsequent event occur- ring *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 a. Limited to the specific event referenced. b. Extended to include all events occurring since the date on which the auditor has obtained sufficient appropriate audit evidence. c. Extended to subsequent events occurring through the date of issuance of the report. d. Limited to events occurring up to the date of the last subsequent event referenced
a. Limited to the specific event referenced.
*Final analytical procedures* are generally intended to: a. Provide the auditor with a final, overall evaluation of the relationships among financial statement balances. b. Test transactions to corroborate management's financial statement assertions. c. Gather evidence concerning account balances that have not yet been investigated. d. Retest control activities that appeared to be ineffective during the assessment of control risk.
a. Provide the auditor with a final, overall evaluation of the relationships among financial statement balances.
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*? a. Review compliance with the terms of debt agreements. b. Review management's plans to dispose of assets. c. Evaluate management's plans to borrow money or restructure debt. d. Consider management's plans to reduce or delay expenditures.
a. Review compliance with the terms of debt agreements.
Which of the following matters should an auditor communicate to those charged with governance? a. Significant Audit Adjustments: Yes. Management's Consultations with Other Accountants: Yes b. Significant Audit Adjustments: Yes. Management's Consultations with Other Accountants: No. c. Significant Audit Adjustments: No. Management's Consultations with Other Accountants: Yes. d. Significant Audit Adjustments: No. Management's Consultations with Other Accountants: No.
a. Significant Audit Adjustments: Yes. Management's Consultations with Other Accountants: Yes
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? a. Review a fire insurance settlement during the subsequent period. b. Examine relevant internal audit reports issued during the subsequent period. c. Inquire of the entity's legal counsel concerning litigation, claims, and assessments arising after year-end. d. Confirm bank accounts established after year-end.
b. Examine relevant internal audit reports issued during the subsequent period.
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*? a. A technological development in the industry that could affect the entity's future ability to continue as a going concern. b. The entity's sale of a subsidiary that accounts for 30 percent of the entity's consolidated sales. c. The discovery of information regarding a contingency that existed before the financial statements were issued. d. The final resolution of a lawsuit explained in a separate paragraph of the auditor's report.
c. The discovery of information regarding a contingency that existed before the financial statements were issued.
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 a. The opinion of a specialist as to whether loss contingencies are possible, probable, or remote. b. A description of litigation, claims, and assessments that have a reasonable possibility of unfavorable outcome. c. An objective appraisal of management's policies and procedures adopted for identifying and evaluating legal matters. d. Corroboration of the information furnished by management concerning litigation, claims, and assessments.
d. Corroboration of the information furnished by management concerning litigation, claims, and assessments.
Examples of External matters
• Legal proceedings • Loss of a major customer or supplier • Loss of a key franchise, license, or patent
Examples of 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 Internal matters
• Work stoppages • Uneconomic long-term commitments • Dependence on the success of one particular project
