Chapter 14

Completing the Audit

The Audit Process

Overview of Audit and Assurance

(Chapter 1)

Professionalism and Professional Responsibilities

(Chapter 2)

Client Acceptance/Continuance and Risk Assessment

(Chapters 3 and 4)

Gaining an Identify Significant

Set Planning
Understanding of Accounts and
Materiality
the Client Transactions

Gaining an Understanding of
Make Preliminary Risk
the System of Internal Control
Assessments
(Chapter 6)

Develop Responses to Risk and an Audit Strategy

Audit Data Analytics

Audit Evidence
(Chapter 5)

(Chapter 7)
Performing Tests of Controls Performing Substantive Procedures
(Chapter 8) (Chapter 9)

Audit Sampling for Substantive Tests

(Chapter 10)

Auditing the Auditing the Purchasing Auditing the Balance Sheet

Revenue Process and Payroll Processes and Related Income Accounts
(Chapter 11) (Chapter 12) (Chapter 13)

Completing and Reporting on the Audit

(Chapters 14 and 15)

Procedures Performed Near Drawing Audit

Reporting
the End of the Audit Conclusions

14-1
14-2  C h a pte r 14  Completing the Audit
Learning Objectives
LO 1 Apply the audit procedures used to search for loss
contingencies.
LO 2  Distinguish between the two types of material
subsequent events and evaluate what effect they have
on the financial statements, if any.
Auditing and Assurance Standards
PCAOB
AS 1201  Supervision of the Audit Engagement
AS 1215 Audit Documentation
AS 1220 Engagement Quality Review
AS 1301  Communications with Audit Committees
AS 2401  Consideration of Fraud in a Financial
Statement Audit
AS 2415  Consideration of an Entity’s Ability to Continue
as a Going Concern
AS 2505  Inquiry of a Client’s Lawyer Concerning
Litigation, Claims, and Assessments
AS 2801  Subsequent Events
AS 2805  Management Representations
AS 2810 Evaluating Audit Results
Cloud 9 - Continuing Case
The partner on the Cloud 9 audit, Jo Wadley, has called a meeting
with the audit team (Sharon Gallagher, Josh Thomas, and Mark
Batten) to discuss the completion of the audit. Jo wants to be sure
that she is briefed on all contentious matters so that she can re-
solve them at the scheduled meetings with Cloud 9’s audit com-
mittee and management.
Sharon, Josh, and Mark hold a preliminary meeting to pre-
pare for the meeting with the partner. On the agenda are final
LO 3  Describe engagement wrap-up procedures
performed at the conclusion of the audit.
LO 4 Evaluate the going concern assumption for a client.
LO 5  Discuss what reporting is required to management
and those charged with governance.
Auditing Standards Board
AU-C 220  Quality Control for an Engagement
Conducted in Accordance with Generally Accepted
Auditing Standards
AU-C 230 Audit Documentation
AU-C 240  Consideration of Fraud in a Financial
Statement Audit
AU-C 250  Consideration of Laws and Regulations in an
Audit of Financial Statements
AU-C 260 The Auditor’s Communication with Those
Charged with Governance
AU-C 450 Evaluation of Misstatements Identified During
the Audit
AU-C 501 Audit Evidence—Specific Considerations for
Selected Items
AU-C 520 Analytical Procedures
AU-C 560  Subsequent Events and Subsequently
Discovered Facts
AU-C 570 The Auditor’s Consideration of an Entity’s
Ability to Continue as a Going Concern
AU-C 580  Written Representations
evidence and misstatements evaluation, search for loss contingen-
cies, subsequent events procedures and evidence, going concern
procedures and assessment, and communication with Cloud 9’s
audit committee.
What issues have arisen with Cloud 9’s audit? How can they
make sure the partner is fully prepared for the meeting with the
client’s management?
  Audit Procedures for Loss Contingencies  14-3

Chapter Preview: Audit Process in Focus

As the audit is nearing completion, specific procedures must be performed before auditors
can draw an overall conclusion on the audit. In this chapter, we discuss audit procedures for
loss contingencies, subsequent events, and auditing the going concern assumption. We also
describe how auditors revisit key audit planning items, such as materiality, audit risk, and risk
of fraud, to determine if their original assessments are still valid or if adjustments are required
that may alter the nature and extent of audit procedures.
Experienced members of the audit team review working papers to ensure the planned
audit procedures have been performed and properly documented. Auditors evaluate the mis-
statements identified throughout the audit and analyze the effect of uncorrected misstate-
ments on the financial statements as a whole to form the audit opinion. This chapter also
reviews other wrap-up procedures including final analytical procedures, engagement quality
review, and final assembly of the audit documentation. Prior to issuing the audit report, audi-
tors obtain a representation letter from management and communicate significant findings or
issues from the audit to those charged with governance.

Audit Procedures for Loss Contingencies

Lea rning Objective 1

Apply the audit procedures used to search for loss contingencies.

Every company, no matter how big or how small, faces risk of events happening today that
have consequences in the future. For example, the explosion of the Deepwater Horizon
offshore oil rig (operated by BP) in 2010 resulted in worker injuries and fatalities and dam-
age to the environment in the Gulf of Mexico. Many lawsuits against BP followed, and some
are still not resolved almost a decade after the incident. What is the proper accounting treat-
ment for a situation like this one in which the company could still be liable to many differ-
ent groups over an extended period of time? FASB ASC Topic 450, Contingencies, provides
accounting guidance for events, or potential events, that create uncertainty for a company.
FASB defines a loss contingency as an existing condition or situation involving uncertainty loss contingency  an existing
as to possible loss that will ultimately be resolved when one or more future events occur condition or situation involving
or fail to occur. Some other examples of a loss contingency include income tax disputes uncertainty as to possible loss that
with the IRS, guarantees of debt of others, threat of expropriation of assets, and pending or will ultimately be resolved when
threatening litigation with employees, customers, vendors, or shareholders. one or more future events occur
or fail to occur
To account for a loss contingency, company management must determine the likelihood
that the future event will trigger a loss. FASB ASC Topic 450 classifies the likelihood of loss
contingencies into three categories:
1.  Probable. The future event is likely to occur.
2.  R
 easonably 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.
If management determines the loss contingency is probable and an amount can be reasonably
estimated, then the company must record a liability and a related expense or loss and disclose
the relevant details of the event in the notes to the financial statements. If the loss contingency
is reasonably possible or the amount cannot be reasonably estimated, then only a disclosure in
the notes is required. If the likelihood of a loss contingency is remote, then nothing needs to
be disclosed in the notes.
Since there is no crystal ball to see into the future, you can appreciate that determining
the likelihood of a loss contingency occurring and trying to estimate a reasonable amount for a
future loss involves significant judgment by management. Therefore, the role of auditors is to
14-4  C h a pte r 14  Completing the Audit
ILLUSTRATION 14.1  
Risk assessment and risk
response procedures that may
identify loss contingencies
legal letter  an audit inquiry
sent to a client’s external and
in-house legal counsel to obtain
information about litigation,
assessments, and claims
ILLUSTRATION 14.2  
Example of legal letter used
for Cloud 9 audit
determine if management’s assessment is reasonable, appropriate liabilities have been ­recorded,
and the disclosures are complete. Auditors should carefully consider the completeness assertion
for loss contingencies. Management may not be sufficiently objective and could fail to identify
loss contingencies or may classify identified contingencies as remote to avoid accruing or disclos-
ing them. Failing to identify one or more material loss contingencies is a material misstatement.
During the execution of all phases of the audit, the audit team should be watchful for
evidence of any potential loss contingencies. Many of the risk assessment procedures used to
gain an understanding of the entity, the industry, and its environment may identify the possi-
bility of loss contingencies. Substantive procedures used when testing account balances and
classes of transactions may also bring to light potential loss contingencies. Illustration 14.1
provides examples of audit procedures used during risk assessment and/or risk response that
can reveal the potential risk for loss contingencies.
Risk assessment and risk response procedures that can reveal the potential risk for loss
contingencies:
1.  Confirming with financial institutions, including guarantees of debt of others.
2.  Inspecting the minutes of board of directors’ meetings.
3.  Inspecting contracts, leases, and correspondence from governmental agencies.
4.  Inspecting tax returns and correspondence with the IRS.
5.  Inquiring of management regarding the completeness of recorded liabilities.
6.  Inquiring of client’s legal counsel.
Toward the end of the audit, auditors perform an inquiry procedure specifically designed to
gather information about loss contingencies arising from litigation, claims, and assessments. Audi-
tors will communicate directly with the client’s external legal counsel by sending a letter of inquiry,
often referred to as a legal letter. If the client has in-house legal counsel responsible for litigation,
claims, and assessments, a legal letter will also be sent to the in-house legal counsel. Attorneys and
their clients have a privileged relationship. That means attorneys cannot talk about their client’s
cases to anyone without permission from the client. Therefore, before auditors can communicate
with the client’s legal counsel, client management must give permission to the attorneys to discuss
their cases with the auditors. The client grants permission to the attorneys by signing the legal letter.
Legal letters are sent to all attorneys the client paid for legal services. AU-C 501 Audit
Evidence—Specific Considerations for Selected Items and AS 2505 Inquiry of a Client’s Lawyer
Concerning Litigation, Claims, and Assessments provide guidance for the content of the legal
letter. The objective of the legal letter is to gather audit evidence regarding the existence of
uncertainties arising from litigation, claims, and assessments; the time period in which the
cause for the legal action occurred; the probability of an unfavorable outcome for the client;
and an estimate of the potential loss. A legal letter used for the Cloud 9 audit is presented in
Illustration 14.2, followed by explanations of the bracketed numbers. The format and wording
of the letter is dictated by auditing standards, so all auditors will follow the same basic format.
[1] Cloud 9 Inc.
[2] March 1, 2023
[3] Smith, Day, & Jones
18696 11th Street, Suite 5000
Seattle, WA 95686
To Legal Counsel:
[4] In connection with an audit of our financial statements as of January 31, 2023, and for the year
then ended, please furnish our auditors, W&S Partners, P.O. Box 525, Seattle, WA 95688, with the
information requested below concerning contingencies involving matters with respect to which
you have devoted substantial attention on behalf of the company in the form of legal c­ onsultation
or representation.
  Audit Procedures for Loss Contingencies  14-5

[5] Regarding pending or threatened litigation, claims, and assessments, please include in your ILLUSTRATION 14.2  
response: (1) the nature of each matter, (2) the progress of each matter to date, (3) how the Com- (continued)
pany is responding or intends to respond (for example, to contest the case vigorously or seek an
out-of-court settlement), and (4) an evaluation of the likelihood of an unfavorable outcome and an
estimate, if one can be made, of the amount or range of potential loss. Accordingly, please furnish
to our auditors such explanation, if any, that you consider necessary to supplement the foregoing
information, including an explanation of those matters for which your views may differ from those
of management.

[6] We understand that whenever, in the course of performing legal services for us with respect
to a matter recognized to involve an unasserted possible claim or assessment that may call for
financial statement disclosure, you have formed a professional conclusion that we should disclose
or consider disclosure concerning such possible claim or assessment, as a matter of professional
responsibility to us, you will so advise us and will consult with us concerning the question of such
disclosure and the applicable requirements of FASB ASC 450. Please specifically confirm to our
auditors that our understanding is correct.

[7] Your response should include matters that existed as of January 31, 2023, and during the period
from that date to the effective date of your response. Please specifically identify the nature of and
reasons for any limitations on your response. Our auditors expect to have the audit completed
about March 15, 2023. They would appreciate receiving your reply by that date with a specified
effective date no earlier than March 7, 2023.

Sincerely,

[8]James W. Harley
Chief Executive Officer
Cloud 9 Inc.

Source: AU-C 501.A69 and AS 2505A.

Sections of the letter in Illustration 14.2 are numbered to correspond with the following
explanations:

1. Client letterhead—The legal letter is prepared on the client’s letterhead because the client
must grant permission for the attorneys to respond. Auditors oversee the preparation and
content of the letter and have control over the mailing and receipt of the letter.
2. Date of the letter—The letter is sent about mid-way through the completion of year-end
fieldwork.
3. Name and address of attorneys—A legal letter should be sent to all attorneys the client
hired during the year for legal services. Auditors can obtain a listing by inspecting the
transactions and invoices related to the client’s legal services expense account.
4. Request for information—This paragraph identifies the financial statements under audit
and states a request to supply information directly to the auditors.
5. Response regarding pending or threatened litigation—This paragraph requests that the
attorneys provide a list and description of pending or threatened litigation, claims, and
assessments. Notice auditors are seeking the attorney’s evaluation of the likelihood of an
unfavorable outcome and an estimate, if possible, of the potential loss.
6. Response regarding unasserted claims or assessments—This paragraph requests that the
attorneys confirm their responsibility to inform management of situations that may in-
volve possible unasserted claims or assessments that may require disclosure. Notice the
reference to the applicable financial reporting framework, which for Cloud 9 is GAAP.
7. Time frame for preparing the response—This paragraph specifies the time parameters for
the attorney’s response. The response should include matters that existed at January 31,
2023, and any matters after year-end up to the date of the attorney’s response letter. Ide-
ally, the date of the attorney’s response should coincide with the end of fieldwork, in this
case March 15, 2023, or very close to that date. Also, this paragraph requests the attorneys
state any reasons for limitations on their response.
8.  Signature—The letter is signed by the client’s chief executive officer.
14-6  C h a pte r 14  Completing the Audit

The nature of the legal environment in the United States is such that it could take years
for a lawsuit or other action to be settled and/or resolved. Therefore, it may not be possible for
the legal counsel to evaluate the time frame of an outcome or a reasonable amount for a loss.
In many cases, just disclosure of the pending litigation, rather than accrual in the financial
statements, is the appropriate way to account for the uncertainty. (See the following Profes-
sional Environment segment for a real-world example.) If the attorneys refuse to respond
appropriately to the legal letter, then it is considered a limitation on the scope of the audit,
which may impact the opinion in the auditor’s report. If auditors cannot gather sufficient
appropriate evidence regarding loss contingencies, then it may not be possible to issue an
unmodified opinion. Situations causing modifications to the audit report will be discussed
in Chapter 15.

Professional Environment  Litigation Contingencies

Large publicly traded companies are under great scrutiny, not only
by regulators such as the SEC but also by the public. Therefore,
it is no surprise that large companies typically have legal issues
in process all the time, such as contract negotiations or disputes
with suppliers or customers and hiring or firing issues with em-
ployees. A majority of these issues are immaterial to the financial
statements as a whole and do not garner public attention through
media outlets or disclosure in the financial statements. A common
practice by companies is to include a generic disclosure in the fi-
nancial statements to inform financial statement readers that var-
ious legal matters are ongoing. For example, the following state-
ment is from Note 15 in the fiscal year 2017 Starbucks annual
report that was filed with the SEC:
Starbucks is party to various other legal proceedings
arising in the ordinary course of business, including,
at times, certain employment litigation cases that
have been certified as class or collective actions, but
is not currently a party to any legal proceeding that
management believes could have a material adverse
effect on our consolidated financial position, results of
operations or cash flows.
A disclosure like this one alerts the public that legal matters are an
ordinary part of conducting business, but at the present time there
is no expectation that any of the legal matters could have a mate-
rial impact on the financial statements. Investors can access the
annual reports of public companies online and find disclosures
similar to this one in the notes of many companies.
Starbucks did have a material litigation contingency that
was first disclosed in the fiscal year 2011 financial statements.
Starbucks and Kraft had entered into a contract in 2004 for
Kraft to manage the distribution, marketing, advertising, and
promotion of Starbucks products. By the end of 2010, the two
parties were in dispute. Starbucks claimed that Kraft materially
breached their contract, and therefore Starbucks was discontin-
uing the distribution agreement. Here is an excerpt from Note 15
of the Starbucks fiscal year 2011 financial statements (emphasis
added):
While Starbucks believes we have valid claims of materi-
al breach by Kraft under the Agreement that allowed us
to terminate the Agreement and certain other relation-
ships with Kraft without compensation to Kraft, there
exists the possibility of material adverse outcomes
to Starbucks in the arbitration or to resolve the
matter. At this time, the Company is unable to esti-
mate the range of possible outcomes with respect to
the arbitration as we have not received any statement or
articulation of damages from Kraft nor have we estimat-
ed the damages to Starbucks caused by Kraft’s breaches.
Information in this regard will be provided during the
discovery process and is currently expected to be available
in late March or early April 2012.
In the Starbucks fiscal year 2012 financial statements, an update
of the dispute with Kraft was provided in Note 15. More infor-
mation was provided regarding the amount of damages Kraft was
seeking, but the dispute had not been resolved by the time the
financial statements were issued. Starbucks did not accrue any
loss contingencies because it determined the amount of the pos-
sible loss could not be reasonably estimated. An excerpt from the
note is provided below (emphasis added). Notice the use of the
terms from FASB ASC 450, such as “probable” and “reasonably
possible.”
On April 2, 2012, Starbucks and Kraft exchanged expert
reports regarding alleged damages on their affirmative
claims. Starbucks claimed damages of up to $62.9 mil-
lion from the loss of sales resulting from Kraft’s failure to
use commercially reasonable efforts to market Starbucks®
coffee, plus attorney fees. Kraft’s expert opined that the
fair market value of the Agreement was $1.9 billion. After
applying a 35% premium and 9% interest, Kraft claimed
damages of up to $2.9 billion, plus attorney fees. The
arbitration hearing commenced on July 11, 2012 and
was completed on August 3. Starbucks presented evidence
of material breaches on Kraft’s part and sought nominal
damages from Kraft for those breaches. Kraft presented
evidence denying it had breached the parties’ Agreement
and sought damages of $2.9 billion plus attorney fees. We
expect a decision from the Arbitrator in the first half of
fiscal 2013.
At this time, Starbucks believes an unfavorable
outcome with respect to the arbitration is not
probable, but as noted above is reasonably possible.
As also noted above, Starbucks believes we have valid
claims of material breach by Kraft under the Agreement
that allowed us to terminate the Agreement without
compensation to Kraft. In addition, Starbucks believes
Kraft’s damage estimates are highly inflated and based
upon faulty analysis. As a result, we cannot reasonably
estimate the possible loss. Accordingly, no loss
contingency has been recorded for this matter.
   Subsequent Events  14-7

In the Starbucks fiscal year 2013 financial statements, another
update of the dispute with Kraft was provided in Note 15. The re-
sults from the arbitration were released. When two parties agree
to let a dispute be settled with arbitration, the decision from the
arbitration is considered final. In other words, there is no appeal
process by either party. Here is an excerpt from Note 15, fiscal
year 2013:
On November 12, 2013, the arbitrator ordered Starbucks
to pay Kraft $2,227.5 million in damages plus prejudg-
ment interest and attorney’s fees. We have estimated pre-
judgement interest, which includes an accrual through
the estimated payment date, and attorneys’ fees to be
approximately $556.6 million. As a result, we recorded
a litigation charge (expense) of $2,784.1 million in our
fiscal year 2013 operating results.
The dispute was settled after being disclosed for two years. The
outcome was definitely unfavorable for Starbucks since it was
ordered to pay cash of $2.2 billion plus interest and attorney’s
fees to Kraft. This is a great example of the uncertainty involved
with litigation disputes and the subjectivity involved with deter-
mining if a potential loss contingency should be accrued or just
disclosed.

Cloud 9 - Continuing Case

Josh (senior) mailed out the legal letters two weeks prior to the responses have been received from the attorneys. Based on the
expected completion of fieldwork date. He sent letters to all at- responses, there do not seem to be any pending legal issues that
torneys that Cloud 9 paid for legal services during the year. All would have a material effect on Cloud 9’s financial statements.

Before You Go On
1.1  What is a loss contingency? Provide an example.
1.2  Explain the audit procedures used to identify loss contingencies.
1.3  List three items that are included in a legal letter and explain why each is important.

Subsequent Events

Lea rning Objective 2

Distinguish between the two types of material subsequent events and evaluate
what effect they have on the financial statements, if any.

The financial statements are prepared by client management on the basis of conditions
existing at year-end, which would be December 31 for a calendar-year entity. As you have
learned in previous chapters, many of the substantive audit procedures are performed af-
ter the year-end date and up through the date of the audit report. How long is this period
of time between year-end and the audit report? The answer depends on whether the au-
dit is for a public company or private company. For public companies, the SEC has strict
deadlines for the filing of Form 10-K, which is the document that contains the company’s
audited annual financial statements. Illustration 14.3 summarizes the SEC’s filing dead-
lines for Form 10-K. For private companies, the timeline for completion of an audit varies
widely, depending on the needs of the users of the financial statements. The most com-
mon user of a private company’s financial statements is a bank or other lender. Typically,
debt covenants require audited financial statements anywhere from 90–120 days after the
­company’s year-end.
14-8  C h a pte r 14  Completing the Audit
ILLUSTRATION 14.3   Category of Filer
Public company filing
deadlines for Form 10-K
subsequent events  events
occurring between the date of the
financial statements and the date
of the auditor’s report
Type I subsequent events 
conditions that existed at the
date of the financial statements
and require adjustment to the
financial statements
Type II subsequent events  cial statements.
conditions that arose after the
date of the financial statements
and may require disclosure in the
notes to the financial statements
ILLUSTRATION 14.4   Subsequent
Illustration of the subsequent
period for a calendar-year
client
Deadline to File
Large accelerated filer ($700 million* or more) 60 days from fiscal year-end
Accelerated filer ($75 million* or more but < $700 million*) 75 days from fiscal year-end
Non-accelerated filer (<$75 million*) 90 days from fiscal year-end
*Amounts refer to worldwide market value of outstanding voting and non-voting common equity held by
non-affiliates.
Source: https://www.sec.gov/answers/form10k.htm.
Since auditors usually conduct part of the audit during the 60–90 day period after year-
end, they should be alert to certain subsequent events that may occur between the date of
the financial statements and the date of the auditor’s report. Illustration 14.4 illustrates an
example of the subsequent period for a calendar-year client whose audit is completed no more
than 60 days after year-end. Some subsequent events may affect amounts that are included in
the year-end financial statements. AU-C 560 Subsequent Events and Subsequently Discovered
Facts and AS 2801 Subsequent Events address the auditor’s responsibilities related to subse-
quent events. The standards distinguish between two types of subsequent events as follows:
•  T
 ype I subsequent event—event that provides evidence of conditions that existed at
the date of the financial statements. A Type I event requires an adjustment to the finan-
•  T
 ype II subsequent event—event that provides evidence of conditions that arose after
the date of the financial statements. A Type II event does not require an adjustment to the
financial statements but may require disclosure in the notes to the financial statements.
period
1/1/2022 12/31/2022 2/15/2023
Period covered by the End of
2022 financial statements fieldwork/
date of auditor’s
report
An example of a Type I event would be the bankruptcy of a client’s customer after year-
end as a result of poor financial condition that existed as of the balance sheet date. If the
customer has a large accounts receivable balance on the client’s year-end balance sheet, then
management needs to reconsider the adequacy of the allowance for doubtful accounts. The al-
lowance balance and the related bad debt expense may need to be increased. Another example
would be the client receiving payment from an insurance company after year-end in resolu-
tion of a claim that was still in negotiations at year-end. Since the outcome of the negotiation
was in favor of the client, management should establish a receivable at year-end.
Type II subsequent events represent conditions and events that did not exist as of the
balance sheet date and do not require adjustment to the financial statements, but may be of
such significance as to require disclosure in the financial statements. For example, shortly
after year-end, management commits to purchasing another business. Purchasing another
business will probably add significant assets and debt to the balance sheet and may result in
changing the capital structure of the client. This commitment is significant and should be
mentioned in the notes. Another example would be the loss of a building or inventory as a
result of a fire or flood after year-end, and the client is underinsured. The situation, and an
estimate of the amount of loss not covered by insurance, should be disclosed in the notes.
   Subsequent Events  14-9

Audit Reasoning Example  Subsequent Event

Imperial Coffees, Inc. is a coffee roaster and direct sells its coffee through grocery stores, restau-
rants, and corporate-owned coffee cafes. For almost a decade, Imperial has experienced explosive
growth and has acquired smaller coffee roasters all over the United States and some international
locations. Imperial’s most recent fiscal year just ended, and its auditors are completing year-end
fieldwork. Jorge is an audit manager on the audit team and meets with Stephanie, Imperial’s
CFO, one month after year-end. Jorge says, “I know the board of directors just had its monthly
meeting. Are the minutes from the meeting available for me to review?” “Yes, I have them right
here,” says Stephanie. “I’ll go ahead and tell you the most important item that was discussed. The
board has decided to acquire the largest coffee roaster in Nicaragua, Central America. The acqui-
sition process will take several months, but should be completed this year. The board feels this is
an excellent strategic move because Nicaragua is the twelfth-largest coffee producer in the world.
Having operations in Nicaragua could help form strategic alliances with the coffee growers there,
which could lead to reduced costs for some of our coffee supply.”
Jorge relays this news to his audit team. Jorge asks Lincoln, a first-year audit associate, if
this event impacts the financial statements they are currently auditing. Lincoln says, “Well, it is
definitely important news that stakeholders should know about. But since the acquisition hasn’t
happened yet, I don’t think it should affect any accounts on the financial statements for the most
recent fiscal year. I do think it should be disclosed in the financial statements since the board has
made the decision and the financials have not yet been issued. Imperial management should draft
a disclosure to include in the notes to the financial statements.” “You are correct, Lincoln,” says
Jorge. “This is called a Type II subsequent event. Management will draft the disclosure and we
will review it.”

The objective of the auditors is to obtain sufficient appropriate audit evidence about
whether events occurring after the balance sheet date but before the auditor’s report date have
been identified and properly accounted for, if necessary. In the course of performing planned
substantive procedures after year-end, auditors may identify subsequent events. Auditing
standards require auditors to also conduct specific audit procedures to identify subsequent
events that may occur up through the date of the auditor’s report. Specific audit procedures to
identify subsequent events include:

•  Obtaining an understanding of how management identifies subsequent events.

•  Inquiring of management and, if necessary, those charged with governance about
whether subsequent events have occurred that may impact the financial statements.
•  Reading the minutes of manager meetings and/or board of directors’ meetings that have
been held after the date of the financial statements.
•  Reading the client’s subsequent interim financial statements, if available, and other data
such as budgets and cash flow forecasts.
•  Scanning manually, or through the use of generalized audit software, sales and receipts
journals or other accounting records relating to transactions that have occurred after the
date of the financial statements.
•  Inquiring of the client’s legal counsel regarding litigation, claims, and assessments (see
“Audit Procedures for Loss Contingencies” in this chapter).

When conducting inquiries of management and those charged with governance, auditors in-
quire about the current status of items that were accounted for on preliminary or estimated
data at the date of the financial statements. Circumstances or events may have occurred
after year-end that would affect estimates or assumptions used at the financial statement
date. Illustration 14.5 provides examples of inquiries of management on specific matters.
The nature of the specific procedures performed for the subsequent events review will
depend on the individual circumstances of each client. Auditors will also rely heavily on their
knowledge of the client’s business gained during the risk assessment phase of the audit. If audi-
tors identify subsequent events that require adjustment to, or disclosure in, the financial state-
ments, they must determine if each event has been properly reflected in the financial state-
ments as required by the appropriate financial reporting framework. If management ­refuses
14-10  C h a pte r 14   Completing the Audit

ILLUSTRATION 14.5  
Examples of inquiries of Inquiries of management regarding subsequent events:
management regarding •  Has the company entered into new commitments, borrowings, or guarantees?
subsequent events
•  Have sales occurred or are sales planned that may affect the carrying value or classification
of assets?
•  Are there any plans to issue new shares or debt instruments (debentures)?
•  Have any assets been seized (or appropriated) by the government or destroyed by natural
disaster?
•  Has any change in ownership occurred or is it contemplated?
•  Have any unusual accounting adjustments been made or are they contemplated?
•  Have any developments occurred regarding risk areas and contingencies?
•  Have there been any significant assessments by tax authorities regarding tax assessments,
fines, and penalties?
•  Have any events occurred that are relevant to the measurement of estimates or provisions
made in the financial statements?

Source: AU-C 560.A6

to make an adjustment or a disclosure that is required for the financial statements to be fairly
presented, auditors would not be able to issue an unmodified audit report. Situations that pre-
vent the issuance of an unmodified audit report will be covered in more depth in Chapter 15.

Cloud 9 - Continuing Case

Procedures to search for subsequent events at Cloud 9 are docu-
mented in the audit program. These include a review of minutes
of board meetings in January, February, and March, and analysis
of the interim results for these months (including analytical proce-
dures). The partner, Jo Wadley, will also formally ask management
about any subsequent events that have come to management’s
attention in the meetings held between year-end and the audit
report date. For example, does Cloud 9 have any plans to issue
additional stock? Have there been any significant tax assessments
or fines? Has Cloud 9 entered into any additional borrowings or
contracts? The CFO tells Jo that Cloud 9 is in the process of signing
a five-year purchase commitment with a new supplier located in
Colombia, South America. The paperwork should be complete by
the next day. The purchase commitment locks in a good price for
some of Cloud 9’s raw materials. Cloud 9 is predicting that prices
of some of its raw materials will be rising over the next few years,
so locking in a commitment now can help save costs in the fu-
ture. Jo relays information about this subsequent event back to the
team. They will need to confirm the details of the contract and
review Cloud 9’s disclosure of this Type II subsequent event.

Before You Go On
2.1 Describe the two types of subsequent events that must be considered as part of the audit of
the financial statements. Explain each type of subsequent event with an example.
2.2 Explain two types of subsequent events procedures an auditor may perform to identify a
subsequent event.

Engagement Wrap-Up

Lea rning O bjective 3

Describe engagement wrap-up procedures performed at the conclusion of the
audit.

After performing audit procedures related to loss contingencies and subsequent events, au-
ditors are in a position to start wrapping up the audit. This is the audit team’s last chance to
  Engagement Wrap-Up  14-11

evaluate audit evidence before forming an opinion on the financial statements and determin-
ing the appropriate independent auditor’s report to issue. This section will address conducting
final analytical procedures, final evaluation of audit findings, completion of working paper
reviews, engagement quality review, and completion of documentation.

Final Analytical Procedures

We have discussed the requirement of using analytical procedures during the risk assessment
phase to identify risk and help auditors to gain an understanding of the client (Chapter 4).
During the risk response phase, analytical procedures can be used, but are not required, as a
substantive test to gather audit evidence (Chapter 9). AU-C 520 Analytical Procedures and AS
2810 Evaluating Audit Results require that analytical procedures be used once again near the
end of the audit to assist the auditor in forming an overall conclusion about whether the finan-
cial statements are consistent with the auditor’s understanding of the entity. At the end of the
audit, this is the auditor’s last opportunity to evaluate the reasonableness of the final financial
statements that reflect any audit adjustments recommended by the auditor and accepted by
the client. The actual analytical procedures performed will depend on auditor judgment
and may vary by client. The procedures may include ratio analysis, trend analysis, and other
analytical procedures as discussed in Chapter 4.
The final analytical procedures are intended to corroborate audit evidence obtained
during the audit and to confirm the financial statements are consistent with the auditor’s
revised expectations based on evidence evaluated during the audit. For example, based on
evidence gathered regarding the valuation of inventory for a computer manufacturing client,
auditors would recommend a significant adjustment to mark down obsolete inventory. Once
the client makes the adjustment, auditors would expect to see a lower value for inventory
due to the markdown adjustment and a loss on the income statement. Auditors also consider
industry factors when performing final analytical procedures. For example, if the computer
manufacturing industry as a whole is experiencing a decline in revenue, auditors would ex-
pect the client would also reflect a similar trend. If the financial statements are not consistent
with the auditor’s expectations, auditors may need to perform additional audit procedures to
gather more audit evidence to reduce the risk of material misstatement to an acceptable level.

Final Evaluation of Audit Findings

At the conclusion of the audit, auditors (1) revaluate materiality decisions made during the
audit; (2) revaluate audit risks based on audit findings, including inherent risk, control risk,
and fraud risk; and (3) evaluate misstatements found during the audit.

Final Evaluation of Materiality

At the conclusion of the audit, auditors revisit the materiality level determined at the be-
ginning of the audit to ensure it is still appropriate based on the results of audit procedures.
Recall from Chapter 3 that materiality is first considered in the planning phase of the audit.
During the execution of the audit, materiality, as a whole or for a specific account or class of
transactions, may be revised if auditors become aware of new information that would have
caused them to determine a different level of materiality. For example, during the audit of
sales transactions, the client informs the auditors that sales returns for the fourth quarter are
higher than normal due to a manufacturing error in some batches of the product. Customers
are returning the defective product and the client is giving them a new product at no charge.
Because of this situation, auditors may decide to lower the performance materiality level for
the occurrence and accuracy assertions for sales transactions and adjust the nature or extent
of their audit procedures. As this example illustrates, any significant revisions to materiality
are likely to be made prior to the final evaluation of audit findings. However, if near the end
of the audit it is determined that a lower level of overall materiality is appropriate, auditors
would consider if sufficient appropriate evidence has been obtained. If the answer is no, they
would determine the nature and extent of further audit procedures to perform to obtain more
audit evidence.
14-12  C h a pte r 14   Completing the Audit

Final Evaluation of Inherent Risk, Control Risk, and Fraud Risk

When planning an audit, auditors identify the presence or absence of factors related to in-
herent risk, the five components of internal control (discussed in Chapter 6), and risk of
fraud (discussed in Chapter 3), and then make their initial assessment of control and fraud
risks. Throughout the audit, they consider whether additional factors or risks are present and
whether they need to revise their assessments of inherent risk, control risk, and fraud risk
at the entity and transaction levels (discussed in Chapter 6). Auditors specifically reconsider
their assessment of control risk at the entity level when they become aware of significant
changes in the client’s system of internal control and after they perform tests of controls.
When the results of substantive procedures identify misstatements, auditors consider
whether the misstatements may indicate the need to reevaluate inherent risk, control risk, or
fraud risk. For example, suppose auditors send accounts receivable confirmations to 100 cus-
tomers to test the existence assertion. All 100 confirmations are returned, but 75 of the cus-
tomers report overstatement errors. This is a surprising result for the auditors. They had tested
internal controls over the sales and accounts receivable processes and concluded that controls
were effective. How could there be so many overstatement errors if controls are effective? Per-
haps they overlooked something during tests of controls. What if the sample used for a test of
controls was not representative of the population? The next course of action would be to re-
evaluate relevant internal controls by gathering additional evidence. Additional evidence may
support the conclusion that a significant deficiency or material weakness exists in controls over
the sales and accounts receivable process. If controls are weak, auditors will increase the con-
trol risk assessment and perform additional substantive tests to detect material misstatements.
If it is determined that fraud is the cause of misstatements in an account or class of
transactions, it does not matter if the misstatements are material or immaterial because fraud
typically does not occur as an isolated incidence. The discovery of fraud causes auditors to
reevaluate their assessment of risk, materiality level, and the nature and extent of audit pro-
cedures that have been performed. They also question their previous assessment of manage-
ment and employee integrity, especially if the fraud involves senior management.
When fraud is discovered, auditors gather sufficient appropriate evidence to support their
conclusion. When auditors determine that an employee has committed fraud (either misap-
propriation of assets or fraudulent financial reporting), they evaluate the scope of the employ-
ee’s responsibilities and whether fraud may also have occurred in other audit areas subject to
the employee’s control. For example, if a divisional controller were responsible for premature
revenue recognition, he or she might be in a position to engage in other inappropriate earn-
ings management activities (such as capitalizing items that should be expensed) that could
result in material misstatements of the financial statements.

Audit Reasoning Example  Discovery of Fraud

Tiny Tots, Inc. (TT) designs and manufactures infant and toddler clothing and is headquartered
in suburban Chicago, Illinois. TT has approximately 300 suppliers of its raw materials. During
interim, the audit team tested internal controls over purchasing and concluded that controls were
strong. Substantive tests for the purchasing process were also performed at interim and included
tests of details of transactions for the first three quarters. No material misstatements were de-
tected during the interim procedures.
It is now year-end, and Lorene, an audit associate, is performing substantive procedures on
the purchases and accounts payable function for fourth-quarter transactions. She has selected a
sample of 50 recorded purchase transactions from the fourth quarter and vouched them to sup-
porting documentation (purchase order, receiving report, and vendor invoice). Five of the transac-
tions are with a new vendor who was added to the approved vendor list during the fourth quarter.
Lorene notices that the new vendor supplies thread to TT and is located in Chicago, which
she finds a bit unusual. Most of TT’s suppliers are located in foreign countries or other parts
of the United States. Lorene decides to Google the vendor to find out more about it; however,
the Google search shows no results for a company of that name in Chicago. She then opens her
Google maps app and enters the address shown on the vendor invoice. To Lorene’s surprise,
the address is a residential address in a Chicago suburb. Lorene tells the senior associate, Jack,
about what she has discovered.
  Engagement Wrap-Up  14-13

Upon further examination, the audit team discovers that a purchasing clerk and accounts pay-
able clerk colluded to create a fictitious vendor for the purpose of misappropriating assets. The ad-
dress for the fictitious vendor belonged to the brother of the accounts payable clerk. Although the
checks that were written to the fictitious vendor were not material, the audit team reconsiders the
assessment of control risk. If controls were assessed as strong during interim testing, then how were
employees able to override the controls and create a fictitious vendor? Could there be a significant
deficiency or material weakness in internal control? Could other transactions be fraudulent? The au-
dit team will perform additional work regarding the controls over purchasing and accounts payable.

AS 2401 Consideration of Fraud in a Financial Statement Audit and AU-C 240 Consid-
eration of Fraud in a Financial Statement Audit require auditors to report fraud to a level of
management at least one level above the level where the fraud occurred. If the fraud involves
senior management, auditors report it to those charged with governance, such as the audit
committee of the board of directors. From there, the responsibility falls on management or
those charged with governance to take action to address the fraud. Action may include calling
the proper law enforcement agency and/or firing the employee(s) involved in the fraud. If
management or those charged with governance fail to take action in a timely manner, auditors
should consider withdrawing from the engagement.
In some cases, auditors may determine that fraud is so pervasive in the business they
are unable to complete their audit procedures, or the fraud will have such an impact on the
client’s reputation they no longer wish to have the company as a client. In these rare cases,
any decision to withdraw from the engagement is not taken lightly, and extensive consultation
both internally within the audit firm and externally with the audit firm’s legal counsel will
occur before any action is taken. If the auditors withdraw, they will inform the appropriate lev-
el of management or those charged with governance and provide reasons for the withdrawal.
If the client is a public company, management must report a change of auditors, and the rea-
son for the change, to the SEC using Form 8-K.

Professional Environment  Forensic Accounting

One of the more popular television genres in recent years has been
crime with a heavy reliance on forensic science to solve cases (for
example, the CSI franchise). The programs are so popular there are
claims that they have led to a jump in enrollments in forensic sci-
ence courses. According to an analysis of the demand for forensic
accounting courses, interest in forensic accounting has also never
been higher, although this is more likely due to the fall-out from
high-profile corporate collapses such as Enron and WorldCom
than from any television program.1 Some auditors claim that these
cases have made boards of directors more aware of their liability
for fraud.2 If a problem is brought to their attention, they appear to
be more willing to order an investigation, and forensic accountants
are called in to do the work.
Another potential cause of the increased interest in foren-
sic accounting is terrorism. Since the tragedy of 9/11, tracing the
money trail behind terrorism has been a high priority for securi-
ty agencies.3 Forensic accounting expertise is similar to auditing
in the sense that both rely on a deep understanding of double-
entry accounting plus a large dose of other skills and attributes. In
the case of forensic accounting, these include expert knowledge
of legal systems and interview techniques. However, at its heart,
forensic accounting relies on accounting knowledge because some
fraudsters go to great lengths to hide their trail and a knowledge of
double-entry bookkeeping is necessary to keep up.4
Forensic accountants need to have an eye on how their find-
ings will be used in court. In fact, “forensic” means something that
will be used, or is suitable to be used, in courts of law. In the past,
most forensic accounting work related to appearances in court as
expert witnesses for personal injury or divorce cases.5 Now, foren-
sic accounting practices focus more on investigation, fraud risk
management, anti-money laundering, and computer forensics.6
The Association of Certified Fraud Examiners (ACFE), an
association for accountants specializing in detecting fraud, has
experienced a sharp rise in membership over the last few years.7
The fraud investigators say they have been trying for years to get
regulators interested in investigating potential fraud cases, such as
the Madoff Ponzi scheme. Now, they say they have noticed a recent
increase in community appreciation of their work.8

1
C. Long, “Forensic Frenzy,” Charter, 78, no. 5 (June, 2007), pp. 20–22.
2
Long, 2007.
3
See for example, information about forensic accounting at www.forensic-accounting-information.com.
4
Long, 2007.
5
Long, 2007.
6
Long, 2007.
7
Association of Certified Fraud Examiners 2010, www.acfe.com.
8
G. Zuckerman, “For Group of Skeptics, the truth is Out There,” The Wall Street Journal (August 8, 2009).
http://webreprints.djreprints.com/2246630965260.html.
14-14  C h a pte r 14   Completing the Audit

Evaluation of Misstatements Identified During the Audit

AU-C 450 Evaluation of Misstatements Identified During the Audit classifies misstatements into
three categories: factual, judgmental, and projected misstatements (see Chapters 9 and 10).
As misstatements are identified and accumulated during the audit, it is important for auditors
to communicate misstatements to management in a timely manner so action can be taken to
correct the misstatements. Auditors typically request that management make adjusting en-
tries to correct all factual misstatements since there should not be any disagreements with
management regarding factual misstatements.
Factual misstatements are misstatements that are known with certainty. This may include
misstatements found with the application of audit data analytics in which auditors use software
to screen the entire population. It may also include the audit of 100% of a population that has
relatively few sampling units, such as notes payable. When auditors audit the entire population,
they can draw a conclusion with certainty about the misstatements found in the population.
Judgmental misstatements typically involve accounting estimates in which uncertainty
is a factor. After performing audit procedures, auditors may determine a different amount for
an accounting estimate than management. For example, suppose auditors estimate a different
amount for a fair value estimate of goodwill than management. They will request that manage-
ment review the assumptions and methods that were used in determining its estimate. After re-
viewing the estimate, management may decide to adjust its estimate or not adjust. Any difference
between what management decides to record and what the auditor recommends should be re-
corded would be considered a misstatement. Auditors document discussions with management
about the issue, including management’s reasons for not making recommended adjustments.
Projected misstatements are the result of audit sampling, which was discussed in Chapter
10. If misstatements are found in an audit sample, auditors use appropriate statistical or nonsta-
tistical methods to project the sample misstatement to the entire population. If the projected mis-
statement is material, they request that management examines the population of transactions to
understand the cause of the misstatement and make appropriate adjustments to the affected ac-
counts. After management makes adjusting entries to correct the misstatements, auditors should
perform additional audit procedures to determine if any misstatements still remain.

Evaluation of Uncorrected Misstatements

During the final evaluation, auditors evaluate the effect of uncorrected misstatements on the
financial statements. Typically, management makes adjustments for material misstatements
but may decide not to correct some immaterial misstatements. For uncorrected misstatements,
auditors obtain an understanding of management’s reasons for not making the corrections.
They take management’s reasoning into consideration when evaluating the overall effect of
uncorrected misstatements on the financial statements as a whole.
When evaluating the effect of uncorrected misstatements, both quantitative and qualitative
factors are considered. Uncorrected, immaterial misstatements should be aggregated to determine
if, in total, they exceed the materiality level for the financial statements as a whole or the materi-
ality level for a class of transactions, account balance, or disclosure. Also, the cumulative effect of
uncorrected, immaterial misstatements from prior periods, if any, should be considered for their
effect on the current year financial statements. Typically, uncorrected, immaterial misstatements
from a prior period are expected to “reverse” in the next period. For example, if purchases are un-
derstated due to a cutoff error in the prior period, the misstatement is considered to reverse in the
following period in which purchases would be overstated. The two immaterial errors would offset
each other over the two-year period. Prior period immaterial, uncorrected misstatements that do
not reverse should be accumulated with current period uncorrected immaterial misstatements to
determine if the combined total is material to the current year financial statements.
Illustration 14.6 provides an example of a working paper analysis of likely misstatements
for the New Millennium Ecoproducts audit. The first section of the working paper shows the
uncorrected overstatement of depreciation expense and the different accounts affected by
the overstatement. The second section shows projected uncorrected misstatements that are
the result of an overstatement of ending inventory discovered from statistical sampling. The
bottom section totals the aggregate likely misstatements by financial statement category.
The aggregate likely misstatement is divided by the related total from the final trial balance
to arrive at the ­aggregate likely misstatement percentage. For example, the aggregate likely
misstatement for current assets of $8,000 is divided by the final trial balance total current
  Engagement Wrap-Up  14-15

ILLUSTRATION 14.6   Analysis of aggregate likely misstatement working paper

Client: New Millennium Ecoproducts  W/P Ref. A-5

Analysis of Aggregate Likely MisstatementsPrepared By: A.E.R. Date 2/25/23
Period-end: December 31, 2022Reviewed by R.E.G. Date: 2/26/23
Debit (Credit)

Description Assets Liabilities Stockholders’ Pretax Income Tax

W/P Ref Acct. No Acquired Current Noncurrent Current Noncurrent Equity Earnings Expense
Uncorrected Known Misstatements:
Overstatement of Depreciation Expense
D-1 1590 Accumulated $   3500
Depreciation
4590 Depreciation $ (3,500) $  (3,500)
Expense
2295 Income Tax $  (1,225) $  1,225 $ 1,225
Payable
Uncorrected Projected Misstatement:
Overstatement of Ending Inventory Projected from Statistical Sample
C-1 4200 Cost of
Goods Sold
1200 Inventory $  (8,000) $  8,000 $  8,000
2295 Income Tax $  2,800 $  (2,800) $ (2,800)
Payable
Aggregate Likely Misstatement $  (8,000) $  3,500 $  1,575 $   0 $  2,925 $  4,500 $ (1,575)
Final Balance from Trial Balance $400,000 $735,000 $225,000 $375,000 $535,000 $ 150,000 $75,000
Aggregate Likely Misstatement % 2.0% 0.5% 0.7% 0.0% 0.5% 3.0% 2.1%

Conclusion: The likely misstatements listed above are deemed to be immaterial, either individually or in their aggregate effects on the
individual accounts, the financial statements categories, or the financial statement totals to which they relate.

assets of $400,000. The result is 2.0%, which means the aggregate likely misstatement for cur-
rent assets is 2.0% of the total current assets. The conclusion of the auditors is at the bottom of
the working paper and states that all of the likely misstatements are deemed to be immaterial.
If uncorrected, immaterial misstatements do not exceed materiality for the financial
statements as a whole or at the class of transactions, account balance, or disclosure level,
there may be qualitative characteristics that cause auditors to evaluate them as material. For
example, if an immaterial misstatement is the result of fraud, auditors consider the impact on
other areas of the audit, as discussed in the above section “Reconsider Assessment of Control
Risk and Risk of Fraud.” Qualitative characteristics will vary by client and by circumstance.
Illustration 14.7 lists examples of situations that cause auditors to consider an uncorrected
misstatement material based on a qualitative characteristic.

ILLUSTRATION 14.7  
Qualitative characteristics of immaterial misstatements:
Examples of qualitative
•  Affects compliance with regulatory requirements. characteristics of immaterial
•  Has the effect of increasing management compensation. misstatements
•  Relates to items involving particular parties, such as individuals related to management.
•  Changes a loss to income or income to loss.
•  Affects compliance with debt covenants or other contracts.
•  Results from the occurrence of fraud.
•  Relates to the incorrect application of an accounting policy that is likely to have a material
effect on future periods.
•  Affects whether the company meets a financial benchmark, such as analyst forecasts of earnings
per share.

Source: AU-C 450.A23.

14-16  C h a pte r 14   Completing the Audit

The working papers include documentation of all misstatements accumulated during the
audit and whether they have been corrected. For the uncorrected misstatements, auditors
should thoroughly document the basis for their conclusions about whether the uncorrected
misstatements are material individually or in the aggregate. In Chapter 15, we discuss the
effect on the auditor’s report of uncorrected misstatements that are material to the financial
statements as a whole.

Completion of Working Paper Review

An audit is an ongoing, cumulative, and iterative process of gathering and evaluating evidence
in support of relevant assertions. All audit documentation will have a preparer and reviewer, or
multiple reviewers. As audit procedures are completed and documented in the working papers,
the preparer will “sign off” with his or her initials when he or she feels the work is ready for
review. The work is reviewed by an audit team member with seniority over the team member
who did the work. (Refer to Illustration 5.6 for the structure of an audit team.) For example, when
an associate signs off on audit procedures related to the audit of accounts payable, the senior
associate reviews the work. Often, the senior has review notes, or “to-do” items, for the associate
to complete. For example, the associate may need to add more explanation to the working papers
of how a procedure was performed, or another sample of invoices may need to be inspected to
gather more evidence in support of a relevant assertion.
The senior associate performs audit procedures related to more complex areas of the
audit, such as intangible assets or investments. As the senior completes his or her proce-
dures, they are reviewed by the manager, and the manager will have review notes for the
senior to address. AU-C 220 Quality Control for an Engagement Conducted in Accordance with
Generally Accepted Audit Standards and AS 1201 Supervision of the Audit Engagement pro-
vide guidance regarding review of the working papers. Illustration 14.8 provides a list of
items an audit team member considers when reviewing the work of another team member.

ILLUSTRATION 14.8  
Items to consider when
reviewing working papers
Working paper reviewer should consider whether:
•  Work has been performed in accordance with appropriate auditing standards.
•  Significant findings or issues have been raised for further consideration or audit testing.
•  Consultations among team members and others within or outside of the audit firm have taken
place, as needed, and the resulting conclusions have been documented.
•  The nature, timing, and extent of the work performed are appropriate and do not need
revision.
•  Work performed supports the conclusions reached and is appropriately documented.
•  Evidence obtained is sufficient and appropriate to support the auditor’s report.
•  Objectives of the engagement procedures have been achieved.

Source: AU-C 220.A16 and AS1201.05(c).

Once an audit team member has responded to the review notes, the appropriate supervisor
reviews the work to ensure the review item was satisfactorily addressed. If satisfied the reviewer
signs off on the working paper. Once completed, the review notes are removed from the audit file
because the working papers are required to stand on their own in terms of the conclusions reached
and the underlying evidence supporting those conclusions. Ultimately, auditors rely on their pro-
fessional judgment to determine if sufficient appropriate audit evidence has been obtained.

Audit Reasoning Example  Working Paper Review

Jacob Bourgeois is a first-year audit associate at TB&I accounting firm. It is his first busy season,
and he is assigned to a manufacturing client in Detroit, Michigan. Jacob has completed the audit
procedures for tests of details of balances for accounts receivable. He feels very confident about
his work and doesn’t think he will have any review comments to address. Jacob tells the audit
senior, Maggie, that his work is ready to be reviewed. The next day, Maggie says to Jacob, “Overall,
you have done a good job and I can tell that you understand the purpose of the audit procedures
  Engagement Wrap-Up  14-17

you have completed. However, there are a few instances in which you have not sufficiently doc-
umented your follow-up procedures. For example, to gather evidence about the client’s past due
accounts, the audit procedures from the audit program are:

1. Examine evidence of collectibility such as correspondence with customers and outside

­collection agencies, credit reports, and customers’ financial statements.
2.  Inquire about collectibility of accounts with appropriate management personnel.

You notated in the working papers that you examined the client’s correspondence with customers
who had large overdue balances. However, you did not put a copy of the correspondence in the
working papers to substantiate that your examination procedure was completed. You also docu-
mented that you spoke with an accounts receivable clerk about the status of overdue accounts. It
is more appropriate to inquire of the accounts receivable manager, someone with more authority,
regarding the status of the overdue accounts. You need to schedule a meeting with the accounts
receivable manager today, and be sure you take good notes so you can thoroughly document your
discussion in the working papers. Also, remember that inquiry alone is not sufficient. You will
need to corroborate any discussions with additional evidence.”

The engagement partner is responsible for the audit engagement and its performance and engagement partner  partner
for the auditor’s report that is issued on behalf of the firm. As the audit is being performed, the or other person in the firm
engagement partner should conduct timely reviews of work completed on accounts, transactions, who is responsible for the audit
or disclosures that require extensive judgment or involve significant risks. If an item is considered engagement and its performance
a critical audit matter or is perhaps a contentious matter with management, it should be reviewed and for the auditor’s report that is
issued on behalf of the firm
as soon as possible so it is resolved on a timely basis. The engagement partner is not required to
review all audit documentation, but may choose to do so. The working papers should adequately
document that all reviews, including those performed by the partner, were completed.

Engagement Quality Review

To ensure the audit team has conducted the audit in accordance with standards and gath-
ered sufficient appropriate audit evidence to support the audit conclusions, an engagement engagement quality control
­quality control reviewer will review selected areas of working papers prior to the issuance reviewer  a partner or other
of the audit report. An engagement quality control reviewer is typically a partner of the ac- person in the firm, who is not
counting firm who is not part of the audit team that completed the audit. The reviewer must part of the engagement team, who
be independent of the client and have sufficient and appropriate experience to objectively has sufficient and appropriate
experience and authority to
evaluate the work completed on the audit. AU-C 220 Quality Control for an Engagement Con-
objectively evaluate the
ducted in Accordance with Generally Accepted Auditing Standards and AS 1220 Engagement
significant judgments that the
Quality Review provide guidance regarding what is involved in a quality review. engagement team made and the
The engagement partner discusses with the engagement quality control reviewer the conclusions it reached in
significant findings and other issues encountered during the audit. The reviewer reads the formulating the auditor’s report
financial statements and the proposed audit report, and reviews working papers related to
significant findings and conclusions reached in the audit. Ultimately, the reviewer evaluates
the conclusions reached in determining if the financial statements are fairly presented and
ensures the proposed auditor’s report is appropriate based on the audit team’s work.

Completion of Documentation
As we have discussed throughout the text, the working papers serve as documentation that the
audit work was completed. The working papers are the property of the audit firm and act as sup-
port for the auditor’s opinion. AU-C 230 Audit Documentation and AS 1215 Audit Documentation
provide guidance for the assembly and retention of the documentation. The working papers do
not have to be completely assembled and archived before the audit report release date. However,
the standards do provide a deadline for the complete assembly of the audit file and a time frame
for how long the audit file should be retained by the firm. Illustration 14.9 summarizes the time
frames for assembly and retention of the audit file for both public and private company audits.
After the audit report release date, no more audit procedures are performed. Assem-
bling the completed file includes administrative tasks such as sorting and organizing working
14-18  C h a pte r 14   Completing the Audit

ILLUSTRATION 14.9   Public Company Private Company

Assembly and retention of
audit documentation
Activity Audit (AS 1215)
Audit file assembly completion 45 days after audit report
deadline release date
Audit file retention 7 years from the audit
report release date
Audit (AU-C 230)
60 days after audit report
release date
5 years from the audit report
release date or as specified by
a state board of accountancy

papers, discarding old documentation that was replaced with updated documentation, and
signing off on completion of checklists related to assembling the file. After the audit file
assembly completion deadline, nothing should be deleted or removed from the audit file.
However, documentation can be added to the file after the assembly completion deadline. If
documentation is added, auditors must indicate who prepared the documentation, the date of
the addition, and the reason for adding it. For example, a firm’s documentation of the audit of
a public company client may be inspected by the PCAOB. If results from the inspection reveal
the need to add further explanation to an audit procedure that was performed, auditors could
add the documentation, noting who prepared it and the reason for adding it (AS 1215.16).
For firms that have multiple office locations, the office that issued the audit report is
responsible for retaining the audit file. Reasonable measures should be taken to ensure the
security of the data, both electronic data and any hard copies retained by the firm, especially
since it contains confidential client information.

Cloud 9 - Continuing Case

Sharon suggests that each member of the team ask themselves
whether they believe that sufficient appropriate evidence has
been gathered on which to base an audit opinion, given their
knowledge and involvement in the audit. Are assessments of con-
trol risk and materiality still valid given evidence obtained from
substantive procedures? No material misstatements were found
during substantive testing, and there is no evidence to suggest
that materiality should be adjusted. All confirmations sent to cus-
tomers, financial institutions, and the stock registrar and transfer
agent have been returned and any differences ­resolved. It appears
that the only other major outstanding items are the engagement
quality control review and the going concern assessment.

Before You Go On
3.1  Explain why it is important to reassess materiality at the end of the audit.
3.2 What are some qualitative characteristics of misstatements that would cause auditors to
classify them as material?
3.3 What is an engagement quality control review? Why is this review important to the public
interest?
3.4  What is meant by “assembly and retention” of the audit files?

Going Concern

Lea rning O bjective 4

Evaluate the going concern assumption for a client.

going concern assumption 

the viability of an entity to remain You may remember the going concern assumption from your financial accounting courses.
in business for the foreseeable The going concern assumption is a fundamental principle in the preparation of the finan-
future cial statements. Under the going concern assumption, an entity is viewed as continuing in
   Going Concern  14-19

business for the foreseeable future with neither the intention nor the need for liquidation. As
a result, assets and liabilities are recorded on the basis that the entity will realize its assets and
discharge its liabilities in the normal course of business.
Management is responsible for evaluating going concern in accordance with the applica­
ble financial reporting framework. Under GAAP, FASB ASC 205-40 Presentation of Financial
Statements—Going Concern requires management to make an assessment of the entity’s abil-
ity to continue as a going concern for the future period of one year beyond the issuance date
of the financial statements. Illustration 14.10 provides a timeline example to illustrate man-
agement’s responsibility. If the financial statements are dated December 31, 2022, the issuance
date will be 45 days or more after December 31, depending on when the audit is completed.
Supposing the financial statements are issued on March 1, 2023, the future period for man-
agement’s assessment of the risk of not being a going concern would be from March 1, 2023,
to March 1, 2024. If management determines there is substantial doubt about continuing as
a going concern, then management must make a note disclosure about the circumstances,
including any plans management may have to mitigate the situation.

ILLUSTRATION 14.10  
Management’s evaluation period Management’s going concern
evaluation period

3/1/2023 3/1/2024
12/31/2022 Date the 12/31/2023
Financial financial
statement statements
date/fiscal are issued
year-end
date

Auditors have a responsibility to gather evidence regarding management’s process for eval-
uating going concern status and the appropriateness of management’s conclusions regarding it.
If management does not have a formal process in place, it could be considered a weakness in
internal control. Auditors also draw their own conclusions about whether there is substantial
doubt about the entity’s ability to continue as a going concern for a reasonable period of time reasonable period of time 
and, if applicable, evaluate the adequacy of any disclosure related to the entity’s circumstances. the period of time required by
What would be a reasonable period of time for the auditor’s evaluation? AU-C 570 The Auditor’s the applicable financial reporting
Consideration of an Entity’s Ability to Continue as a Going Concern defines a reasonable period of framework, or if no such
time as the same period required by the client’s financial reporting framework. Therefore, under framework exists, for one year
after the date that the financial
GAAP, a reasonable period of time is one year from the date the client issues financial statements,
statements are issued
as shown in Illustration 14.10. (Current PCAOB AS 2415 defines a reasonable period of time as
one year from the date of the financial statements. Therefore, for public company audits, the time
frame for the auditor’s evaluation is shorter than for a private company client.)
According to AU-C 570, auditors do not have a responsibility to perform any audit pro-
cedures to identify going concern issues beyond the time period evaluated by management.
However, AU-C 570 does require that auditors inquire of management about any conditions
or events beyond the period of management’s evaluation that may have an effect on the
entity’s ability to continue as a going concern. For example, using Illustration 14.10, auditors
must inquire of management if there are any known conditions or events after March 1, 2024,
that could have an impact on going concern.
AU-C 570 and AS 2415 provide guidance for the auditor’s evaluation of the entity’s ability
to continue as a going concern. Audit procedures that are performed throughout the audit as
part of risk assessment and risk response should identify events or conditions that could sig-
nify going concern issues. Illustration 14.11 provides a list of audit procedures and examples
of the types of going concern issues that may be identified through the performance of routine
audit procedures. If one or more going concern issues are identified at any point during the
audit, auditors will use their professional judgment and consider the need to revise their risk
assessments and alter the nature, timing, or extent of audit procedures.
14-20  C h a pte r 14   Completing the Audit

ILLUSTRATION 14.11   Audit Procedure Identification of Possible Going Concern Issue

Audit procedures that may
identify going concern issues
Analytical procedures during risk
assessment
Review of subsequent events
Review of compliance with terms of
debt and loan agreements
Reading of minutes of meetings with
stockholders, board of directors, and
other important committees of the
board
Inquiry of client’s legal counsel
Confirmation with related parties
and third parties of the details of
arrangements to provide or maintain
financial support
May identify negative trends such as working capital
deficiencies, adverse key financial ratios, and decreasing
cash flow from operations
May identify internal or external matters that have
occurred such as loss of a key franchise, loss of a principal
customer, or work stoppages due to natural disaster
May identify possible financial difficulties such as re-
structuring of debt, default on loan or similar
agreements, or need to dispose of substantial assets
May identify internal or external matters that have
occurred such as labor difficulties, arrearages in
dividends, or substantial dependence on the success
of a particular project
May identify external matters that have occurred such as
legal proceedings that might jeopardize the client’s ability
to operate
May identify possible financial difficulties such as default
on financing arrangements, restructuring of financing
agreements, or need to seek new sources or methods of
financing

Source: AU-C 570.A7 and .A28.

If auditors determine there is substantial doubt about the entity continuing as a going
concern, the next step is obtaining information about management’s plans to mitigate or min-
imize the adverse effects of the situation. For example, if a client is experiencing a severe cash
shortage but has a letter from its bank agreeing to provide additional financing, the letter
reduces, but does not remove, the risk that the going concern assumption may be in doubt.
Other examples of mitigating factors include:

•  A letter of guarantee from a parent company.

•  The ability to raise additional funds by issuing more stock.
•  The ability to sell an unprofitable segment of the business.
•  A reduction of expenditures.
•  The ability to sell assets without interrupting the entity’s operating capacity.

Auditors perform audit procedures to gather evidence about the mitigating factors and con-
sider whether the plans can be effectively implemented. For example, if management plans
to sell assets that have been used in operations, is there a market for the assets? How quickly
could they be sold and for how much? Would the sale of the assets be sufficient to enable the
entity to continue as a going concern for a reasonable period of time? Auditors draw upon
their knowledge of the entity, the industry, and their professional judgment when evaluating
the information to arrive at a conclusion.
After considering management’s plans, if auditors determine there is substantial doubt
about the entity’s ability to continue as a going concern, the next steps are to consider the
possible effects on the financial statements and on the auditor’s report. Regarding the finan-
cial statements, auditors evaluate the adequacy of management’s note disclosure about the
going concern issue. The disclosure should include a description of the conditions or events
causing the substantial doubt, management’s evaluation of the significance of those condi-
tions or events, and management’s plans to minimize the effects of the situation. Auditors
consider modifying the auditor’s report to further emphasize the substantial doubt about the
entity’s ability to continue as a going concern. This is something that investors or other key
stakeholders should know. You can understand that the client might not want any more atten-
tion brought to the situation because, in fact, it could make it more difficult for the client to
implement its plans for mitigating the situation. For example, obtaining alternative financing
may be more difficult if the auditor’s report is modified for a going concern issue. Noting these
conditions could also negatively impact the stock price for a public company. Given these
   Management Representation and Communication with Those Charged with Governance   14-21

serious implications, auditors consider this decision very carefully. The specific modifications
that would be made to the auditor’s report are discussed in Chapter 15.
The final step is to communicate with those charged with governance. Those charged
with governance, such as a board of directors, probably already know about the situation, but
auditors still communicate the nature of the events that are causing doubt about the entity’s
ability to continue as a going concern. Auditors also discuss the note disclosure and other ef-
fects on the financial statements. If the auditors decide to issue a modified auditor’s report, it
should be communicated to those charged with governance.

Cloud 9 - Continuing Case

Sharon and the team discuss the existence of any issues throw-
ing doubt on the appropriateness of the going concern assump-
tion at Cloud 9. The financial ratios indicate no problems with
solvency, and the major borrowings are not due to be repaid
or refinanced for another four years. However, Cloud 9’s man-
agement is anticipating a decline in earnings this year because
of the costs associated with the new store opening and the
sponsorship deal. Cloud 9 does have a sizeable line of credit at
its bank that is currently not being utilized. If Cloud 9 has an
unexpected need for additional cash, Cloud 9 management could
draw on the line of credit. The team makes a note that these
issues have been formally reviewed and they conclude that there
are no significant issues casting substantial doubt on the going
concern assumption.

Before You Go On
4.1  Explain the going concern assumption. How does it affect a company’s accounting?
4.2 List three factors that might indicate the going concern assumption may be at risk. What
audit procedures would detect the factors?
4.3 Explain some mitigating factors that could offset possible going concern issues.

Management Representation and Communication

with Those Charged with Governance

Lea rning Objective 5

Discuss what reporting is required to management and those charged with
governance.

Throughout the entire audit, auditors communicate often with management and other client
personnel in the process of gathering audit evidence. As the audit draws to a conclusion,
some required communications must take place with management and those charged with
governance, and the communications must be documented. The remainder of this section will
explain the management representation letter and the required communications with those
charged with governance.

written representation  a
Management Representation Letter written statement by management
provided to the auditor to confirm
AU-C 580 Written Representations and AS 2805 Management Representations provide guid- certain matters or to support
ance about using written representations as audit evidence. A written representation is other audit evidence
14-22  C h a pte r 14   Completing the Audit
management representation
letter  a letter from manage-
ment to the auditor acknowledg-
ing management’s responsibility
for the preparation of the finan-
cial statements and details of any
verbal representations made by
management during the course of
the audit
ILLUSTRATION 14.12  
Management representation
letter for Cloud 9 audit
a written statement by management provided to the auditor to confirm certain matters or
to support other audit evidence (AU-C 580.07). Generally, a written representation com-
plements other audit procedures that were performed and generally does not provide suf-
ficient appropriate audit evidence on its own. For example, auditors ask management for
a written representation that no material subsequent events have occurred that require
adjustment to or disclosure in the financial statements. That evidence does not relieve au-
ditors of their duty to perform audit procedures designed to identify subsequent events. The
written representation supplements the inquiries made of management regarding subse-
quent events and the evidence gathered from audit procedures related to subsequent events
identification.
As we have discussed throughout the text, auditors make many inquiries of manage-
ment during risk assessment, testing of internal controls, and performance of substantive
procedures. The responses to the inquiries are documented in the auditor’s working papers.
As supplemental evidence to the inquiries, auditors are required to obtain a management
­representation letter as a final piece of audit evidence. A management representation letter
is a letter from management to the auditor acknowledging management’s responsibility for
the preparation of the financial statements and details of any verbal representations made by
management during the course of the audit. However, the management representation letter
is not a substitute for obtaining sufficient, appropriate evidence regarding the financial state-
ments through other audit procedures.
As you can imagine, the letter could be quite daunting to write because of the volume
of inquiries made of management during the audit. To help with this task, AU-C 580.A35
and AS 2805.16 provide illustrative management representation letters that auditors can
use as a guideline for what should be included in the letter. Illustration 14.12 contains a
management representation letter for the Cloud 9 audit. Since Cloud 9 is a public company,
the letter has been prepared using the example provided in PCAOB AS 2805.16.
[1] Cloud 9 Inc.
[2] March 15, 2023
[3] W&S Partners
P.O. Box 525
Seattle, WA 95688
Dear W&S Partners:
[4] We are providing this letter in connection with your audit of the consolidated financial state-
ments of Cloud 9 Inc. as of January 31, 2023, and for the year then ended for the purpose of ex-
pressing an opinion as to whether the consolidated financial statements present fairly, in all mate-
rial respects, the financial position, results of operations, and cash flows of Cloud 9 in conformity
with accounting principles generally accepted in the United States of America. We confirm that
we are responsible for the fair presentation in the consolidated financial statements of financial
position, results of operations, and cash flows in conformity with generally accepted accounting
principles.
[5] Certain representations in this letter are described as being limited to matters that are material.
Items are considered material, regardless of size, if they involve an omission or misstatement of
accounting information that, in the light of surrounding circumstances, makes it probable that the
judgment of a reasonable person relying on the information would be changed or influenced by
the omission or misstatement.
[6] We confirm, to the best of our knowledge and belief, as of March 15, 2023, the following repre-
sentations made to you during your audit:
1. The financial statements referred to above are fairly presented in conformity with accounting
principles generally accepted in the United States of America.
   Management Representation and Communication with Those Charged with Governance   14-23

2. We have made available to you all—

a. Financial records and related data, including the names of all related parties and all rela-
tionships and transactions with related parties.
b. Minutes of the meetings of stockholders, directors, and committees of directors, or
summaries of actions of recent meetings for which minutes have not yet been prepared.
3. There have been no communications from regulatory agencies concerning noncompliance
with or deficiencies in financial reporting practices.
4. There are no material transactions that have not been properly recorded in the accounting
records underlying the financial statements.
5. We believe that the effects of the uncorrected financial statement misstatements summarized
in the accompanying schedule are immaterial, both individually and in the aggregate, to the
financial statements taken as a whole.
6. We acknowledge our responsibility for the design and implementation of programs and con-
trols to prevent and detect fraud.
7. We have no knowledge of any fraud or suspected fraud affecting the entity involving—
a. Management,
b. Employees who have significant roles in internal control, or
c.  Others where the fraud could have a material effect on the financial statements.
8. We have no knowledge of any allegations of fraud or suspected fraud affecting the entity re-
ceived in communications from employees, former employees, analysts, regulators, short
sellers, or others.
9. The company has no plans or intentions that may materially affect the carrying value or clas-
sification of assets and liabilities.
10. The following have been properly recorded or disclosed in the financial statements:
a. Related party transactions, including sales, purchases, loans, transfers, leasing arrange-
ments, and guarantees, and amounts receivable from or payable to related parties.
b.  Guarantees, whether written or oral, under which the company is contingently liable.
c. Significant estimates and material concentrations known to management that are re-
quired to be disclosed in accordance with the FASB ASC Topic 275, Risks and Uncertainties.
[Significant estimates are estimates at the balance sheet date that could change materi-
ally within the next year. Concentrations refer to volumes of business, revenues, available
sources of supply, or markets or geographic areas for which events could occur that would
significantly disrupt normal finances within the next year.]
11. There are no—
a. Violations or possible violations of laws or regulations whose effects should be
considered for disclosure in the financial statements or as a basis for recording a loss
contingency.
b. Unasserted claims or assessments that our lawyer has advised us are probable of
assertion and must be disclosed in accordance with Financial Accounting Standards Board
(FASB) ASC Topic 450, Contingencies.
c. Other liabilities or gain or loss contingencies that are required to be accrued or disclosed
by FASB ASC Topic 450.
d. Side agreements or other arrangements (either written or oral) that have not been
disclosed to you.
12. The company has satisfactory title to all owned assets, and there are no liens or encumbranc-
es on such assets nor has any asset been pledged as collateral.
13. The company has complied with all aspects of contractual agreements that would have a ma-
terial effect on the financial statements in the event of noncompliance.

[7] To the best of our knowledge and belief, no events have occurred subsequent to the
balance-sheet date and through the date of this letter that would require adjustment to or
disclosure in the aforementioned financial statements.

James W. Harley
[8] Chief Executive Officer

David Collier
[8] Chief Financial Officer
14-24  C h a pte r 14   Completing the Audit

Sections of the management representation letter in Illustration 14.12 are numbered to

correspond with the following explanations:
1. Client letterhead—Since the letter is to the auditors from management, the letter is writ-
ten on client letterhead. However, the letter is typically drafted by auditors and presented
to management for review and signing.
2. Date—The letter is generally dated the same as the audit report so the representations made
by management include the subsequent period leading up to the date of the audit report.
3.  Address—The letter is addressed to the audit firm.
4. Identification of audit—This paragraph identifies the financial statements and the pur-
pose of the audit. It also provides a statement in which management accepts responsi-
bility for the fair presentation of the financial statements in conformity with generally
accepted accounting principles in the United States.
5. Materiality—This paragraph states a materiality threshold for items that will be included
in the letter.
6. List of items that management is confirming—This section of the letter is a listing of the
items the auditor wants management to confirm. Read through the listing and you’ll see
it encompasses many important audit items we have discussed in this text, such as proper
application of the financial reporting framework, availability of documents and records,
fraud detection and prevention, and proper disclosure in the financial statements.
7. Subsequent events statement—The final paragraph is a statement confirming that no
subsequent events have occurred through the date of the letter that have not already been
accounted for or disclosed.
8.  Signatures—The letter is signed by the CEO and CFO of the client.
The example provided in Illustration 14.12 is a basic example. Auditors can add more
items to the letter that are tailored to each client’s situation. For example, if inventory obsoles-
cence is a recurring issue in the client’s industry, auditors may add an item for management
to confirm that appropriate provisions have been made regarding slow-moving or obsolete
inventory. Public companies also must make some of these representations public in the quar-
terly and annual filings with the SEC. Section 302 of the Sarbanes-Oxley Act requires the CEO
and CFO to sign statements certifying they are responsible for the effectiveness of internal
controls, the financial statements are presented fairly, and there are no untrue statements of a
material fact or omission of material items.
If management refuses to sign a management representation letter, that would cause the
auditors to question management’s integrity, competence, and ethical values, and could have
serious ramifications for the audit. Auditors would be especially concerned about the reliabil-
ity of audit evidence obtained through inquiry of management. The refusal by management
to sign the representation letter would be considered a scope limitation and could affect the
auditor’s opinion on the financial statements. Chapter 15 provides more information about
the effect of a scope limitation on the auditor’s opinion.

Communication with Those Charged with

Governance
In Chapter 4, we discussed the concept of corporate governance. Governance structures will
vary by client. Public companies will have a board of directors with an audit committee, and
large private companies may also have a board of directors. For medium and smaller compa-
nies, governance responsibility may fall upon owners, partners, trustees, or a committee of
upper management. In very small companies, one person may be in charge of governance,
such as the owner-manager. Auditing standards AU-C 260 The Auditor’s Communication with
Those Charged with Governance and AS 1301 Communications with Audit Committees
address the auditor’s responsibility to communicate certain audit matters with those charged
with governance. As discussed in Chapter 4, auditors must communicate their responsibility
for forming and expressing an opinion on the financial statements that have been prepared
by management. This communication typically takes the form of an engagement letter and
   Management Representation and Communication with Those Charged with Governance   14-25

­ appens at the beginning of the engagement (refer to the section “Corporate Governance” in
h
Chapter 4). Auditors also provide a general overview of the planned scope and timing of the
audit to those charged with governance. During this communication, auditors do not reveal in-
depth detail about the planned audit procedures because they do not want to compromise the
effectiveness of the audit. But this dialogue can open a discussion about risks the client faces
and can assist the auditor in gaining a better understanding of the entity and its environment.
Communication with those charged with governance, with management, and with third
parties, when applicable, is also covered in several other auditing standards. For example, if
auditors have identified a fraud, or have information that indicates the existence of a fraud,
they are required to communicate these matters to an appropriate level of management by
AU-C 240 Consideration of Fraud in a Financial Statement Audit. Similarly, when auditors
have identified material noncompliance with laws and regulations, they are required to com-
municate their findings to those charged with governance in accordance with AU-C 250
Consideration of Laws and Regulations in an Audit of Financial Statements.
Toward the end of the audit, auditors communicate significant findings or issues from
the audit to those charged with governance. This communication should take place before the
audit report is issued. The communication may be oral or written, but either way it must be
documented in the working papers. Illustration 14.13 lists the matters to be communicated
with those charged with governance near the end of the audit.

ILLUSTRATION 14.13   Matters to be communicated with those charged with governance

Significant Finding or Issue

from the Audit
Appropriateness of significant
accounting policies
Process used by management in
developing sensitive accounting
estimates
Difficulties encountered during the
audit
Disagreements with management
Other significant findings or issues
Uncorrected misstatements
Corrected misstatements
Business conditions affecting the entity
Consultations with other accountants
Written representation the auditors are
requesting
Explanation
The applicable financial reporting framework may provide different alternatives for ac-
counting for an item. For example, there are different cost flow assumptions for inventory
(FIFO, LIFO, weighted average). Auditors discuss if the method management has chosen is
appropriate for the industry and for the entity.
Auditors communicate the significant assumptions used in developing the estimate, the
degree of subjectivity involved, and the relative materiality of the estimates to the financial
statements as a whole.
Significant difficulties include delays in management providing information, unrealistic
time within which to complete the audit, restrictions imposed on the auditor by manage-
ment, and the unavailability of expected information.
Disagreements may arise over the application of accounting policies to specific transactions
or events, assumptions for developing estimates, disclosures to be included in the financial
statements, or the scope of the audit. Even if the disagreements were resolved, they should
be communicated to those charged with governance.
Every client is unique; therefore, items specific to each client may need to be communi-
cated to those charged with governance. For example, if a client is involved with major
litigation, auditors would discuss the potential effect on the financial statements of an
unfavorable outcome.
Auditors accumulate individually immaterial uncorrected misstatements and discuss them
collectively to those charged with governance. For material uncorrected misstatements,
auditors should request that they be corrected.
Misstatements that were brought to management’s attention and corrected should also be
communicated to management.
If there are industry, economic, or other uncertainties that could affect the entity’s ability
to continue as a going concern, these matters should be communicated to those charged
with governance.
If auditors and management disagree on an issue, management may contact other outside
accountants to see if they may agree with management’s views. If auditors are aware that
management has consulted with other accountants, then it should be brought to the atten-
tion of those charged with governance. Auditors should communicate their own views on
the issue and how they differ from management’s views.
Auditors should provide those charged with governance with a copy of the management
representation letter.

Source: AU-C 260.12-.14.

14-26  C h a pte r 14   Completing the Audit

critical accounting policies
and practices  accounting
policies and practices that are
most important to the portrayal of
the company’s financial condition
and results, and require manage-
ment’s most difficult, subjective,
or complex judgments
critical accounting estimates 
accounting estimates whose na-
ture and impact on the financial
statements are material because
of the high levels of subjectiv-
ity and judgment necessary to
account for highly uncertain
matters
For a public company audit, the items in Illustration 14.13 should be communicated with
the audit committee of the board of directors. In addition, the PCAOB’s AS 1301 includes
some unique terminology that is not included in AU-C 260. AS 1301 specifies that critical
accounting policies and practices and critical accounting estimates must be commu-
nicated to the audit committee. An entity’s critical accounting policies and practices are most
important for the portrayal of the company’s financial condition and results, and require man-
agement’s most difficult, subjective, or complex judgments. For example, a large bank might
make a record number of new loans during the year, which could mean increased profits.
However, management must also determine how many of those new loans may go unpaid in
the future. That could involve subjective and complex judgments. Critical accounting policies
and practices are often unique to the industry or to the entity and are typically more subjective
than common situations that affect most entities. Auditors must discuss their assessment of
management’s application of and disclosure of the critical accounting policies and practices,
including any recommended modifications that management did not make.
Critical accounting estimates are accounting estimates that possess the following two
characteristics:
1. The nature of the estimate is material due to the levels of subjectivity and judgment nec-
essary to account for highly uncertain matters or the susceptibility of such matters to
change.
2. The impact of the estimate on financial condition or operating performance is material.

For example, estimating the amount of a loss contingency from a material litigation sit-
uation, such as the Starbucks example in the Professional Environment box earlier in the
chapter, is a critical accounting estimate. The outcome of litigation may be highly uncertain,
and the circumstances may change over the course of a long court battle that spans several
years. In addition, the circumstances that led to the litigation are unique to the entity and
generally cannot be compared to situations of other companies. Auditors must communicate
how they concluded that the estimate is or is not reasonable.
Recall from Chapter 6 that material weaknesses and significant deficiencies in ICFR are
also required to be communicated to those charged with governance. The communication
must be in writing and is required for both public and private company clients. Refer to the
section “Management Letters” in Chapter 6 for an example of a management letter used to
communicate internal control deficiencies.

Cloud 9 - Continuing Case

Sharon prepares a draft management representation letter for Jo,
the partner, to review before presenting it to Cloud 9’s CEO and
CFO to sign. The letter includes a statement about manage-
ment’s responsibility for critical accounting policies and critical
accounting estimates. Sharon also drafts a report to be used for
communication with Cloud 9’s audit committee. The report in-
cludes critical items for Cloud 9. Revenue recognition is a critical
accounting policy to discuss with the audit committee. Key items
that impact revenue recognition include the opening of a new
company-owned store and sales and sales returns to retailers
such as department stores. Some of the critical accounting esti-
mates to discuss with the audit committee include estimating the
allowance for doubtful accounts, inventory valuation in light of a
fickle fashion market, and valuation of derivatives.

Before You Go On
5.1  What is the purpose of the management representation letter?
5.2 Name five items of governance interest that would be communicated to those charged with
governance. Explain why each is important to be communicated to those charged with
governance.
5.3 What characteristics of an estimate would classify it as a critical accounting estimate?
Provide an example of a critical accounting estimate for a computer manufacturing company.

Learning Objectives Review
1  Apply the audit procedures used to search for loss
contingencies.
A loss contingency is an existing condition or situation involving un-
certainty as to possible loss that will ultimately be resolved when one
or more future events occur or fail to occur. The auditors perform
procedures to determine if material contingencies have been identi-
fied and properly included and disclosed in the financial statements.
For loss contingencies related to litigation, claims, and assessments,
the auditors will send a legal letter to all attorneys who performed
services for the client during the year. The attorneys will respond
with information regarding the likelihood of an unfavorable
outcome and, if possible, an estimate of the expected loss for the
client.
2  Distinguish between the two types of material subse-
quent events and evaluate what effect they have on the
financial statements, if any.
Material events may occur between the financial statement date and
the date the audit is completed. There are two types of subsequent
events. Type 1 subsequent events are those that provide additional
evidence with respect to conditions that existed at year-end. These
require an adjustment to the financial statements. Type 2 subsequent
events are those that provide evidence about conditions that devel-
oped subsequent to year-end. These are not required to be recorded in
the financial statements, but they must be disclosed in the footnotes.
Auditing standards require that audit procedures be performed to
identify subsequent events.
3  Describe engagement wrap-up procedures performed
at the conclusion of the audit.
At the end of the audit, when all of the planned substantive pro-
cedures are substantially completed, the auditors will conduct fi-
nal analytical procedures to assist in forming an overall conclusion
about whether the financial statements are consistent with the au-
ditor’s understanding of the client. The team will evaluate audit re-
sults, which entails reassessing materiality, control risk, and the risk
of fraud; considering quantitative and qualitative factors of
Key Terms Review
Critical accounting estimates Legal letter
Critical accounting policies and practices Loss contingency
Engagement partner Management representation letter
Engagement quality control reviewer Reasonable period of time
Going concern assumption Subsequent events
  Key Terms Review  14-27
uncorrected ­immaterial ­misstatements; and determining if suffi-
cient appropriate audit evidence has been obtained to support the
auditor’s conclusions. The review of the working papers by various
members of the audit team will also be completed. An engagement
quality control reviewer, typically a partner in the firm who is not on
the audit team, will review the conclusions reached in determining
if the financial statements are fairly presented and ensuring that the
proposed auditor’s report is appropriate based on the audit team’s
work. The auditors have an audit file assembly completion deadline
that is after the audit report release date (see Illustration 14.9). No
documentation can be deleted from the file after this date. The audit
firm must retain the audit file for a specified number of years (seven
years for a public company client and five years for a private com-
pany client).
4  Evaluate the going concern assumption for a client.
The auditor is required to consider whether there is substantial doubt
about the client’s ability to continue as a going concern for a reason-
able period of time, which is the same period of time required by the
client’s financial reporting framework. Audit procedures that are con-
ducted as part of risk assessment and risk response are sufficient for
determining if a client has a going concern issue. If there is a going
concern issue, auditors should inquire about management’s plans to
mitigate the issue and consider if management’s plans are feasible.
If audit evidence indicates there is a going concern issue, then man-
agement must disclose the situation in the notes to the financial
statements.
5  Discuss what reporting is required to management
and those charged with governance.
At the end of the audit, the auditor requests that the CEO and CFO
sign a management representation letter, which is a letter from man-
agement to the auditor acknowledging management’s responsibility
for the preparation of the financial statements and detailing any verbal
representations made by management during the course of the audit.
The auditors are also required to communicate with those charged
with governance at the conclusion of the audit. Illustration 14.13
lists required topics to discuss with those charged with governance.
The communication can be oral or written, but either way it must be
documented in the working papers.
Type I subsequent event
Type II subsequent event
Written representation
14-28  C h a pte r 14   Completing the Audit
Audit Decision-Making Example
Background Information
Your client, Broadcast Cable, Inc. (BC), is a large, privately owned
company that offers digital television, internet, telephone, and
home automation services. BC has been operating for 55 years.
Your audit team is busy wrapping up the audit in the final days of
fieldwork and completing the review of the working papers. The
audit partner and audit manager are preparing to meet with BC’s
audit committee as required by AU-C 260, and they call a meeting
of the entire audit team to discuss what should be communicated
to the audit committee. The team agrees that the following items
are key issues that emerged from the audit:
•  The digital home entertainment industry is experiencing
rapid change, and customers’ choice of products for their
homes is changing.
•  Controls testing revealed a significant deficiency in controls
over the processing of returns of customer deposits.
•  Several factual misstatements were identified that were col-
lectively immaterial.
•  BC has some equipment that appears to be obsolete and
no longer used in operations, but BC management has not
recorded any impairment loss related to the equipment.
Identify the Audit Issue
The audit team must compile a listing of significant findings
or issues from the audit and communicate them to the audit
committee. The listing can be communicated orally or in writing
to the audit committee, but it must be documented in the working
papers.
Gather Information and Evidence
The audit team discusses more details of the key audit matters:
•  The digital home entertainment industry is experiencing
rapid change. BC could experience a business model disrup-
tion and decreased future revenues if more customers move
to “on-demand” services and decrease or eliminate their
digital television service. Companies such as Amazon.com
and Disney are emerging as key players in the delivery of
home entertainment. Also, customers are choosing to drop
services, such as home phone lines, that historically have
been staples in every household. BC management should
be strategically planning for migration to next-generation
technologies.
•  Controls testing revealed a significant deficiency in
­controls over the processing of returns of customer
deposits. When a customer cancels service and returns the
digital cable box, BC processes a refund of the customer’s
CPAexcel
CPAexcel questions and other resources are available in WileyPLUS.
deposit for the digital cable box. The audit team discovered
multiple instances of duplicate refunds being processed to
customers.
•  Several factual misstatements were identified that were col-
lectively immaterial. They were all corrected by ­management.
•  BC has some equipment that appears to be obsolete and
no longer used in operations, but BC management has not
recorded any impairment loss related to the equipment. Net
property, plant, and equipment represents 31% of BC’s total
assets. Equipment such as trucks, cables, and wires are crit-
ical items that BC uses to provide its services. The obsolete
equipment consists of wiring, cable, and conduits related to
residential phone services and legacy analog cable services.
The audit team recommended that management mark
down the obsolete items to fair market value and record a
loss. The book value of the obsolete items is $1,059,500. The
items can be sold for scrap, so once they are marked down
to fair market value, BC would record an impairment loss of
$400,000. The materiality level for the financial statements
as a whole is $500,000. Management did not agree with the
assessment and has not made any adjustments for obsolete
equipment.
Analysis and Evaluation
The manager and partner agree that the items listed above should
be communicated to the audit committee. The issue with the obso-
lete equipment is perhaps the most concerning item. BC manage-
ment disagrees with the auditors that the equipment is impaired
and a loss should be recorded. The amount of the loss is below the
materiality level for the financial statements as a whole; however,
if the $400,000 loss is recorded, it would decrease net income to a
level that would impact upper management bonuses for the year.
The impact on bonuses could be the reason that management is
refusing to mark down the obsolete equipment. Because of this
qualitative aspect, the manager and partner agree that the adjust-
ment should be considered material.
Audit Conclusion
The audit partner and manager draft the report to present and
discuss with BC’s audit committee and also draft a copy of the
management representation letter to present to the audit commit-
tee. Regarding the obsolete equipment issue, it will be the audit
committee’s responsibility to take action and request that manage-
ment make the recommended adjustment. If the audit committee
does not take appropriate action, the audit team should consider
what impact that may have on the audit report and also consider
it a reflection on the integrity of both management and the audit
committee.

Multiple-Choice Questions
1  (LO 1)  If management considers a material loss contingency to
be probable but an amount cannot be reasonably estimated, the prop-
er accounting treatment is:
a.  note disclosure only.
b.  accrual in the financial statements only.
c.  accrual in the financial statements and note disclosure.
d.  no adjustment or disclosure necessary.
2.  (LO 2)  Subsequent events occur after:
a.  the start of the fiscal year.
b.  the appointment of the auditor.
c.  the end of the fiscal year.
d.  the going concern assumption.
3.  (LO 2)  Which of the following is an example of a subsequent
event?
a.  A
 bond issuance after the balance sheet date but prior to issu-
ance of the financial statements.
b. A cybersecurity attack that occurred in the third quarter of
the fiscal year.
c. Legal action that was settled in the last month of the fiscal year.
d.  A major customer declaring bankruptcy two months before
the client’s year-end.
4.  (LO 2)  Which of the following is a Type II subsequent event?
a.  B
 ankruptcy of a customer subsequent to year-end, which
would be considered when evaluating the adequacy of the
allowance for uncollectible accounts.
b.  Loss of plant as a result of fire or flood after year-end.
c. Deterioration in financial results after year-end, which may
indicate doubt about the ability to continue as a going concern.
d.  An amount received related to an insurance claim that was in
the course of negotiation at year-end.
5.  (LO 3)  At the conclusion of the audit, the wrap-up process
involves all of the following except:
a.  r eview of proper and complete execution of planned audit
procedures.
b. determination that all necessary matters have been appropri-
ately considered.
c. revisiting assessments for materiality, control risk, and risk
of fraud.
d.  sending confirmations to financial institutions.
6.  (LO 3)  All of the following are examples of qualitative character-
istics of a misstatement except:
a.  affects management’s compensation for the period.
b.  exceeds the amount for performance materiality.
c.  changes a net loss to a net income for the period.
d.  affects compliance with debt covenants.
7.  (LO 3)  If auditors discover fraud during the audit, it should first
be reported to:
a.  the SEC.
b.  the PCAOB.
Multiple-Choice Questions  14-29
c.  the employee who is committing the fraud.
d.  an appropriate level of management or those charged with
governance.
8.  (LO 3)  The audit firm must retain the audit file of a public
c­ ompany client for:
a.  7 years.
b.  6 years.
c.  5 years.
d.  4 years.
9.  (LO 4)  The going concern assumption means:
a. the entity is facing difficulties continuing as a viable business
entity.
b. the entity is viewed as continuing in business for the foresee-
able future with no need for liquidation.
c.  assets and liabilities are stated at liquidation values.
d.  the auditor is concerned whether the entity is going to change
locations.
10.  (LO 4)  For a private company client that follows GAAP, audi-
tors must consider the going concern assumption for a reasonable
period of time, which is:
a.  o ne year from the date the financial statements are
issued.
b.  one year from the completion of fieldwork.
c.  one year from the date of the financial statements.
d.  one year from the completion of interim audit procedures.
11.  (LO 5)  All of the following statements are included in a man-
agement representation letter except:
a.  there have been no violations of laws or regulations.
b. no subsequent events have occurred that require adjustment
to or disclosure in the financial statements.
c.  the auditor’s fee for completing the audit.
d.  the effects of uncorrected misstatements are immaterial,
both individually and in the aggregate, to the financial
statements.
12.  (LO 5)  Communication with those charged with governance
must occur:
a.  after the audit report is issued.
b.  before the audit report is issued.
c.  before legal letters are sent to attorneys.
d.  after the financial statements are released.
13.  (LO 5)  Accounting policies and practices that are most import-
ant to the portrayal of the company’s financial condition and results,
and require management’s most difficult, subjective, or complex
­judgments are called:
a.  critical accounting policies and practices.
b.  critical accounting estimates.
c.  significant accounting policies and practices.
d.  material contingencies.
14-30  C h a pte r 14   Completing the Audit

Review Questions
R14.1  (LO 1)  Describe the auditor’s process for preparing, sending,
and receiving responses from legal letters, including at what point
during the audit the letters are sent.
R14.2  (LO 2)  Differentiate between the two types of subsequent
events. List some audit procedures that may identify subsequent events.
R14.3  (LO 2)  Discuss the auditor’s responsibility for detecting sub-
sequent events prior to the completion of fieldwork.
R14.4  (LO 3)  Explain the process of “engagement wrap-up.” Why
is it important?
R14.5  (LO 3)  Provide an example of why an auditor would reevaluate
control risk near the end of the audit. Provide a different example of
why an auditor would reevaluate fraud risk near the end of the audit.
R14.6  (LO 3)  Discuss actions an auditor would take when misstate-
ments identified during the audit are not corrected by the client.
R14.7  (LO 3)  Explain the process of an engagement quality control
review.
R14.8  (LO 3)  What are the audit file assembly deadlines and the
audit file retention policies for public and private company audits?
Provide an analysis of why you think the deadlines and policies are
different for public and private company audits.
R14.9  (LO 4)  Evaluate why the accounting assumption of “going
concern” is of interest to auditors. Are there specific audit procedures
that must be performed related to the going concern assumption?
Why or why not?
R14.10  (LO 5)  Why is the management representation letter ob-
tained at the end of the audit? Discuss the impact on the audit if man-
agement refused to sign the management representation letter.
R14.11  (LO 5)  AU-C 260 stresses the importance of communica-
tion with “those charged with governance.” Who are “those charged
with governance?” Discuss why it is important that the auditor com-
municate with them (and not others).
R14.12  (LO 5)  Discuss the items an auditor communicates at the
end of the audit to those charged with governance.

Analysis Problems
AP14.1  (LO 1)  Basic   Communication with lawyers  Conversations between the board of direc-
tors of Acme Inc. and the engagement partner of the audit, Angelo Del Santo, have revealed that Acme
uses three law firms. Ball & Partners performs all legal work related to property transfers, mortgages,
and leases. Brown & Associates handle all employment matters, such as claims for unfair dismissal and
complex employment contracts. Zimmerman & Co. are retained for all other matters, such as agreements
relating to products and suppliers and any international matters.

Required
a.  Discuss the information that Angelo wants to obtain from the attorneys and how this information
is obtained.
b. What procedures could Angelo perform to discover if any other law firms have performed work for
Acme during the fiscal year?

AP14.2  (LO 2)  Moderate   Reporting subsequent events  Brad Scarlett is reviewing the results of
the subsequent events audit procedures. Brad is writing a report for the audit partner based on these
results and will be attending a meeting tomorrow with the partner and representatives of the company to
discuss them. The issue will be whether the financial statements should be amended or additional notes
included for these subsequent events.
Many of the items are not material and Brad will recommend that no action be taken with respect
to these. However, there are several items that Brad believes are material and should be discussed at the
meeting. These are:

•  The board is planning to issue shares in a private offering on February 15.

•  T
 he share issue is to fund the purchase of a 60% stake in another company. The negotiations are in
the final stages and although the contract is not yet signed, it will be signed by February 15.
•  A
 lawsuit was filed in court in the week after year-end claiming damages for illness allegedly caused
by chemicals used at a subsidiary company’s manufacturing plant in the 2000s. This is the tenth
such lawsuit filed and the client has denied responsibility in all cases because it was unreasonable to
believe at that time that these chemicals had adverse health effects. The claimant has new scientific
evidence that counters this defense.
•  T
 he review of subsequent cash receipts has revealed that several of the receivables that were consid-
ered doubtful have now been paid.

The year-end for the company is December 31 and the audit report is due to be signed on February 20.
 Analysis Problems  14-31

Required
For each item, discuss what type of subsequent event it is and the appropriate treatment in the financial
statements.

AP14.3  (LO 2)  Basic   Events after balance date  Martin Rorke is reviewing the results of the
review of subsequent cash receipts. There are several receipts listed from customers that were con-
sidered doubtful at the end of the year (December 31). Martin is also reviewing evidence showing
that another customer that had a large balance at year-end unexpectedly declared bankruptcy on
January 10.

Required
Analyze how this information should be reflected in the financial statements.

AP14.4  (LO 2)  Moderate   Reporting subsequent events  On October 14, Montevista Inc. made
deposits with an overseas supplier totaling $500,000 for the production of specialty items. On October
27, the supplier closed due to political unrest in the country. Montevista hired an international trade
consultant to gain more information about the situation. The consultant concluded on January 11 that
it is unlikely that the deposit will be recovered. Montevista purchases over $3 million worth of items
from this supplier every year. Year-end for the Montevista audit is December 31, and the audit report is
due to be signed on February 26.

Required
a.  Discuss what audit procedures would be used to gather evidence about this situation.
b.  What is the appropriate treatment of this item in the December 31 financial statements?

AP14.5  (LO 3)  Basic   Audit wrap-up  Lucy Huang has just finished her first audit assignment. She
is now assisting her audit manager, Tom Lucas, with the wrap-up of the engagement. He has asked Lucy
to make a list of all open review notes, to-do items, and audit procedures, and note for each whether the
matter requires more attention, has been resolved (but not yet noted on file), or is no longer relevant
because of other events.
Tom has also asked Lucy to go through the files and remove all unnecessary documentation, drafts,
and review notes. Lucy is very nervous about this task because she believes her inexperience will mean
she will not be able to distinguish “unnecessary” from “necessary.” She remembers learning about
Arthur Andersen being prosecuted because it shredded files related to the Enron audit that should
have been kept.

Required
a.  What types of “additional attention” would open matters require?
b.  Explain why documents in a client’s audit file would be “unnecessary.” Provide two examples.

AP14.6  (LO 4)  Basic   Going concern  Mark Jackson is the partner on the audit team for a new client,
Central Companies (CC). The client hired Mark’s firm in August 2022, in preparation for the December 31,
2022, audit. Mark’s firm is replacing the predecessor firm that audited CC for the last 12 years. Since January
2022, CC has experienced a slowdown in sales as evidenced by lower inventory turnover ratios. Slower in-
ventory turnover has negatively impacted operating cash flow, which has resulted in CC paying some of its
suppliers late. Some of the smaller suppliers are demanding that CC pay cash on delivery of inventory items.
Mark is also aware of correspondence between CC and its bank that indicates the company started having
cash flow problems as far back as 2021. CC’s management is convinced that business will pick up and
therefore has not laid off any employees or made any other strategic changes to try and improve cash flow.

Required
Discuss any significant events or conditions that Mark will consider when evaluating if there is substan-
tial doubt about CC’s ability to continue as a going concern.

AP14.7  (LO 4)  Moderate   Research   Assessing going concern  Columbia Metal Fabricators
(CMF) makes steel components for the construction industry. It specializes in extreme precision manu-
facturing where tolerances are measured in distances of less than one millimeter. Its products are used in
revolving restaurants, automatic doors, and similar construction components. In the past, the majority of
its sales have been to international construction companies, particularly in the Middle East. A drop in the
price of oil has slowed construction in the Middle East, and the extremely expensive buildings requiring
high-precision steel components are becoming less popular. In addition, some of the technology used
14-32  C h a pte r 14   Completing the Audit

by CMF has been copied by companies in Southeast Asia, resulting in extreme price competition in this
section of the construction industry for the first time.
CMF is highly leveraged. Two years ago, the company borrowed a large sum of money to fund the
purchase of new office headquarters and the latest laser-cutting equipment. The loan is due for renewal
three months after year-end. One week before signing the audit report, the bank has still not agreed to
renew the loan and CMF’s management has begun negotiations with another bank.

Required
a.  Evaluate factors that would raise substantial doubt about the going concern assumption for CMF.
Discuss any mitigating factors.
b.  If there is a substantial going concern issue, what details should be disclosed in CMF’s notes to the
financial statements? (Note: You may want to access AU-C 570 for more details about auditing the
adequacy of the disclosure.)

AP14.8  (LO 5)  Challenging   Misstatements and the audit report  Katrina Ellis is the engage-
ment partner of the audit of Champion Securities, an investment company. Most of Champion’s
assets and liabilities are financial and their valuation is critical to the assessment of the company’s
solvency and profitability. Katrina has employed two outside experts to value the financial assets and
liabilities because they are extremely complex to value, particularly the energy market derivatives
and the instruments traded in foreign markets. In addition, the valuations are highly dependent on
market conditions and the specific and detailed requirements of the recently revised accounting
standards.
Throughout this year’s audit, Katrina has had difficulties with the CEO of Champion Securities.
He is vehemently opposed to any asset write-downs she has suggested. The CEO has the backing of the
chairman of the board, and Katrina has been unable to get the CEO to agree with her concerns about the
valuations of the financial assets and liabilities the company has made. In past years, Katrina has had
an amicable relationship with both the CEO and the chairman, and the audits have run very smoothly.
Katrina now realizes that this harmonious relationship was mainly due to the boom in the market. It
was unlikely there would be arguments about writing up the value of the company’s assets during these
good times.
Katrina, with the help of the experts, has prepared a summary of the relevant items, detailing the
revised values for the assets and liabilities and the associated effects on income and retained earnings.
The CEO has dismissed this summary and the audit recommendations with the comment, “The market
has hit the bottom and is recovering. There is no need to show these write-downs because by the time the
financial statements are published, the values will be back to where they were before the market fell. It
is all a waste of time. In fact, I think you are just being difficult. I think we need an auditor who is a bit
more realistic.”

Required
a.  Katrina has planned a meeting with the audit committee of the board of directors. Draft a report that
she would discuss with the audit committee.
b.  Katrina is also drafting the management representation letter that the CEO will need to sign. If he
refuses to sign the letter, discuss the implications for the audit.

AP14.9  (LO 5)  Basic   Public Company   Research   Section 302 of the Sarbanes-Oxley Act 
As discussed in the “Management Representation Letter” section of this chapter, Section 302 of SOX
requires the CEO and CFO of public companies to sign a certification statement when the financial
statements are filed with the SEC. You can access these documents through a public company’s website.
For example, in your web browser, search “Starbucks Investor Relations.” The website link will be the
first item in the search. Select SEC Filings. On the SEC Filings page you can search for all of Starbucks’
filings with the SEC. In the Year filter, select the most current year or you can leave it as All Years, and
in the Groupings Filter, select Annual Filings, then click Submit. The 10-K filings will appear. You can
download the 10-K in Word, PDF, or Excel format. Once downloaded, scroll to the end of the document.
(It is very long, usually about 200 pages.) The certification statements are the last pages of the Starbucks
10-K. (Note that you can use this same procedure to access the 10-K for any public company.)

Required
Read the certification statements and compare them to the management representation letter in
Illustration 14.12. Differentiate between the certification statement and the management representation
letter. Be specific with your responses.
 Audit Decision Cases  14-33

Audit Decision Cases

King Companies, Inc.
Questions C14.1 and C14.2 are based on the following case.

King Companies, Inc. (KCI) is a private company that owns five auto parts stores in urban Los Angeles,
California. KCI has gone from two auto parts stores to five stores in the last three years, and it plans con-
tinued growth. Eric and Patricia King own the majority of the shares in KCI. Eric is the chairman of the
board of directors of KCI and CEO, and Patricia is a director as well as the CFO. Shares not owned by Eric
and Patricia are owned by friends and family who helped the Kings get started. Eric started the company
with one store after working in an auto parts store. To date, he has funded growth from an inheritance
and investments from a few friends. Eric and Patricia are thinking about expanding by opening three to
five additional stores in the next few years.
KCI employs 20 full-time staff. These workers are employed in store management, sales, parts deliv-
ery, and accounting. About 40% of KCI’s business is retail walk-in business, and the other 60% is regular
customers where KCI delivers parts to their locations and bills these customers on account. During peak
periods, KCI also uses part-time workers.
In mid-February 2023, while the December 31, 2022, audit was nearing the final wrap-up stage, KCI
was contacted by the manufacturer of its most popular line of brake pads and rotors. The manufacturer
notified KCI of a major defect recently discovered with its brake pads and rotors produced during August
2022 through November 2022. Several deadly car accidents have been attributed to the faulty brake parts,
and the manufacturer is moving as quickly as possible to recall the affected parts. The manufacturer
stated that KCI should pull the affected products off its shelves immediately and notify as many custom-
ers as possible who may have purchased the defective product. KCI management acts quickly and starts
looking through its sales records to see which customers purchased the affected parts. KCI also contacts
its attorney about the situation to begin discussions on how this might adversely affect KCI.

C14.1  (LO 1)  Challenging   Loss contingency  Information gathering and analysis: Does KCI have
a potential loss contingency? Discuss procedures the auditors should perform to gather evidence about
this situation.

C14.2  (LO 2)  Challenging   Subsequent event  Evaluation and conclusions: Evaluate whether the
recall qualifies as a subsequent event and its impact on the 2022 financial statements, if any.

Mobile Security, Inc.

Questions C14.3 and C14.4 are based on the following case.

Mobile Security, Inc. (MSI) has been an audit client of Leo & Lee, LLP for the past 12 years. MSI is a small,
publicly traded aviation company based in Cleveland, Ohio, where it manufactures high-tech unmanned
aerial vehicles (UAV), also known as drones, and other surveillance and security equipment. MSI’s prod-
ucts are primarily used by the military and scientific research institutions, but there is growing demand
for UAVs for commercial and recreational use. MSI must go through an extensive bidding process for
large government contracts. Because of the sensitive nature of government contracts and military prod-
uct designs, both the facilities and records of MSI must be highly secured.
The auditors are nearing the final wrap-up stages of the audit for the year ended June 30, 2023. The
following table shows final financial information for all four quarters of fiscal year end June 30, 2023
(amounts in millions).

Item 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

Total assets $96.00 $92.00 $93.00 $89.00
Total revenues 33.00 31.00 28.00 22.00
Pretax income 3.20 2.79 2.24 1.57

In October 2022, MSI installed a new cloud-based inventory costing system. During interim work,
the audit team found some errors with the costing calculations in the new system, which led to errors
in recommended sales prices used in MSI’s competitive bidding process. There were also problems with
proper inventory cutoff at year-end. Some raw materials that were in transit were not recorded in inven-
tory when they should have been. The audit team has a meeting scheduled for the afternoon to discuss
the findings and next steps to wrap up the engagement.
14-34  C h a pte r 14   Completing the Audit

For the past five years, the engagement quality control reviewer was Sally Pickering, a partner with
Leo & Lee. Sally retired three months ago. For the past month, the firm has been considering who would
take Sally’s place as the engagement quality control reviewer for the MSI audit. The industry and opera-
tions of MSI are very specialized. Unfortunately, no other partner in the firm, other than the engagement
partner on the audit team, has experience in the industry or with MSI.

C14.3  (LO 3)  Challenging   Public Company   Final evaluation of audit evidence
a.  Analysis and evaluation: Evaluate the impacts the costing errors and inventory cutoff errors have
on the audit and the assessments of control risk, fraud risk, and materiality. Does your evaluation
change depending on whether the errors are material or immaterial?
b.  Evaluation and conclusions: Refer to C3.4 in Chapter 3 in which you calculated planning materiality
for MSI based on results from the first two quarters and estimates for the last two quarters. Now
that you have the results of all four quarters (see table above), evaluate your calculation of planning
materiality from C3.4. Would you have adjusted your planning materiality during the year-end field-
work based on the actual results from the third and fourth quarters? If so, what would be the ad-
justed amount? What effect, if any, would your adjustment have on your planned audit procedures
for year-end fieldwork?

C14.4  (LO 3)  Moderate   Public Company   Research   Engagement quality control review 
Information gathering: If Leo & Lee does not have an internal qualified individual to serve as engagement
quality control reviewer, what options does the firm have? Research AS 1220 to provide a full response
(www.pcaobus.org). What characteristics should the engagement quality control reviewer possess? De-
scribe the actual engagement quality control review process, such as when it is conducted and the primary
tasks of the reviewer.

Brooks Health Group

Questions C14.5 and C14.6 are based on the following case.

Goodfellow & Perkins gained a new client, Brookwood Pines Hospital (BPH), a private, not-for-profit
hospital. The fiscal year-end for Brookwood Pines is June 30. You are the audit partner reviewing the
working papers for the BPH audit for the fiscal year end June 30, 2023. Today is August 2, 2023, and it is
expected that fieldwork will be completed in three weeks.
BPH provides medically necessary care to patients, regardless of their ability to pay. Both uninsured
and underinsured patients are offered discounts of up to 100% of charges based on their income as a
percentage of the federal poverty level guidelines. BPH does not pursue collection of these accounts;
therefore, they are not reported in patient service revenue and accounts receivable. The cost of providing
the charity care is included in operating expenses.
BPH’s investments consist of mutual funds, common equities, corporate and U.S. government debt
issues, state and municipal government debt issues, and trusts. A majority of the investments are the
result of charitable contributions to the hospital by generous donors. Earnings from the investments are
used to cover the costs of the charity care. BPH is also eligible for certain government grants to help cover
the costs of the charity care.
During your review, you note that during the third and fourth quarters the financial markets per-
formed well and BPH recorded strong returns for its equity investments. However, beginning toward the
end of the fourth quarter through today, the financial markets have taken a hit. Enacted future tax law
changes, increasing interest rates, higher unemployment, and trade conflicts with other countries are
negatively impacting the economy and the financial markets. Analysts are predicting a continued drop
in the overall market performance and a bear market for some time. Since BPH relies on investment re-
turns to cover the costs of charity care, you consider how smaller investment returns could impact BPH’s
ability to operate. Also, in times of economic downturns, individuals may not be as charitable. Therefore,
BPH could see a drop in donations.
Another situation that is on your mind is a kitchen fire that occurred at BPH last week. Thankfully
no one was seriously injured, but BPH did not have full insurance coverage for the accident. The kitchen
was badly damaged and had to be shut down along with the cafeteria seating area used for hospital visi-
tors. Until the kitchen can be repaired, BPH is paying an outside catering service to deliver meals daily to
patients and employees only. Visitors can no longer purchase items from the cafeteria. You are concerned
that negative publicity from the kitchen fire incident could lead to decreased revenues if physicians de-
cide to contract with a competing hospital.
You spoke with BPH’s controller yesterday about the fire incident. The controller said they do have
the funds to repair the kitchen and are currently accepting bids from contractors for the repair work.
They hope to have a contractor selected by next week so work can get started quickly. They are antici-
pating having the kitchen open in about six weeks. The controller did express concern over the added
expense of the repairs and the high cost of having an outside service provide daily meals to patients and
 Audit Decision Cases  14-35

employees. He also said they have received concerned calls from many of the doctors who use BPH for
their patient services. BPH administration is working very hard at “damage control” to assure the doctors
that the hospital is safe and abiding by all codes required by the state department of health and hospitals.

C14.5  (LO 2)  Moderate   Final review issues—subsequent events

a.  Analysis: Explain your responsibilities with respect to the kitchen fire.
b.  Evaluation: Recommend how this event should be handled in the financial statements.

C14.6  (LO 4, 5)  Challenging   Final review issues—going concern and communicating with
those charged with governance  Evaluation: You are drafting a document with items to discuss with
BPH’s audit committee closer to the end of the audit. In addition to the kitchen fire incident, what else
should you communicate to the audit committee?

Cloud 9 - Continuing Case

Answer the following question based on the information pre-
sented for Cloud 9 in the appendix to this text and the current and
earlier chapters. You should also consider your answers to the case
study questions in earlier chapters.
Required
a. Based on your findings from the Cloud 9 problems in
Chapters 11, 12, and 13, evaluate whether Cloud 9 has any
significant deficiencies or material weaknesses in internal
control.
b. Based on everything you know about the audit of Cloud 9,
prepare a report of items to be communicated to the audit
committee of Cloud 9’s board of directors.