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COMPLETING THE AUDIT

CHAPTER 24

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CHAPTER 24 LEARNING OBJECTIVES

24-1 Design and perform audit tests related to presentation and


disclosure audit objectives.
24-2 Conduct a review for contingent liabilities and commitments.

24-3 Obtain and evaluate letters from the client’s attorneys.

24-4 Conduct a post-balance-sheet review for subsequent events.

24-5 Design and perform the final steps in the evidence-accumulation


segment of the audit.

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CHAPTER 24 LEARNING OBJECTIVES

24-6 Integrate the audit evidence gathered and evaluate the overall
audit results.
24-7 Communicate effectively with the audit committee and
management.
24-8 Identify the auditor’s responsibilities when facts affecting the audit
report are discovered after its issuance.

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OBJECTIVE 24-1
Design and perform audit tests
related to presentation and
disclosure audit objectives.

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PERFORM ADDITIONAL TESTS FOR PRESENTATION
AND DISCLOSURE

As part of Phase IV of the audit, auditors evaluate evidence


they obtained during the first three phases of the audit
and perform additional procedures for presentation and
disclosure-related objectives.
One of the auditor’s primary concerns related to
presentation and disclosure is determining whether
management has disclosed all required information
(completeness).
Presentation and disclosure-related objectives are shown
in Table 24-1.

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OBJECTIVE 24-2
Conduct a review for contingent
liabilities and commitments.

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REVIEW FOR CONTINGENT LIABILITIES
AND COMMITMENTS

Three conditions are required for a contingent liability to exist:


1. There is a potential future payment to an outside party or the
impairment of an asset that resulted from an existing condition.
2. There is uncertainty about the amount of the future payment or
impairment.
3. The outcome will be resolved by some future event or events.
The three levels of likelihood and the required financial statement
treatment are shown in Table 24-2.
Contingency footnotes describe the nature of the contingency. An
illustration of a footnote is shown in Figure 24-1.

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REVIEW FOR CONTINGENT LIABILITIES
AND COMMITMENTS (CONT.)

Auditors are especially concerned about certain pending


liabilities:
• Pending litigation for patent infringement, product liability, or
other actions
• Income tax disputes
• Product warranties
• Notes receivable discounted
• Guarantees of obligations of others
• Unused balances of outstanding letters of credit

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REVIEW FOR CONTINGENT LIABILITIES
AND COMMITMENTS (CONT.)

Auditor’s primary objectives in verifying contingent


liabilities:
• Evaluate the accounting treatment of known contingent
liabilities to determine whether management has
properly classified the contingency (classification
presentation and disclosure objective).
• Identify to the extent practical any contingencies not
already identified by management (completeness
presentation and disclosure objective).

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REVIEW FOR CONTINGENT LIABILITIES
AND COMMITMENTS (CONT.)
Audit Procedures for Finding Contingencies:
• Inquire of management about the possibility of unrecorded contingencies.
• Review current and previous years’ internal revenue agent reports for income
tax settlements.
• Review the minutes of directors’ and stockholders’ meetings for indications of
lawsuits or other contingencies.
• Analyze legal expense for the period under audit for indications of contingent
liabilities, especially lawsuits and pending tax assessments.
• Obtain a letter from each major attorney performing legal services for the client
as to the status of pending litigation or other contingent liabilities.
• Review audit documentation for any information that may indicate a potential
contingency.
• Examine letters of credit in force as of the balance sheet date and obtain a
confirmation of the used and unused balances.

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REVIEW FOR CONTINGENT LIABILITIES
AND COMMITMENTS (CONT.)
Closely related to contingencies are commitments: Agreements to
commit the firm to a set of fixed conditions in the future, regardless
of what happens to profits or the economy as a whole.
Evaluation of Known Contingent Liabilities: If auditors conclude
that there are contingent liabilities, they must evaluate the
significance of the potential liability and the nature of the
disclosure needed in the financial statements.
CPAs often obtain a separate evaluation of the potential liability
from its own legal counsel, especially highly material ones, rather
than relying on management or management’s attorneys.

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REVIEW FOR CONTINGENT LIABILITIES
AND COMMITMENTS (CONT.)

Audit Procedures for Finding Commitments: The search for


unknown commitments is usually performed as part of the
tests in each audit area.
The auditor should also be aware of the possibility of
commitments when reading minutes, contracts, and
correspondence files.

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OBJECTIVE 24-3
Obtain and evaluate letters from the
client’s attorneys.

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INQUIRY OF CLIENT’S ATTORNEYS
A procedure auditors rely on for evaluating known litigation and
other claims and identifying new claims against the client is the
inquiry of the client’s attorneys.
• An example of a typical letter sent to the attorney for return directly to the CPA’s office is
shown in Figure 24-2 on page 772.

If an attorney refuses to provide the auditor with information about


material existing lawsuits (asserted claims) or unasserted claims,
auditors must modify their audit report to reflect the lack of available
evidence (a scope limitation which required a qualified or disclaimer
of opinion).
Sarbanes-Oxley requires attorneys serving public companies to
report material violations of federal securities laws committed by the
company.

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OBJECTIVE 24-4
Conduct a post-balance-sheet review
for subsequent events.

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REVIEW FOR SUBSEQUENT EVENTS

The third part of completing the audit is the review for


subsequent events.
The auditor’s responsibility for reviewing subsequent events
is normally limited to the period beginning on the balance
sheet date and ending with the date of the auditor’s report.
The period covered by subsequent events review and the
timing of that review are shown in Figure 24-3.

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REVIEW FOR SUBSEQUENT EVENTS (CONT.)
Two types of subsequent events require consideration by
management and evaluation by the auditor:
• Those that have a direct effect on the financial statements and require
adjustment
• Those that do not have a direct effect on the financial statements but
for which disclosure may be required
Examples of those that require adjustment:
• Declaration of bankruptcy by a customer with an outstanding
accounts receivable balance
• Settlement of litigation at an amount different from the amount
recorded on the books
• Disposal of equipment not being used in operations at a price below
the current book value

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REVIEW FOR SUBSEQUENT EVENTS (CONT.)
Examples of those for which disclosure may be required:
• A decline in the market value of securities held for temporary
investment or resale
• The issuance of bonds or equity securities
• A decline in the market value of inventory as a consequence of
government action barring further sale of a product
• The uninsured loss of inventories as a result of fire
• A merger or acquisition
Auditors of accelerated filers may also identify events related
to internal control over financial reporting that arose
subsequent to year-end.

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REVIEW FOR SUBSEQUENT EVENTS (CONT.)

Audit Tests: There are two categories of audit procedures for


the subsequent events review:
1. Procedures normally integrated as a part of the verification of
year-end account balances
2. Procedures performed specifically for the purpose of
discovering events or transactions that must be recognized as
subsequent events
The first category includes cutoff and valuation tests done as
part of the tests of details of balances.

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REVIEW FOR SUBSEQUENT EVENTS (CONT.)
Audit Tests (cont):
The second category are performed specifically to obtain
information to incorporate into the current year’s account balances
or footnotes as tests of the completeness presentation and
disclosure objective. These include:
• Review records prepared subsequent to the balance sheet date.
• Review internal statements prepared subsequent to the balance sheet
date.
• Examine minutes issued subsequent to the balance sheet date.
• Correspond with attorneys.
• Inquire of management.
• Obtain a letter of representation—this letter is mandatory.

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REVIEW FOR SUBSEQUENT EVENTS (CONT.)
Dual Dating:
Occasionally the auditor determines that a subsequent event that
affects current period financial statements occurred after the date of
the audit report but before the audit report was issued.
In that situation, auditing standards require the auditor to extend
audit tests for the newly discovered subsequent event. The auditor
has two equally acceptable options for doing so:
1. Expand all subsequent events tests to the new date—with this
option, the auditor simply changes the report date to the new date.
2. Restrict the subsequent events review to matters related to the new
subsequent event—with this option, the auditor issues a dual-date
audit report.

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OBJECTIVE 24-5
Design and perform the final steps in
the evidence-accumulation
segment of the audit.

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FINAL EVIDENCE ACCUMULATION
Perform Final Analytical Procedures: Auditing standards
require auditors to perform analytical procedures during
the completion of the audit.
It is common for a partner to do analytical procedures
during the final review of the audit documentation.
Results from final review may indicate that additional audit
evidence is necessary. If any unexpected relationship is
found due to client misstatement, the auditor should
propose an adjustment if the misstatement is material.

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FINAL EVIDENCE ACCUMULATION (CONT.)
Evaluate Going-Concern Assumption: Auditing standards
require the auditor to evaluate whether there is a substantial
doubt about a client’s ability to continue as a going concern at
least one year beyond the balance sheet date.
• Auditors use analytical procedures, discussions with
management, and their knowledge of the client’s business to
assess the likelihood of financial failure within one year.
• A final assessment of the entity’s going-concern status is
desirable after all evidence has been accumulated and proposed
audit adjustments have been incorporated into the financial
statements.

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FINAL EVIDENCE ACCUMULATION (CONT.)
Obtain Management Representation Letter: Auditing standards
require the auditor to obtain written representations from
management, usually in a letter of representation documenting
management’s most important oral representations made
during the audit.
• This letter is prepared on the client’s letterhead, addressed to
the CPA, and signed by high-level corporate officials.
• The letter should be dated no earlier than the date of the
auditor’s report to ensure that there are adequate
representations about subsequent events.

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FINAL EVIDENCE ACCUMULATION (CONT.)
Obtain Management Representation Letter (cont):
The three purposes of the client letter of representation are:
1. Impress upon management its responsibilities for the
assertions in the financial statements.
2. Remind management of potential misstatements or omissions
on the financial statements.
3. Document the responses from management to inquiries about
various aspects of the audit.

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FINAL EVIDENCE ACCUMULATION (CONT.)

Obtain Management Representation Letter (cont):


Auditing standards suggest four categories of specific matters
that should be included:
1. Financial statements
2. Completeness of information
3. Recognition, measurement, and disclosure
4. Subsequent events
PCAOB auditing standards require the auditor to also obtain written
representation from management regarding internal control over
financial reporting.

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FINAL EVIDENCE ACCUMULATION (CONT.)
Consider Supplementary Information in Relation to Financial
Statements as a Whole:
Clients often include additional information beyond the basic
financial statements.
The basic financial statements and additional supplementary
information are illustrated in Figure 24-4.
Auditors must clearly distinguish their audit and reporting
responsibility for the primary financial statements and for
supplementary information.

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FINAL EVIDENCE ACCUMULATION (CONT.)
Read Other Information in the Annual Report: Auditing
standards require the auditor to read other information
included in the annual report pertaining directly to the
financial statements.
• Auditor responsibility to read other information included in
annual report pertains only to information that is not part of the
financial statements but is published with them.
• If the auditor concludes that a material inconsistency exists, they
should request the client to change the information. If the client
refuses, the auditor should include an explanatory paragraph in
the audit report or withdraw from the engagement.

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OBJECTIVE 24-6
Integrate the audit evidence
gathered and evaluate the
audit results.

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EVALUATE RESULTS

Sufficient Appropriate Evidence: To make a final evaluation


as to whether sufficient appropriate evidence has been
accumulated, the auditor reviews the audit documentation
for the entire audit to determine whether all material classes
of transactions, accounts, and disclosures have been
adequately tested.
Auditors often use a completing the audit checklist, which is
a reminder of items that may have been overlooked.
A partial completing the audit checklist is shown in Figure
24-5.

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EVALUATE RESULTS (CONT.)
Evidence Supports Auditor’s Opinion:
An essential part of evaluating whether the financial statements are
fairly stated involves the auditor’s review of the summary of
misstatements found in the audit. In addition to known
misstatements, the auditor must consider possible misstatements.
• Both known and projected misstatements are shown in Figure 24-6 on
page 783.
Financial Statement Disclosures: Before completing the audit,
auditors must make a final evaluation of whether the disclosures in
the financial statements satisfy all presentation and disclosure
objectives.
• A partial financial statement disclosure checklist is shown in Figure
24-7.

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FINAL EVIDENCE ACCUMULATION (CONT.)
Audit Documentation Review:
There are three reasons why an experienced member of the audit
firm must thoroughly review audit documentation at the completion
of the audit:
1. Evaluate the performance of inexperienced personnel.
2. Make sure that the audit meets the CPA firm’s standard of
performance.
3. Counteract the bias that often enters into the auditor’s judgment.
Except for final independent review, the review of audit
documentation should be conducted by someone who is
knowledgeable about the client and the circumstances of the audit.

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FINAL EVIDENCE ACCUMULATION (CONT.)

Engagement Quality Review: At the completion of larger


audits, it is common to have the financial statements and entire
set of audit files reviewed by a completely independent
reviewer who has not participated in the audit.
• An engagement quality review is required for SEC engagements,
including the review of interim financial information and the
audit of internal controls. This reviewer often takes an
adversarial position to make sure the audit was adequate.
Summary of Evidence Evaluation: Evaluating whether there
is sufficient appropriate evidence and whether evidence
supports the opinion on the financial statements is
summarized in Figure 24-8.
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FINAL EVIDENCE ACCUMULATION (CONT.)

Issue the Audit Report:


The auditor should wait to decide the appropriate audit
report to issue until all evidence has been accumulated and
evaluated, including all steps of completing the audit.
Most CPA firms have comprehensive audit reporting
manuals to assist them in selecting the appropriate
wording of the report they decide to issue.

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OBJECTIVE 24-7
Communicate effectively with the
audit committee and
management.

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COMMUNICATE WITH THE AUDIT COMMITTEE
AND MANAGEMENT

Communicate Fraud and Illegal Acts: Auditing standards


require the auditor to communicate in writing all fraud
and illegal acts to the audit committee or equivalent,
regardless of materiality.
Communicate Internal Control Deficiencies: The auditor
must communicate in writing significant internal control
deficiencies and material weaknesses in the design or
operation of internal control to those charged with
governance.

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COMMUNICATE WITH THE AUDIT COMMITTEE
AND MANAGEMENT (CONT.)
Other Communications with Audit Committee: Auditing standards
require the auditor to communicate certain additional information to
those charged with governance.
There are four principal purposes of these required communications:
1. Communicate auditor responsibilities in the audit of financial
statements.
2. Provide an overview of the scope and timing of the audit.
3. Provide those charged with governance with significant findings
arising during the audit.
4. Obtain from those charged with governance information relevant to
the audit.

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COMMUNICATE WITH THE AUDIT COMMITTEE
AND MANAGEMENT (CONT.)

Other Communications with Audit Committee (cont):


Sarbanes-Oxley requires additional communications for
auditors of public companies. As the audit is completed, the
auditor should determine that the audit committee is informed
about the initial selection of and any changes in significant
accounting policies.
Management Letters: A management letter is intended to inform
client personnel of the CPAs recommendations for improving
any part of the client’s business.

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OBJECTIVE 24-8
Identify the auditor’s responsibilities
when facts affecting the audit report
are discovered after its issuance.

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SUBSEQUENT DISCOVERY OF FACTS
Although rare, auditors sometimes learn after the audited financial statements
have been issued that the financial statements are materially misstated.
When this subsequent discovery of facts occurs, the auditor has an obligation
to make certain that users who are relying on the financial statements are
informed about the misstatements or change in the conclusion on the
effectiveness of internal controls.
If the auditor discovers that the statements are misleading after they have
been issued, the most desirable action is to request that the client issue an
immediate revision of the financial statements that includes an explanation of
the reason for the revision.
The timeline for subsequent discovery of facts is shown in Figure 24-9.

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