This Document Contains Chapters 17 to 18 Chapter 17 Completing the Audit Engagement Answers to Review Questions 17-1 A contingent liability is defined as an existing condition, situation, or set of circumstances involving uncertainty as to possible loss to an entity that ultimately will be resolved when some future event occurs or fails to occur. FASB ASC Topic 450, “Contingencies,” classifies uncertainties into three categories: 1. Probable: The future event is likely to occur. 2. Reasonably possible: The chance of the future event occurring is more than remote but less than likely. 3. Remote: The chance of the future event occurring is slight. Examples of contingent liabilities include • Pending or threatened litigation • Actual or possible claims and assessments • Income tax disputes • Product warranties or defects • Guarantees of obligations to others • Agreements to repurchase receivables that have been sold 17-2 The auditor requests that the attorney provide the following information on pending or threatened litigation: • A list and evaluation of any pending or threatened litigation to which the attorney has devoted substantial attention. The client may provide the list. • A listing of unasserted claims and assessments considered by management to be probable of assertion and reasonably possible of unfavorable outcome. • A description and evaluation of the outcome of each pending or threatened litigation. This should include the progress of the case, the action the entity plans to take, the likelihood of unfavorable outcome, and the amount or range of potential loss. • Identification of any pending or threatened litigation or claims not included in management’s list or a statement that the list is complete. • Comments on unasserted claims where his or her views differ from management's evaluation. • Indication if his or her response is limited and the reasons for such limitations. 17-3 Two examples of long-term commitments are the purchase of raw materials or the sale of products at a fixed price. When the fair market value of the good is less than the purchase price included in the purchase contract, the entity will have to recognize a loss on a long- term commitment even though there has been no exchange of goods. 17-4 The two types of subsequent events that require consideration by management and evaluation by the auditor relevant to financial statement audits are Type I Events that provide additional evidence about conditions that existed at the date of the balance sheet and affect the estimates that are part of the financial statement This Document Contains Chapters 17 to 18 preparation process. These types of events require adjustment of the financial statements. Type II Events that provide evidence about conditions that did not exist at the date of the balance sheet but arose subsequent to that date. These types of events usually require disclosure in the notes to the financial statements. In some instances, where the effect of the event or transaction is very significant, pro forma financial statements may be necessary in order to prevent the financial statements from being misleading. Examples of Type I events or conditions are • An uncollectible account receivable resulting from continued deterioration of a customer's financial condition leading to bankruptcy after the balance sheet date, where the bankruptcy is the event that reveals the customer’s poor financial condition at the balance sheet date. • The settlement of a lawsuit after the balance sheet date for an amount different from the amount recorded in the year-end financial statements. Examples of Type II events or conditions are • Purchase or disposal of a business by the entity after the balance sheet date. • Sale of a capital stock or bond issue by the entity after the balance sheet date. • Loss of the entity's manufacturing facility or assets resulting from a casualty such as a fire or flood occurring after the balance sheet date. • Losses on receivables arising from conditions such as a casualty arising subsequent to the balance sheet date. While not required by this question, it is important to note that the two types of subsequent events that require consideration by management and evaluation by the auditor relevant to the audit of internal control over financial reporting (ICFR) are 1. Control events that reveal information about a material weakness that existed as of the end of the reporting period. If the event reveals information about a material weakness, the auditor should issue an adverse opinion regarding the effectiveness of internal control over financial reporting. If the auditor is unable to determine the effect of the subsequent control event on the effectiveness of the company’s internal control, the auditor should disclaim an opinion. 2. Control events that create or reveal information about a new condition that did not exist as of the end of the reporting period. If the information has a material effect on the company, the auditor should include an explanatory paragraph describing the event and its effects or directing the reader’s attention to the event and its effects as disclosed in management’s report. Examples of the control events or conditions (relating to both before and after the reporting period) are • Relevant internal audit reports (or similar functions, such as loan review in a financial institution) issued during the subsequent period. • Independent auditor reports (if other than the primary auditor’s) of significant deficiencies or material weakness. • Regulatory agency reports on the company’s internal control over financial reporting. • Information about the effectiveness of the company’s internal control over financial reporting obtained through other engagements (AS5). 17-5 The auditor would consider dual dating the audit report when a subsequent event is recorded or disclosed in the financial statements after the date on which the auditor has obtained sufficient appropriate audit evidence but before the issuance of the financial statements (refer to Figure 17-1 in the text). In this case, the auditor will choose to dual date if they want to limit their responsibility for events subsequent to the date on which they auditor has obtained sufficient appropriate audit evidence to the disclosed subsequent event. 17-6 Auditing standards (AU-C 520, PCAOB AS No. 2810), require that the auditor perform analytical procedures at the final review stage of the audit. The objective of conducting final analytical procedures near the end of the engagement is to help the auditor assess the conclusions reached on the financial statement components and to help the auditor evaluate the overall financial statement presentation. 17-7 The auditor obtains a representation letter in order to corroborate significant oral representations made to the auditor and to document the continued appropriateness of those representations. The representation letter also reduces the possibility of misunderstanding between management and the auditor. 17-8 A quality review partner is generally not associated with the details of the engagement and is expected to provide an independent review of the audit. The quality review partner can protect the firm from an inappropriate or non-independent relationship between the audit partner and the client. The engagement quality control reviewer performs an objective evaluation of the significant judgments made by the engagement team and the conclusions reached in formulating the auditor’s report. He or she discusses significant findings or issues with the engagement partner and reads the financial statements and the proposed auditor’s report. The engagement quality reviewer reviews selected audit documentation relating to the significant judgments the engagement team made and the related conclusions it reached, and evaluates the conclusions reached in formulating the auditor’s report. Finally, he or she considers whether the proposed auditor’s report is appropriate. 17-9 The four overall steps in the going concern evaluation process are as follows: 1. Independently evaluate whether the results of audit procedures performed during the planning, performance, and completion of the audit indicate whether there is substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time not to exceed one year from the issuance of the financial statements. 2. If there is substantial doubt, the auditor should obtain information about management's plans to mitigate the going concern problem and assess the likelihood that such plans can be implemented. 3. Conclude, in light of management’s plans, whether it is probable that the entity will be able to continue as a going concern; if not, consider the adequacy of the disclosures about the entity’s ability to continue and include a separate section in the auditor’s report disclosing the going-concern issue under the heading “Substantial Doubt About Entity’s Ability to Continue as a Going Concern.” 4. Assess management’s going-concern evaluation and related disclosures. 17-10 The four major categories of events or conditions that may indicate going concern problems and examples of each are Financial conditions: • Recurring operating losses • Current-year deficit • Accumulated deficits • Negative net worth • Negative working capital • Negative cash flow • Negative income from operations • Inability to meet interest payments Other financial difficulties: • Default on loans • Dividends in arrears • Restructuring of debt • Denial of trade credit by suppliers • No additional sources of financing Internal matters: • Work stoppages • Uneconomic long-term commitments • Dependence on the success of one particular project External matters: • Legal proceedings • Loss of a major customer or supplier • Loss of a key franchise, license, or patent 17-11 The items to be communicated are organized into three categories: appointment and retention of the auditor, obtaining information relevant to the audit and communicating the audit strategy, and communicating the results of the audit. See Table 17-5 for details of items to be communicated. Note: The auditor’s communication with those charged with governance would normally take place at or near the end of the engagement. However, if a significant event occurs, such as fraudulent activities by senior management, the auditor would normally contact those charged with governance immediately. 17-12 Generally, when previously issued financial statements contain material misstatements due to unintentional or intentional actions by management, the financial statements will require revision. If the client refuses to cooperate and make the necessary disclosures, the auditor should notify the board of directors and take the following steps, if possible: 1. Notify the client that the auditor's report must no longer be associated with the financial statements. 2. Notify any regulatory agencies having jurisdiction over the client that the auditor's report can no longer be relied upon. 3. Notify each person known to the auditor to be relying on the financial statements. Usually, notification to a regulatory agency, such as the SEC, is the only practical way to provide appropriate disclosure. Answers to Multiple-Choice Questions 17-13 c 17-18 a 17-14 d 17-19 a 17-15 a 17-20 a 17-16 b 17-21 c 17-17 a Solutions to Problems 17-22 Since the events or conditions that should be considered in the financial accounting for and reporting of litigation, claims, and assessments are matters within the direct knowledge, and often, control of management of an entity, management is the primary source of information about such matters. Accordingly, Harper's audit procedures with respect to the existence of loss contingencies arising from litigation, claims, and assessments should include the following: • Inquire and discuss with management the policies and procedures adopted for identifying, evaluating, and accounting for litigation, claims, and assessments. • Obtain from management a description and evaluation of litigation, claims, and assessments that existed at the date of the balance sheet being reported on, and during the period from the balance sheet date to the date the information is furnished, including an identification of those matters referred to legal counsel. • Examine documents in the client's possession concerning litigation, claims, and assessments, including correspondence and invoices from lawyers. • Obtain assurance from the client, ordinarily in the form of a representation letter, that it has disclosed all unasserted claims which the lawyer has advised the client are probable of assertion and must be disclosed in accordance with generally accepted accounting principles (FASB ASC 450). • The auditor should request the client's management to send a letter of inquiry to those lawyers with whom management consulted concerning litigation, claims, and assessments. Examples of other procedures undertaken for different purposes that might also disclose litigation, claims, and assessments are the following: • Read minutes of stockholders, directors, and appropriate committee meetings held during and subsequent to the period being examined. • Read contracts, loan agreements, leases, and correspondence from taxing or other governmental agencies, and similar documents. • Obtain information concerning guarantees from bank confirmation forms. • Inspect other documents for possible guarantees by the client. 17-23 The omissions, ambiguities, and inappropriate statements and terminology in Cao's letter are as follows: • A description of the progress of each case to date is omitted. • The evaluation of the likelihood of an unfavorable outcome for each case is unclear. • An estimate, if one can be made, of the amount or range of potential loss of each case is omitted. • The other pending or threatened litigation on which Young was consulted is not identified and included. • The unasserted claims and assessments probable of assertion that have a reasonable possibility of an unfavorable outcome are not identified. • Consolidated's understanding of Young's responsibility to advise Consolidated concerning the disclosure of unasserted possible claims or assessments is omitted. • Materiality (or the limits of materiality) is not addressed. • The reference to a limitation on Young's response due to confidentiality is inappropriate. • Young is not requested to identify the nature of and reasons for any limited response. • Young is not requested to include matters that existed after the balance sheet date, up to the date of Young's response. • The date by which Young's response is needed is not indicated. • The reference to Young's response possibly being quoted or referred to in the financial statements is inappropriate. • Vague terminology such as "slight" and "some chance" is included where "remote" and "possible" are more appropriate. • There is no inquiry about any unpaid or unbilled charges, services, or disbursements. 17-24 a. For the financial statement audit, the two types of subsequent events that require Namiki’s consideration and evaluation are • Events that provide additional evidence concerning conditions that existed at the balance sheet date and affect the estimates inherent in the process of preparing financial statements. This type of subsequent event requires that the financial statements be adjusted for any changes in estimates resulting from the use of such additional evidence. • Events that provide evidence concerning conditions that did not exist at the balance sheet date but arose subsequent to that date. Such events result in financial statement disclosure. If Taylor is a public company, the audit of internal control over financial reporting includes two types of subsequent events that the auditor must consider: • Control events that reveal information about a material weakness which existed as of the end of the reporting period. If the event reveals information about a material weakness, the auditor should issue an adverse opinion on the effectiveness of internal control over financial reporting. If the auditor is unable to determine the effect of the subsequent control event on the effectiveness of the company’s internal control, the auditor should disclaim any opinion. • Control events that create or reveal information about a new condition which did not exist as of the end of the reporting period. If the information has a material effect on the company, the auditor should include an explanatory paragraph describing the event and its effects or directing the reader’s attention to the event and its effects as disclosed in management’s report. b. The auditing procedures Namiki should consider performing to gather evidence concerning subsequent events include the following: • Compare the latest available interim statements with the financial statements being audited. • Ascertain whether the interim statements were prepared on the same basis as the audited financial statements. • Inquire whether any contingent liabilities or commitments existed at the balance sheet date or the date of inquiry. • Inquire whether there was any significant change in the capital stock, long-term debt, or working capital to the date of inquiry. • Inquire about the current status of items in the audited financial statements that were accounted for on the basis of tentative, preliminary, or inconclusive data. • Read or inquire about the minutes of meetings of stockholders or the board of directors. • Inquire of the client's legal counsel concerning litigation, claims, and assessments. • Obtain a management representation letter, dated as of the date of Namiki's audit report, as to whether any subsequent events would require adjustment or disclosure. • Make such additional inquiries or perform such additional procedures Namiki considers necessary and appropriate. • Examine and/or inquire about findings included in internal audit reports completed after year end. 17-25 1. The explosion in Agronowitz's plant that led to the uncollectibility of Scornick Company’s accounts receivable was an event whose conditions did not exist at the balance sheet date. Thus, the event is a Type II event, and should be disclosed in the financial statements of the year just ended. 2. The tax court ruling in favor of Scornick Company is an event whose conditions existed at the balance sheet date but were clarified later, and which involves the revision of an estimate. Thus, under normal circumstances the event would be considered a Type I event, and the financial statements of the year just ended would be adjusted to reflect the favorable ruling. However, ASC 740-10-25-8, Income Taxes, prescribes special rules for resolutions of income tax matters after the balance sheet date. According to ASC 740-10-25-8, “a change in facts subsequent to the reporting date but prior to the issuance of the financial statements shall be recognized in the period in which the change in fact occurs.” Accordingly, the adjustment to reflect the favorable ruling would be recognized in 2019, and not in the financial statements for the year ended December 31, 2018. 3. The sale of Scornick's Manufacturing Division is an event whose conditions did not exist at the balance sheet date and is thus a Type II event. This event, at a minimum, requires disclosure in the financial statements of the year just ended. However, due to the size of the division being sold, pro-forma financial statements may be necessary. 4. This is not an event that is considered a subsequent event for financial statement purposes. 5. This is not an event that is considered a subsequent event for financial statement purposes. 17-26 a. An auditor is required to obtain a written management representation letter as part of every audit performed in accordance with generally accepted auditing standards. The purposes of obtaining a written management representation letter are to • Confirm the oral representations given to the auditor, including that management accepts responsibility for the fair presentation of the financial statements. • Indicate and document the continuing appropriateness of management's representations. • Reduce the possibility of misunderstanding concerning the matters that are the subject of the representations. • Complement the other auditing procedures by corroborating the information discovered in performing those procedures. • Obtain evidence concerning management's future plans and intentions (e.g., when refinancing debt or discontinuing a line of business). b. The representation letter should be addressed to the auditor and dated as of the date of the auditor's report. The letter should be signed by members of management whom the auditor believes are responsible for and knowledgeable, directly or through others in the organization, about the matters covered by the representation. Their refusal to sign the letter would constitute a limitation on the scope of the audit sufficient to preclude an unqualified/unmodified opinion and affect the auditor's ability to rely on other management representations. c. Obtaining a management representation letter does not relieve an auditor of any other responsibility for planning or performing an audit. Accordingly, an auditor should still perform all the usual tests to corroborate representations made by management. 17-27 Other matters that Heinrich's representation letter should specifically confirm include whether or not • Management acknowledges responsibility for the fair presentation in the financial statements of financial position, results of operations, and cash flows in conformity with generally accepted accounting principles (or other basis of accounting). • All material transactions have been properly reflected in the financial statements. • There are other material liabilities or gain or loss contingencies that are required to be accrued or disclosed. • The company has satisfactory title to all owned assets, and whether there are liens or encumbrances on such assets or any pledging of assets. • There are related-party transactions or related accounts receivable or payable that have not been properly disclosed in the financial statements. • The company has complied with all aspects of contractual agreements that would have a material effect on the financial statements in the event of noncompliance. • Events have occurred subsequent to the balance sheet date that would require adjustment to, or disclosure in, the financial statements. • The accountant has been advised of all actions taken at meetings of stockholders, the board of directors, or other similar bodies that may affect the financial statements. • All financial records and data were made available. • Management is aware of fraud that could have a material effect on the financial statements or that involve management or employees who have significant roles in the internal control system. • Provision, when material, has been made to reduce receivables to their estimated net realizable value. • Provision, when material, has been made to reduce excess or obsolete inventories to their lower of cost of market. • Provision has been made for any material loss to be sustained in the fulfillment of, or from inability to fulfill, any sales commitments. • Provision has been made for any material loss to be sustained as a result of purchase commitments for inventory quantities in excess of normal requirements or at prices in excess of the prevailing market prices. 17-28 1. B 2. N 3. N 4. D 5. L 6. F 7. N 8. P 9. J 10. B 11. B 12. F 13. B 14. C 15. N 16. M Solutions to Discussion Cases 17-29 a. FASB ASC Topic 450, "Contingencies," deals with the accounting for loss contingencies. The auditor must decide whether an estimated loss from the contingency is probable and estimable, probable but not estimable, reasonably possible, or remote. Since the EPA has not initiated a lawsuit or other regulatory action against Ceramic Crucibles of America (CCA), the potential loss is an unasserted claim. It is necessary to consider whether the facts would lead to a conclusion about the probability that a claim will be asserted against CCA and, if so, whether the amount of the cleanup cost is reasonably estimable. An argument can be made that a claim will not occur or not have a significant effect on CCA's financial statements. First, the fact that CCA has been named as a PRP with two other companies may not lead to a claim against the company. This line of reasoning argues that the Durango site was placed on the National Priorities List (NPL) only because each state must have a site on the list, not because of the extent of the pollution. Second, the rating of the Durango site is considerably lower than the ratings of other sites on the list. Third, there are two viable PRPs who are responsible for the vast majority of the contaminants. Finally, based on the fact that the EPA has paid most of the costs of pollution cleanups and only a fraction of the costs of pollution cleanups have been borne by industry, it is quite likely that the company may never have to pay. An unfavorable outcome under these facts might be considered remote, and no disclosure would be required. An argument can also be made that, based on the current evidence of pollution on the site, and the fact that once the EPA has put a site on the NPL and has authorized an investigation of the site, it is unlikely that they will not assert a claim. In this case, it is considered probable that a claim will be asserted and there is a reasonable possibility that the outcome will be unfavorable. However, CCA's financial position does not appear to be threatened by potential action because its pollution levels are significantly below the levels of others, the other PRPs are capable of paying their share of potential fines, the company no longer uses lead in its production process, its past use of lead met FDA requirements, and no waste water has been discharged since the company acquired the property. CCA could also sue the prior owners of the property for their share of the damages should there be an adverse outcome to the investigation. b. In assessing the materiality of an uncertainty it must be recognized that some uncertainties are unusual in nature or infrequent in occurrence and thus more closely related to financial position than to normal, recurring operations (e.g., litigation related to alleged violations of antitrust or securities laws). In such instances, the auditor should consider the possible loss in relation to shareholders' equity and other relevant balance sheet components such as total assets, total liabilities, current assets, and current liabilities. The potential loss of between $10 million to $13 million represents a reduction in stockholders' equity of 4.5 percent to 7.0 percent. These amounts might be considered material to the financial statements and thus require disclosure by the client in the footnotes. However, considering that the likelihood of the claim is remote and that CCA (or EPA) can take action against the other PRPs, it is unlikely that an unfavorable outcome would be material. It also does not appear that an unfavorable outcome would have an adverse affect on the company's financial position. c. The auditor could obtain and examine a number of additional pieces of evidence, including the following: • Copies of any public documents (e.g., the report rating the site as 8.3) that led to the site being added to the National Priorities List. • Financial information on the other PRPs. • Information on CCA's change to lead-free mud in its crucibles. • The affidavits from CCA's employees on the discharges into the levee. • Any environmental engineering studies conducted by CCA. The auditor would obtain representations from management concerning its estimate of the likelihood of a materially adverse outcome. This should be included in the management representation letter. d. It is highly unlikely that the investigation would affect the auditor's report. Thus, a standard unqualified audit report would be issued. 17-30 This case presents a realistic situation that can arise on an audit engagement. The main issue of the case is whether the auditor needs to require the client to make adjustments to the financial statements for possible misstatements that have been identified during the audit. These proposed adjustments can result in conflicts between the auditor and client. a. The issue is the possible obsolescence of the specialized computer components for the special-order optical scanner. The auditors identified these components as possible obsolete items in the prior year. The client explained that the items could be sold without a loss. The components were not sold during the prior year or in the year just ended, and there appear to be no prospects of a future sale. Based on these facts, the auditor should insist that the components be written down to their fair market value, which appears to be zero. b. In the prior year, the auditors waived the adjustment of $20,000 for accrued vacation pay based on materiality considerations. By the end of the next year, the amount of accrued vacation pay amounted to $300,000. Since GAAP requires accrual of such expense and the amount is material, the auditor should insist on accruing the executives' vacation pay. c. It is difficult to provide detailed guidance on how Schmidt should handle the client's demands. Schmidt should try to explain to Adams that GAAP requires that such adjustments are required in order for the financial statements to present fairly. She should also point out that shareholders might react very negatively if they were to discover that management was manipulating earnings from period to period in order to maintain the stock's price. The potential for stockholders' lawsuits could increase significantly. Regardless, if Schmidt believes that both adjustments are necessary, she must require the client to make the adjustments or resign from the engagement. 17-31 a. Your partner would not require WWM to record the adjustment since the total for the three-year period ($7,500 + $5,000 + $75,000 = $87,500) is less than materiality of $100,000 for the current year. b. With prior years’ items of $22,500 and $15,000, the total ($112,500) would be greater than materiality for the current year, so an adjustment would be required. (Note: We have ignored the effect of depreciation in this example.) c. The adjustment would have to be large enough to reduce the unadjusted amount to less than $100,000. Therefore, the auditor would require WWM to adjust its financial statements by at least $12,500. Solutions to Internet Assignments 17-32 a. Students can find any of a number of reported contingencies—this is a common type of disclosure. The identified contingency will be disclosed in the financial statements if it is a Type II contingency, or if it is a Type I contingency but the amount is not reasonably estimable. b. Examples of procedures that may help the auditor identify contingent liabilities include • Reading the minutes of meetings of the board of directors, committees of the board, and stockholders. • Reviewing contracts, loan agreements, leases, and correspondence from government agencies. • Reviewing tax returns, IRS reports, and schedules supporting the client’s income tax liability. • Confirming or otherwise documenting guarantees and letters of credit obtained from financial institutions or other lending agencies. • Inspecting other documents for possible guarantees or other similar arrangements. In addition, near the completion of the engagement the auditor conducts specific audit procedures to identify contingent liabilities. Such procedures include: • Inquiry of management regarding the client’s policies and procedures for identifying, evaluating, and accounting for contingent liabilities. • Examining documents in the entity’s records such as correspondence and invoices from attorneys for pending or threatened lawsuits. • Obtaining a legal letter that describes and evaluates any litigation, claims, or assessments. • Obtaining written representation from management that all litigation, asserted and unasserted claims, and assessments have been disclosed in accordance with FASB ASC Topic 450, “Contingencies.” 17-33 The SEC’s EDGAR database search engine is a good source for finding situations where the auditor has withdrawn an audit report on a company (www.sec.gov). Students will also find information on news sites (e.g., The Dow Jones Interactive website). Chapter 18 Reports on Audited Financial Statements Answers to Review Questions 18-1 An auditor is associated with financial statements when he or she has consented to the use of his or her firm’s name in a document such as an annual report. 18-2 Accounting changes can be categorized into changes that affect consistency and those that do not affect consistency. The word “consistency” refers to the application of accounting principles. If a change in accounting principle or in the method of its application has a material effect on the comparability and consistency of the financial statements and the auditor concurs with the change, the auditor should refer to the change in an explanatory or emphasis-of-matter paragraph. Accounting changes that affect comparability but do not affect consistency, such as a change in an estimate or the correction of an error that does not involve a change in accounting principle, are normally disclosed in the footnotes to the financial statements but do not require an explanatory or emphasis-of-matter paragraph in the auditor's report. An accounting change can affect comparability but not consistency because an accounting principle can be consistently applied even when the underlying data used to apply it may change. For example, when the estimate of the useful life of a building changes, the company may still consistently apply straight-line depreciation, but the depreciation expense will not be comparable to that of the previous year due to the change in estimate. 18-3 An example of a client-imposed scope limitation is where a client requests that the auditor not confirm accounts receivable because of concerns about creating conflicts with customers. An example of a circumstances-imposed scope limitation is when the auditor is not engaged to conduct the audit until after year-end. Under such circumstances, the auditor may not be able to observe inventory. Auditors should be particularly cautious when a client places a limit on the scope of the engagement because the client may be trying to prevent the auditor from discovering material misstatements. Auditing standards suggest that when restrictions imposed by the client significantly limit the scope of the engagement, the auditor should disclaim an opinion on the financial statements. 18-4 The concept of materiality plays a major role in the auditor's choice of audit reports. If the departure from GAAP is immaterial, the auditor issues an unqualified/unmodified opinion. If the departure from GAAP is material but not pervasive, the auditor issues a qualified (“except for”) opinion. If the departure is so pervasive that its effects are highly material, the auditor issues an adverse opinion. For example, suppose that a client accounts for leased assets as operating leases when proper accounting requires that the leases be capitalized. If a client has only one small piece of equipment that is accounted for inappropriately, the auditor will probably issue an unqualified/unmodified opinion because the item is not material. However, if the client has many significant leased assets that are accounted for as operating leases instead of capitalized leases, the auditor will normally issue a qualified or adverse opinion, depending on the magnitude of the problem. 18-5 The auditor should issue an unmodified report on the 2017 financial statements and a qualified report on the 2018 financial statements because the current year is not in conformity with GAAP. The non-GAAP accounting for the lease transaction should be disclosed in the audit report. The opinion on the 2018 financial statements would not be adverse because, while the misstatement is material, it is not pervasive. 18-6 The auditor has no responsibility beyond the financial information contained in the report, and he or she has no obligation to perform any audit procedures to corroborate the other information. However, auditing standards (AU-C 720) requires that the auditor read the other information and consider whether such information is consistent with the information contained in the audited financial statements. 18-7 If the auditor determines that other information contained with audited financial statements is incorrect, the auditor should request that the client correct the other information. If the other information is not revised, the auditor should include an explanatory (or other-matter) paragraph in the audit report, withhold the report, or withdraw from the engagement. The auditor also should communicate the material inconsistency to the client and the audit committee in writing and consider getting legal advice as to any further appropriate action. 18-8 Examples of special reports include reports on • Financial statements prepared on a basis of accounting other than GAAP (e.g. The cash basis of accounting) • Specified elements, accounts, or items of a financial statement. • Compliance with aspects of contractual agreements or regulatory requirements related to audited financial statements. (In addition to these, there are others that are beyond the scope of this book, such as financial presentations to comply with contractual agreements or regulatory provisions, and financial information presented in prescribed forms or schedules that require a prescribed form of auditor's report.) 18-9 Four bases for special purpose financial statements are • Regulatory basis. • Tax basis. • Cash (or modified cash) basis. • Contractual basis. It is important that the financial statements and the audit report clearly identify which basis of accounting is being used so that the financial statements are not confused with financial statements prepared on a GAAP basis. Answers to Multiple-Choice Questions 18-10 b 18-16 c 18-11 c 18-17 b 18-12 a 18-18 b 18-13 a 18-19 b 18-14 a 18-20 c 18-15 c 18-21 c Solutions to Problems 18-22 a. The auditor would issue an unqualified audit report with modified wording for the reliance on the other auditors. In this case, the principal auditor does not intend to take responsibility for the other auditor's work. b. The auditor should issue a qualified audit report because management has not complied with GAAP. The auditor is not required to prepare the statement of cash flows for disclosure in the audit report. c. This approach is not in accordance with GAAP because such contingencies must be disclosed in the notes to the financial statements if the amount of the contingency can be reasonably estimated and the loss is probable. A departure from GAAP such as this one requires either a qualified or an adverse opinion, depending on the materiality of the item in question. In this case the potential settlement is likely to be very large given the proportions of the tragedy in terms of human loss and suffering. In addition, the tragedy may well threaten the company’s ability to be involved in similar projects in the future and perhaps its own survival. Thus, an adverse opinion is very likely the most appropriate response. d. Because the client wouldn’t allow the confirmations to be sent, the appropriate response would generally be either a qualified opinion or a disclaimer of opinion for a scope limitation imposed by the client’s management, depending on the materiality of accounts receivable. However, even if accounts receivable isn’t highly material, if the auditor suspects fraud by upper management, the scope limitation would merit a disclaimer. e. Since the auditor is satisfied about the inventory balance using alternative audit procedures, a standard unqualified audit report can be issued. The alternative audit procedures would normally include a physical count subsequent to year end and reconciliation to the balance at the end of the reporting period. f. Since the client fails to disclose the related-party transaction, the auditor should issue a qualified or adverse audit report depending on the materiality of the matter. The client’s failure to disclose the related parties means that the financial statements do not comply with GAAP. g. Recall that the instructions to the problem indicate the assumption that all matters listed are at least material. Since the change in accounting principle is properly accounted for, the auditor should issue an unqualified audit report with an explanatory paragraph for a lack of consistency in the application of GAAP. 18-23 a. The auditor should issue a standard unmodified audit report. It is acceptable for an entity to use different inventory methods in different international regions. Many countries do not allow LIFO, and it can be costly for the entity to maintain inventory records using both valuation methods. b. The auditor should issue a standard unmodified audit report. As long as this uncertainty is properly disclosed or accounted for in accordance with GAAP, the auditor need not modify the audit report. In this case, a negative outcome for this uncertainty appears to be remote. Therefore, the client is not required to disclose the uncertainty in the financial statements. c. This is a correction of an error in principle because the use of replacement cost to value inventory is not in accordance with GAAP. The auditor should modify the standard unmodified report by adding an emphasis-of-matter paragraph describing the change from replacement cost to FIFO for valuing inventory. d. This is a change in accounting estimate. Such a change does not affect consistency in the application of accounting principles, and the auditor should thus issue a standard unmodified audit report. e. The auditor should issue a standard unmodified audit report because the client corrected the mistake before issuing the financial statements. f. The CPA is not independent of the company but the how the lack of independence should be handled depends on whether Rothenburg is a public company. Under PCAOB standards the auditor should issue a disclaimer for a lack of independence, and the auditor is not allowed to disclose the reasons for the auditor’s lack of independence. Under ASB standards (for non-public entities), the auditor will not issue a report unless required to do so by law or regulation, but similar to PCAOB standards, if issued, the report should disclaim an opinion due to lack of independence. However, under ASB standards, the auditor may choose to disclose the reasons for the lack of independence, but if the auditor so chooses, all relevant reasons for the lack of independence must be included. g. If the client refuses to make the adjustment to the loan-loss reserve, the auditor should issue a qualified or adverse opinion because the financial statements will not be in accordance with GAAP. The auditor may also have substantial doubt about the entity’s ability to continue as a going concern, which could result in the addition of an emphasis-of-matter paragraph to the audit opinion to disclose the going concern issues. If the auditor concludes that there is a going concern problem and the client refuses to disclose the issue in the notes to the financial statements, the auditor’s opinion will be adverse. 18-24 1. May & Marty needs to satisfy itself about the independence and professional reputation of Dey & Dee and assure itself that there has been coordination of activities between the two auditors in order to achieve a proper review of matters affecting consolidation. Whether or not it makes reference to Dey & Dee's examination, May & Marty should consider performing the following procedures: • Make inquiries about the professional reputation and standing of Dey & Dee to one or more of the following: • AICPA, applicable state society of CPAs, and/or local chapter. • Other sources such as other practitioners, bankers, or other credit grantors. • Obtain a representation from Dey & Dee that it is independent under the requirements of the AICPA and, if appropriate, the requirements of the SEC. • Ascertain through communication with Dey & Dee that • Dey & Dee is aware that the BGI-Western financial statements are to be included in the BGI consolidated financial statements on which May & Marty will report, and that Dey & Dee's report will be relied upon by May & Marty. • Dey & Dee is familiar with GAAP and GAAS and conducted its examination in accordance therewith. • Dey & Dee has knowledge of the relevant financial reporting requirements for statements and schedules to be filed with regulatory agencies, such as the SEC. • A review will be made of matters affecting elimination of intercompany transactions and accounts, as well as the uniformity of accounting practices among components included in the financial statements. 2. May & Marty could adopt the position of not making reference to Dey & Dee's examination of BGI-Western if May & Marty is able to satisfy itself about the independence and professional reputation of Dey & Dee and takes steps it considers appropriate to satisfy itself as to Dey & Dee's examination of BGI-Western. Ordinarily, May & Marty would be able to adopt the position of not making reference to Dey & Dee's examination when any one of the following conditions exists: • Dey & Dee is an associate or correspondent firm and its work is acceptable to May & Marty based on May & Marty's knowledge of the professional standards and competence of Dey & Dee; or • Dey & Dee is retained by May & Marty and the work is performed under May & Marty's guidance and control; or • May & Marty takes steps it considers necessary to satisfy itself as to Dey & Dee's examination. Such steps may include a visit to Dey & Dee to discuss Dey & Dee's audit procedures or a review of Dey & Dee's audit program and/or working papers. In addition, May & Marty is satisfied about the reasonableness of the statements of BGI-Western for purposes of inclusion in BGI's consolidated financial statements; or BGI-Western's financial statements are not a material part of BGI's consolidated financial statements. 18-25 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Shareholders and Board of Directors of Devon Incorporated Opinion on the Financial Statements We have audited the consolidated balance sheet of Devon Incorporated as of December 31, 2018, and the related consolidated statement of operations, stockholders' equity, and cash flows for the period ended December 31, 2018. In our opinion, except for the effects of not capitalizing finance-lease obligations, and except for not disclosing the change in inventory methods as discussed in the preceding paragraphs, the financial statements referred to above present fairly, in all material respects, the financial position of Devon Incorporated as of December 31, 2018, and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Devon Incorporated’s internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 28, 2019 expressed an unqualified opinion that Devon Incorporated maintained, in all material respects, effective internal control over financial reporting. Basis for Opinion These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. The financial statements of Devon Incorporated for the year ended December 31, 2017, were audited by other auditors, whose report dated March 30, 2018, expressed an unqualified opinion on those statements. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. An audit includes performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matters The critical audit matters communicated below are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements and (2) involved especially challenging, subjective, or complex audit judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which it relates. Critical Audit Matters Auditor Response Inventory Valuation The Company is heavily involved in inventory sales, leading any changes to the inventory account to warrant detailed review from us and the audit committee. During the year, Devon changed its method of valuing inventory from the first-in, first-out method to the last-in, first-out method. This change was made because management believes LIFO more clearly reflects net income by providing a closer matching of current costs and current revenues. Our focus was to validate that the change helped current revenues match current costs, as stated from management’s assertion. As seen in Devon’s financial statements, the Company’s inventory account is material and it is the primary asset that it uses to generate revenue. We conducted detailed end-to-end walkthroughs of the inventory processes, utilizing Company conducted inventory counts and our own inventory counts to verify that recorded amounts are appropriate. We then conducted testing of inventory values by use of market rates to determine the reasonableness of differences between last-in inventory values and first-in values. In response to the changes in the method of valuing inventory made during the year, we also performed the following: • reviewed the design of the new method to ensure that inventory amounts and prices are properly recorded and will be correctly utilized in valuations going forward • verified with other industry competitors that a similar method of valuing inventory using LIFO is appropriate. Finance – Lease Obligations The Company is involved in a wide-range of leasing agreements with outside parties. Current leasing standards, according to generally accepted accounting principles, require finance-lease obligations to be capitalized. Our focus was to understand why certain finance-lease obligations were not capitalized and how they should properly be treated. The balance sheet accounts relating to property and debt were impacted as they did not include these finance-lease obligations We confirmed with outside party regarding the amounts and terms of the various finance-lease agreements that the Company was engaged in. The use of positive confirmations allowed for high assurance of the amounts in question and the true structure of the agreements. Based on observations and interviews conducted with key accounting personal over these leasing agreements, we gathered evidence regarding the current treatment financing-leases are given. that should have been capitalized. No disclosure had been made concerning these amounts. Rao Rao, CPA We have served as the Company’s auditor since 2018. February 28, 2019 18-26 INDEPENDENT AUDITOR’S REPORT We have audited the accompanying statements of assets, liabilities, and fund balances arising from modified cash transactions of Modern Museum, Inc., as of December 31, 2018 and 2017, and the related statements of support, revenue, and expenses and changes in fund balances--modified cash basis and changes in financial resources--modified cash basis for the years then ended. Management’s Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with accounting principles generally accepted in the United States of America; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of consolidated financial statements that are free from material misstatement, whether due to fraud or error. Auditor’s Responsibility Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditor’s judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity’s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. Opinion In our opinion, the financial statements referred to above present fairly, in all material respects, the assets, liabilities, and fund balances arising from modified cash transactions of Modern Museum, Inc., as of December 31, 2018 and 2017, and its support, revenue, and expenses and the changes in its fund balances and changes in financial resources for the years then ended, on the basis of accounting described in Note X. Basis of Accounting We draw attention to Note X of the financial statements, which describes the basis of accounting. The financial statements are prepared on the basis of modified cash receipts and disbursements, which is a basis of accounting other than accounting principles generally accepted in the United States of America. Our opinion is not modified with respect to this matter. Kristen & Valentine, CPAs March 12, 2019 18-27 Report of Independent Registered Public Accounting Firm To the Shareholders and Board of Directors of Kim Company: Opinion on the Financial Statements We have audited the accompanying balance sheets of Kim Company as of December 31, 2018 and 2017, and the related statements of income, retained earnings, and cash flows for the years then ended. In our opinion, the balance sheets of Kim Company as of December 31, 2018 and 2017, and the related statements of income, retained earnings, and cash flows for the year ended December 31, 2018, present fairly, in all material respects, the financial position of Kim Company as of December 31, 2018 and 2017, and the results of its operations and its cash flows for the year ended December 31, 2018, in conformity with accounting principles generally accepted in the United States of America. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Kim Company’s internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 12, 2019 expressed an unqualified opinion that Kim Company maintained, in all material respects, effective internal control over financial reporting. Basis for Opinion These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. Except as explained in the following paragraph, we conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform our audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. An audit includes performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. We did not observe the taking of the physical inventory as of December 31, 2016, since that date was prior to our appointment as auditors for the Company, and we were unable to satisfy ourselves regarding inventory quantities by means of other auditing procedures. Inventory amounts as of December 31, 2016, enter into the determination of net income and cash flows for the year ended December 31, 2017. Because of the matter discussed in the preceding paragraph, the scope of our work was not sufficient to enable us to express, and we do not express, an opinion on the results of operations and cash flows for the year ended December 31, 2017. Critical Audit Matters (No critical audit matters were noted in the problem; however, at a minimum the noted issue with the auditor not taking physical inventory would likely be noted as a critical audit matter. Since this issue is referred to above, this critical audit matter could be cited by reference to the above description). Friday & Co. Friday & Co., CPAs We have served as the Company’s auditor since 2017. March 12, 2019 18-28 The auditors' report contains the following deficiencies: The report should be divided by the main categories: • Opinion on the Financial Statements • Basis of Opinion • Critical Audit Matters Report title & Address: • "Independent" is omitted from the title of the auditors' report. • Report should be addressed to the shareholders and board of directors. Opinion on Financial Statements paragraph: • The opinion paragraph references owners’ equity while the opening paragraph references the statement of “capital.” Basis of Opinion paragraph: • The auditor’s responsibility to express an opinion on the financial statements is omitted. • There is no mention that the auditor considers internal control in making risk assessments and in designing appropriate audit procedures. • Reference to assessing “significant estimates made by management” is omitted. Critical Audit Matters paragraph: • No deficiencies Signature: • CPA firm’s name must be signed • Must disclose the number of years that the firm has served as the client’s auditor. Solution to Discussion Case 18-29 a. PCAOB AS 2415 provides guidance to the auditor for evaluating an entity's ability to continue as a going concern. This auditing standard states specifically that the auditor has a responsibility to evaluate whether the entity will be able "to continue as a going concern for a reasonable period of time," which is defined in that paragraph as "not to exceed one year beyond the date of the financial statements being audited." The standard provides that in the process of the audit, the auditor has to consider whether certain conditions and events that have been identified might indicate that there is substantial doubt about the entity's ability to continue as a going concern (see Ch. 17). It states further that the conditions and events "depend on the circumstances," which may not be significant in and of themselves but may be significant in combination with other conditions and events, such as the following: • Negative trends. • Other indications of possible financial difficulties. • Internal matters. • External matters that have occurred. Once conditions or events that may indicate a going-concern problem have been identified, the auditor should consider how management plans to overcome the adverse effects of the conditions and events. The auditor should consider the following: • Plans to dispose of assets. • Plans to borrow money or restructure debt. • Plans to reduce or delay expenditures. • Plans to increase ownership equity. b. In this case, the situation is somewhat different, because the auditor knows that for the year ended March 31, 2018, the previous auditor had determined that there was substantial doubt about Paper Packaging's ability to continue as a going concern and consequently the auditor's report included an explanatory paragraph discussing a going- concern uncertainty. That report identified the conditions and events, which resulted in those conclusions. PCAOB AS 2415.16 states that “if substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time existed at the date of prior period financial statements that are presented on a comparative basis, and that doubt has been removed in the current period, the explanatory paragraph included in the auditor's report (following the opinion paragraph) on the financial statements of the prior period should not be repeated.” (Emphasis added.) It appears, then, that the burden of proof has shifted. The auditor needs to evaluate whether the conditions and events that caused the auditor to modify the report for a going-concern uncertainty continue to exist or whether the auditor can be satisfied that there has been sufficient improvement in Paper Packaging's financial condition that there is no longer a substantial doubt about the company's ability to continue as a going concern. c. In making the determination of whether to modify the report, the auditor must consider how successful management has been in overcoming the conditions that existed at March 31, 2018. In this case, the following positive events have occurred since the March 31, 2018, year-end: • The company has renegotiated its 2014 credit agreement. That agreement has a ten- year term, requires no repayment of principal during the first two years, and provides for 8 percent annual interest for the term of the agreement. • The arbitration proceedings were resolved in 2019. • The company settled all outstanding legal actions in 2018. • Most of the company's tax issues have been resolved, and, according to the company’s outside legal counsel, those still pending are expected to result in a net cash inflow to the company. • The company is negotiating with the remainder of the holders of the debentures that had been due in 2018 in an attempt to settle the matter in an orderly manner. Although most of the adverse conditions that existed at the 2018 year-end have been resolved favorably, at March 31, 2019, the company is still in default on $4.6 million of the 2018 debentures. Further, the company’s loss exceeds the amount allowed on its renegotiated credit agreement, putting the company in technical default even with respect to the revised covenants. These facts alone may well be sufficient grounds for including a going concern modification in the report on the March 31, 2019, financial statements. Paper Packaging’s management may argue that the company had a cash balance of $5.5 million at year-end and expects to generate net cash flow of $3.2 million in the upcoming year. Further, Paper Packaging expects its 2020 earnings before income taxes and extraordinary items to be $1.5 million. However, the data presented raises questions about whether the company’s budgeting process is reliable (see past budget- to-actual data). In the end, whether or not to include a going-concern paragraph in the auditor’s report (and to require the company to include relevant disclosures to the financial statements) is a difficult and often contentious judgment. While there is often no clear “right answer,” the facts in this case would indicate a strong presumption toward concluding that there is substantial doubt about the company’s ability to continue as a going concern. Solution Manual for Auditing and Assurance Services: A Systematic Approach William F. Messier, Steven M. Glover, Douglas F. Prawitt 9781260687637, 9780077732509, 9780077732509, 9781259162312
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