CH-15-18 Completing the Audit – Auditing: An International Approach : Book Guide

This Document Contains Chapters 15 to 18 CHAPTER 15 Completing the Audit SOLUTIONS FOR REVIEW CHECKPOINTS 15-1 Revenue and Expense Accounts Lease revenue Lease revenue Fixed assets and receivables Franchise revenue Receivables and intangibles Royalty and license revenue Receivables and investments Repair and maintenance Fixed assets and liabilities Interest expense Liabilities 15-2 Many of the revenue and expense accounts are not material in relation to the financial statements and may be combined with other accounts in the financial statements. These accounts can be audited through analytical procedures. Such procedures compare the account balance to related balance sheet accounts, to sales, to industry averages or to a multiple-year trend to ascertain whether any unusual fluctuations are present. Unusual or unexpected items would have to be investigated and material items vouched to supporting documents. 15-3 These procedures can be used to obtain information about the material accuracy of balances in minor expense accounts: * Analytical comparison of current balances to two or more prior years' balances, looking for unusual fluctuations or lack of change when other information indicates change should have occurred. * Vouching supporting documents for expense entries to obtain detail evidence about existence/occurrence, valuation, and classification. * Documents vouched in connection with detail test of controls procedures, if any, performed in the acquisition and expenditure cycle test of controls work. 15-4 "Unusual revenue transactions" can cause significant audit evidence and reporting problems when such transactions are designed by management to create inappropriate earnings. These transactions pose a combination of: evidence-gathering problems, auditor responsibility for detecting errors and irregularities, and reporting- disclosure problems. 15-5 The results of the overall analytical procedures help the auditor incorporate all they learned in the course of the collecting the audit evidence to form the final conclusions on fair presentation of the financial statements. The final analysis procedures can be similar to those for risk assessment; for example, comparing financial and nonfinancial data and examining ratios and trends that may indicate unexpected relationships. However, by performing this analysis at a late stage in the audit, the auditors have the benefit of considerable knowledge about the auditee’s business. The audit findings give the auditor a better basis to form expectations about the financial statement relationships, increasing the their chances of noticing something out of line. The final analysis can be sharper and more focused on finding potential misstatements than the preliminary risk assessment was. The final analysis differs from analysis used to obtain substantive evidence by being directed at the financial statements overall rather than targeted at specific assertions for accounts or transactions. 15-6 The verification of the cash flow statement is primarily by analysis. Because it explains the major changes in balance sheet accounts and provides a bridge between the balance sheet and the income statement (when the indirect method is used) the information in the cash flow statement should tie into audits of other balances; for example, cash flows for both additions to and proceeds of disposal of fixed assets should tie in to information in the audit working papers on fixed assets, and changes in long-term debt or share capital should tie in to the financing cash flows reported, and reconciling items between net income and cash from operations should tie in to income statement information. 15-7 This statement in a letter from auditee's lawyer is permissible (the lawyer is not refusing to cooperate) from the auditor's viewpoint. However, it will not affect the auditor's opinion directly since there is no indication of the character of the lawyer’s response with respect to litigation for which she or he is legal counsel. 15-8 In addition to the letter, other procedures that are used to gather evidence regarding contingencies include: * Standard bank confirmation, in particular any guarantees made by the company on debts of others. * Inquiry of auditee management. * Reading of the minutes of the board of directors. * Vouching to purchase and sales contracts. * Vouching to lease agreements, confirmation with lessor or lessee. * Vouching to debt agreements, confirmation with lender. 15-9 Companies and auditors might experience difficulty making appropriate disclosures about litigation contingencies for these reasons: * High level of emotion surrounding the lawsuits. * Fear that financial statement disclosure will be construed as an admission of guilt. * The legal framework for evaluating litigation outcomes varies significantly from the framework used by auditors. * More visible channels exist for disclosure of litigation information (e.g., business press). 15-10 There are two types of subsequent events: 1. The first type consists of those events that provide additional evidence with respect to conditions that existed at or prior to the balance-sheet date and affect the estimates and balances inherent in the process of preparing financial statements. The use of the evidence requires an adjustment to the financial statements. 2. The second type consists of those events that provide evidence with respect to conditions that did not exist at the date of the balance sheet being reported on but arose subsequent to that date. These events should not result in an adjustment of the financial statements. However, disclosure may be required to prevent the financial statement from being misleading. In some cases, pro forma financial statements may be required to ensure adequate disclosure. 15-11 If stock dividends or splits occur in the subsequent period, they are given retroactive recognition. That is, the financial statements are adjusted. Retroactive recognition is given since, by the time the statements reach users, the stock dividend or split may have been affected, and to report financial data as if it had not occurred might be considered misleading. 15-12 The primary purpose of the management representation letter is to elicit acknowledgment from management in writing of its ultimate responsibility for the adequacy of the financial statements and related disclosures. It also confirms management’s assertion that uncorrected misstatements will not have material impact on the financial statements. 15-13 With respect to receivables, such letters typically state that all receivables are valid and include proper amounts; also stated is the amount written off in the past year and the current provision for uncollectibles. In connection with inventories, the auditee represents that the dollar amount of inventories reflects physical quantities determined by a count and priced by a stated accounting method. The auditee also represents that provision has been made by the company for all obsolete and damaged inventory. In regard to minutes, the auditee represents that all minutes of meetings of shareholders, directors, and executive committees which have been transmitted to the auditor are complete and authentic records for the period under audit (including the subsequent period). The auditee should state whether any events occurred subsequent to the date of the financial statements that, in the auditee's opinion, require adjustment or disclosure in the statements. 15-14 Written representations and lawyers' letters are obtained near the end of the audit work and dated on or near the audit report date because the auditors are responsible for determining whether important events that occurred after the balance sheet date are properly entered in the accounts or disclosed in the financial statement notes. 15-15 Related party transactions are not at arms-length and so may be transacted at amounts that would not arise in a normal business transaction. This can affect the asset valuation as the ‘cost’ of the transaction is less reliable as an indicator of the asset’s value at the transaction date. 15-16 Review "to do" lists are notes about unfinished or deficient audit work that arise from reviews of the audit working papers. They are used to facilitate completion of outstanding work that is required to complete the audit programs and to document the working paper review process. A good reason for keeping the "to do list" in the audit working paper files is to show evidence of careful review and completion of the audit. 15-17 In an engagement quality review," a second partner not otherwise associated with an engagement will take the report (in draft copy) and all working papers and review the entire engagement with a fresh view. The purpose of the review is to obtain the unbiased view of a professional expert who is not committed to a particular engagement or its problems. It is performed to aid in maintaining high standards of professional practice by ensuring the quality control standards of the firm are followed. The engagement quality review is required for audits of publicly listed entities and in this case must be performed before dating the audit report. Audit firms may also have policies to perform engagement quality reviews on other audits, such as large or high profile entities. 15-18 The existence of the "unbilled contract revenue" asset account in the general ledger should raise a red flag. Such an account means that management has recognized an estimated revenue amount that has not yet been billed to the customer in accordance with contract terms. Even though the revenue is "unbilled," the related cost of goods sold should still be in the cost of goods sold account. While accounting theory and practice permit recognizing unbilled revenue in certain cases (e.g. percentage of completion for construction contracts), the accounting has been known to harbor abuses in some cases. Specific audit procedures such as enquiry, analysis, and confirmation should be used to get evidence that the revenues exist and that the amount the company has recognized is appropriate under its stated revenue recognition policy. 15-19 Auditors should always select the auditee's adjusting journal entries for detailed audit because experience has shown that nonstandard adjusting journal entries are the source of accounting errors and frauds more often than are standard repetitive accounting for systematic transactions. This phenomenon makes the population of adjusting journal entries an area of high risk of material misstatement, calling for thorough control and substantive testing (100%). SOLUTIONS FOR EXERCISES AND PROBLEMS EP15-1 Management written representation letter a. 1. The primary responsibility for the correctness of statements lies with management; written representations emphasize this point. 2. A letter reduces to and confirms in writing information which is asked of management. It will prevent misunderstanding between management and the auditor and remind management that all appropriate information should be revealed to the auditor. 3. The letter provides evidence for review or subsequent use that the auditor has made the proper enquiries concerning matters which may not be readily disclosed in the accounting records. 4. Some items as to which the representations are sought are not readily observable or found in the records of the firm but their existence would materially affect the fairness and accuracy of the financial reports. 5. For an initial audit, such representations prove valuable in establishing a starting point in building a permanent file. b. Written management representations do not in any way relieve the auditor of following standard audit procedures or reduce his or her responsibilities when expressing an opinion on the auditee's statements. EP15-2 Engagement and management representation letters a. 1. The objectives of the engagement letter are to: a. Make sure that the PA and the auditee are in agreement about the nature of the engagement. b. Inform the auditee about the scope of the PA's work and what may be expected to result. c. Provide a written record of the responsibilities assumed by the PA and those retained by the auditee. (This understanding protects both the PA and the auditee.) 2. The PA usually prepares the engagement letter as a follow-up to a verbal understanding reached with the auditee. It is required that the auditee sign and return a copy of the engagement letter to the PA. It also is acceptable for the auditee to prepare its own letter summarizing an understanding of the nature of the engagement. 3. The engagement letter should be sent at the beginning of the engagement so that misunderstandings, if any, can be remedied. 4. Obviously, the engagement letter will be most useful in clarifying misunderstandings on a first engagement. For recurring audits of financial statements, it is required to prepare an engagement letter at the start of each examination. Auditee personnel or the nature of the engagement may change, and the resubmission of the letter gives both parties an opportunity to review the circumstances and update the terms of the engagement when needed. For other continuing engagements, the engagement letter also should be updated periodically--probably on a yearly basis. b. 1. The objectives of the auditee management’s representation letter are to: confirm oral representations given to the auditors, indicate and document the appropriateness of such representations, and reduce the possibility of misunderstandings. 2. The auditee's representation letter should be prepared by the auditors (to ensure all items are included) and signed by members of management whom the auditors believe are responsible for and knowledgeable about matters covered by the representations. Normally, the chief executive officer and chief financial officer should sign. 3. The auditee's representation letter should be obtained at the end of the audit work and should be dated as of the date of the auditors' report (the date of the end of field work). 4. The auditee's representation letter should be prepared for each examination as the representations apply to one period's financial statements. The items that need representation will change from one period or another, as will the people who should sign the letter. c. 1. The PAs should obtain an engagement letter when performing accounting services involving unaudited financial statements, such as in a compilation or review engagement (Chapter 16). The engagement letter is probably more important in unaudited engagements than in audited engagements because there is more likelihood of misunderstanding. The engagement letter should include: a description of the nature and limitations of the services to be performed, a description of the report, a statement that the engagement cannot be relied upon to disclose errors, irregularities or illegal acts, and that the PAs will inform the auditee of any matters than come to their attention. 2. The PAs are required to obtain a management representation letter when performing review engagements by CICA 8200.25. EP15-3 Subsequent events and contingent liabilities a. 1. A subsequent event is an event or transaction that occurs subsequent to the balance sheet date but prior to the issuance of the financial statements and auditor's report that has a material effect on the financial statements and therefore requires adjustment or disclosure in the financial statements. 2. The two types of subsequent events are: * Events which affect the financial statements at the balance sheet date--this new information may reveal a heretofore unknown condition or provide clarity regarding some of the estimates inherent to the accounting process. These events must be reported by adjusting the financial statements to recognize the new evidence. * Events that relate to occurrences that arose subsequent to the balance sheet date--these events do not result in adjustment to the financial statement; however, the effect of the event on the future period may be such that note disclosure is advisable. Proper disclosure requires that the statement reader be informed that the conditions reported in the balance sheet cannot be extended into the future. b. 1. A contingent liability is an existing condition or situation, or set of circumstances, that gives rise to a possible obligation of the enterprise, but involving uncertainty as to whether it actually exists. The uncertainty will ultimately be resolved when one or more future events occur or fail to occur. The business enterprise must have already sustained an event which exposed it to a potential loss but all aspects of the event have not yet been concluded. The ultimate effect of the event will not be known with certainty until the occurrence of some future event which will conclude the event and resolve the current contingency. Under IFRS-IAS 37, contingent liabilities are distinguished from ‘provisions’ by the criteria that they are possible (but not probable) present obligations to give up resources in future but the existence of this obligation needs to be confirmed by further future events, or becasue a sufficiently reliable estimate of the amount of the obligation cannot be made. 2. A contingent liability should be disclosed when it is possible that a liability has been incurred but the amount cannot be reasonably estimated. Under IFRS-IAS 37, contingent liabilities are disclosed even if it is not probable that an outflow of economic resources will be required to settle the obligation, but they not recognized as liabilities in the balance sheet. Under the ASPE framework, a contingent loss should be recognized as a liability (i.e., accrued) if information available prior to issuance of the financial statements indicates that it is probable that a liability has been incurred at the date of the financial statements, and the amount of the loss can be reasonably estimated. A possible contingent liability should be disclosed. Under both IFRS and ASPE, where the probability that a possible obligation would require an outflow of resources is remote, no disclosure is required. c. Subsequent events may provide new and important information about known or unknown contingency losses as of the balance sheet date. The subsequent event may very well modify the circumstances surrounding the contingent loss thereby changing the reporting method from no disclosure to note disclosure (or in the case of the ASPE framework, accrual). For example, a contingent loss may have been recorded as a note disclosure because, at the balance sheet date, the company had only a reasonable possibility that a loss may be incurred. A subsequent event occurs which in the accountants' judgment makes it probable that a contingent liability has been incurred. The contingent liability will now have to be accrued in the financial statements (provided an amount can be estimated). EP15-4 Lawyer’s letters a) Mainly completeness of liabilities, contingency disclosure. b) Other evidence for these might come from debt confirmation responses, review of legal and insurance documents and correspondence, and minutes but this would tend to be less direct and explicit than from specific confirmation from the lawyers. Management representations relate to these issues but are not considered sufficient ‘evidence’ for audit purposes. c) Ideally the lawyers’ letter would be dated as close as possible to the date of the auditor’s report to cover any subsequent event that needs to be considered by the auditor. EP15-5 Management representation letters The question refers to the illustration of a management representation letter in Exhibit 15-4. a) The illustrative letter assumes that: • The engagement is an audit of financial statements prepared in accordance with International Financial Reporting Standards (IFRS); • the auditor is required to report on the current year's financial statements and the corresponding figures for the previous year (not comparative financial statements of the previous year - see CAS 710); and • management and the auditor have reached an understanding on the immateriality of uncorrected misstatements for the purposes of the written representations. b) The representations in the example letter that need to be provided regardless of their materiality: 1. Management's belief that the financial statements are presented fairly in accordance with the applicable financial reporting framework, in this case IFRS; 2. Knowledge of any known or probable instances of non-compliance with legislative or regulatory requirements, including financial reporting requirements; (The reason the above representations are included without considering materiality is that these representations are not directly related to items included in the financial statements.) 3. Knowledge of any illegal or possibly illegal acts; 4. Knowledge of fraud or suspected fraud affecting the entity involving management, employees who have significant roles in internal control; or others, where the fraud could have a non-trivial effect on the financial statements 5. Knowledge of any allegations of fraud or suspected fraud affecting the entity's financial statements communicated by employees, former employees, analysts, regulators or others. (The above representations with respect to management or those employees who have significant roles in internal control are included regardless of their materiality because of the possible effects of illegal acts or fraud on other aspects of the audit.) c) If an event subsequent to the date of the balance sheet has been disclosed in the financial statements the fourth point in the illustrative letter is modified as follows: "To the best of our knowledge and belief, except as discussed in [note number] to the financial statements, no events have occurred subsequent to the balance sheet date that require..." d) If management has received a communication regarding an allegation of fraud or suspected fraud, the information may be included in the letter for reference. EP15-6 Procedures for Identifying Contingent Liabilities · Review the prior year’s audit files for any contingent liabilities identified in the prior audit · Examine the client’s legal correspondence files for any undisclosed lawsuits and information · Review amounts recorded as legal expenses to find any undisclosed lawsuits and information · Review the minutes of meetings of shareholders and directors · Review contracts, agreements, leases, and related correspondence for evidence of claims. · Enquire of banks concerning guarantees · Review the status of tax assessments from CRA for unpaid taxes · Confirm with Manufacturing Bank of Canada the existence of and conditions attaching to long-term debt (Source: CGA-Canada AU1 Examination September 2010) EP15-7 a. Business processes, financial statement assertions Items in business processes in Exh 7-13 Financial statements and related items Shares Balance sheet, owners’ equity Debts Balance sheet, long-term liabilities Grants Balance sheet, contributed capital (may also be shown in income, or as a reduction of cost of assets grant was used to acquire) Donations Balance sheet, donated capital Capital Assets Balance sheet, long-term assets Long-term Investments Balance sheet, long-term assets Interest Income statement, expenses Dividends Statement of changes in retained earnings Revenues Generated Income statement, revenues Goods Created and Sold Balance sheet, inventory and Income statement, cost of goods sold Services Created & Sold Income statement, expenses e.g. salaries Operating Income Income statement, subtotal before net income Losses Income statement Statement of changes in retained earnings Retained Earnings Balance sheet, equity Statement of changes in retained earnings Taxes Income statement, deducted from pre-tax income b. The audit file indexing system provided in Appendix 11C would use the following page numbering for the audit planning and evidence documentation for the financial statement items noted in a. Pages 700 – 799 will be used for AUDIT PLANS AND PROCEDURES AND EVIDENCE DOCUMENTATION related to the INCOME STATEMENT, e.g., 705 Revenues — Audit procedures 720 Cost of sales — Audit procedures 730 Payroll and other expenses — Audit procedures Pages numbered A – Z will be used for the ASSETS, including the AUDIT PLANS, PROCEDURES AND EVIDENCE DOCUMENTATION, e.g., A. 100 Cash B. 100 Investments C. 100 Accounts receivable, trade and other D. 100 Inventory E. 100 Loans and advances receivable L. 100 Prepaid expenses and other assets N. 100 Long-term investments U. 100 Property, plant and equipment W. 100 Intangible assets and goodwill Pages numbered AA – ZZ will be used for the LIABILITIES AND EQUITY, including the AUDIT PLANS AND PROCEDURES AND EVIDENCE DOCUMENTATION, e.g., AA. Bank indebtedness BB. Notes payable and bank debt CC. Accounts payable and accrued liabilities FF. Income taxes GG. Loans and advances payable KK. Long-term debt TT. Net assets UU. Equity c. XBRL This could be used as a team project for students interested in web-based technology application in financial reporting. The websites noted provide details of the underlying structure that is used in creating financial data items that are reported in web-accessible formats, which enable data transfer from the website report to a variety of end-user applications and systems. This part illustrates how the XBRL technology can bring financial reporting to a similar level of accessibility as text in the html format, so it can be imported into spreadsheets or other user applications for further analysis. The tagging conventions correspond to the traditional financial statement classifications used in a., with different levels corresponding to the financial statement, as well ad the sub-total and the bottom line total the item falls into. For example, cash is tagged to appear as an item in the balance sheet, and in the current asset subtotal and the total assets balance in that financial statement. Cash would also be coded to appear in the Cash flow statement as the final total of that statement. Tags in XBRL can also used to show items that have been audited or reviewed by an external accountant. The assurance statement can be viewed by users. This is an important development in auditing that will allow assurance to be provided on financial information that companies provide on their website. It is seen as a key step in developing more timely reporting of reliable financial information, such as quarterly reports shortly after the quarter end. The tight timelines for providing this type of assurance will require development of audit approaches that continuously gather evidence supporting the company’s account balances and transactions. Ultimately, in theory these developments in XBRL web-based technology and audit techniques could support real-time online financial reporting some time in the future. SOLUTIONS TO DISCUSSION CASES DC15-1 Management representation letter omissions Other matters the representation letter should specifically confirm include whether: * Management acknowledges responsibility for the fair presentation in the financial statements of financial position, results of operations, and changes in financial position in conformity with generally accepted accounting principles (or other acceptable financial reporting framework). * 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 amounts receivable or payable that may need to be 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, board of directors, and committees of 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 irregularities that could have a material effect on the financial statements or that involve management or employees who have significant roles in the system of internal control. * Provision, when material, has been made to reduce excess or obsolete inventories to their estimated net realizable value. * 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. DC15-2 Subsequent events procedures a. The purpose of this review is to ascertain whether there have been any material transactions or events which have a significant bearing on the audited statements and might require qualification of the auditor's opinion, disclosure by notes, or financial statement adjustments. The postaudit review period the auditor is responsible for disclosure of any material event of which he or she is aware until the date of the audit report, March 12. b. In preparing the audit program, the auditor considers the postaudit review as a continuation of the regular audit and as in a continuing audit engagement, all audit steps may not be necessary. The suggested postaudit program follows: 1. Review all books of original entry for unusual transactions to February 20, the date of the end of field work, with enquiry and follow up on any potentially material matters up to March 12, the date of the audit report. 2. Review the January and February (if available) monthly internal financial statements prepared by the company as follows: a. Compare the balance sheet, income, and retained earnings statements to the general ledger accounts to ascertain that the amounts are in agreement with the books. b. Compare significant balance sheet and income statement amounts with the audited amounts and investigate important variations. c. Compare the results of operations for the month of January and February with the January and February operations in the audited period and investigate any unusual or important variations. 3. Discuss the following matter with company officials: a. Sales and profit trends and significant sales trends in the industry. b. Company operations and market conditions. c. Increases or decreases in the prices of the company's product. d. Increases in basic raw material prices--which may result in decreasing gross profits. e. Decreases in basic raw material prices--which may result in increasing gross profits. f. Major purchase commitments for material or capital additions. g. Subsequent bookings or cancellations of sales orders. h. Corporate taxes--changes in law, assessments, tax department audits, etc. i. Renegotiation proceedings. j. Wage and salary adjustments. k. Pending lawsuits and settlement of same. l. Special dividends. m. Losses of important customers, exceptional bad debt losses, or pledging of receivables. n. Changes in accounting and financial policies. o. New borrowings, issue of shares or other financing, including any new dividend restrictions or important covenants agreed to in connection therewith. p. Purchase or sale of major plant and equipment, fires, explosions, abandonments of plant, etc. q. Strikes and status of wage negotiations in progress. 4. Enquire about meetings and review corporate minutes of directors and shareholders to the date of financial statements approval. 5. Obtain letters from company's legal counsel with respect to developments of any contingent liabilities, together with an opinion as to the outcome of any pending litigation. 6. Secure a representation letter from responsible company officers that there have been no material events or transactions subsequent to the audit date which might have a material effect on the audited financial statements. DC15-3 Subsequent events - cases 1. If the $1.40 price had been used to value the inventory at December 31 on a lower-of-cost-or-market basis, the inventory figure should be adjusted because the actual quotation of $1.40 was a transitory error and no purchases had been made at that price. 2. Report on the action of the new share issue in a note to the balance sheet. Consider presenting a pro forma shareholders' equity section of the balance sheet. 3. Report the fire loss in a note to the balance sheet and refer to it in connection with the income statement, since earning power is presumably affected. Consider the need for pro forma financial statements reflecting the loss of production capacity. 4. Report this change in investment composition in notes to the statements because it changes the character of the assets and operations which are being reported upon and which the reader tends to assume are continuing. Consider presenting a pro forma balance sheet (and detail schedule of investments). 5. Although information of the rebellion is common knowledge, the users of the financial statements may not be aware of the auditee's subsidiary located in the foreign country. The statements should disclose through a note both the location of the subsidiary's operations and the rebellion, particularly if the parent's investment is a significant portion of its total assets, or the total assets or gross revenues of the unconsolidated subsidiary are significant in relation to the consolidated assets or revenues. 6. The case presents various issues that involve using judgment in assessing how accounting policies should be applied. A possible analysis and conclusion is the following. Strictly speaking the revenue recognition criterion set out in Comtois’s accounting policy note has not been met. However, in substance the conditions for revenue recognition may have been met, as long as the delay in signing the contract is only due to the Minister’s time constraints and not business uncertainties. The auditor may be able to get comfort on this from enquiries of Ministry assistants and that may support recognizing revenue. The exception to the policy would need to be disclosed in this case, and consideration could be given to revising the policy if this kind of contract is expected to occur more often in future. 7. One possible analysis and conclusion as follows. The share issue and loan are related party transactions and should be disclosed. The loan forgiveness should also be disclosed as a subsequent event. These are relevant transactions for the company’s other shareholders to be informed of. DC15-4 Subsequent events - cases a. and b. combined 1. The provincial government's approval of a plan for the construction of an express highway would have to come to the PA's attention through enquiries of officers and key personnel, examination of the minutes of the meetings of the board of directors and stockholders, and reading of local newspapers. The details of the item would have to be disclosed as a separate note. 2. It is improbable that the PA would learn the source of the $25,000 unless it were revealed in a discussion with the president or his personal accountant, or unless the auditor prepared the president's personal income tax return, in which case the interest charges might have led to his investigation of the use to which the funds were put. Setting out the loan in the balance sheet as a loan from an officer would be sufficient disclosure. The source of the funds would not be disclosed because it is the officer's personal business and has no effect upon the corporation's financial statements. 3. The additional liability for the ore shipment would have been revealed to the PA in scanning of January transactions. The auditor’s regular examination to transactions and related documents such as purchase contracts would have caused him or her to note the item for subsequent follow-up to determine the final liability. In addition, the auditee's letter of representation might have mentioned the potential liability. The item would not require separate disclosure by footnote or otherwise and would be handled by adjusting the inventory, and accounts payable by the amount of the additional charge, $9,064. ($20,600 x 72/50 = $29,664.) 4. The PA might learn of the agreement to purchase the treasurer's stock ownership through enquiries of management and legal counsel, examination of the minutes of the meetings of the board of directors and shareholders and subsequent reading of the agreement. The absence of the treasurer might also arouse the PA's curiosity. The details of the agreement would be disclosed in a note because the use of company cash for the repurchase of stock and the change in the amount of stock held by shareholders might have a heavy impact on subsequent years' financial statements. Usually, a management change, such as the treasurer's resignation, does not require disclosure in the financial statements. The details underlying the separation (personal disagreements and divorce) would not be disclosed. 5. Through enquiries of management, review of financial statements for January, scanning of transactions, and observations, the PA would learn of the reduced sales and of the strike. Disclosure should be made in the financial statements of these conditions and the facts available at the date of the report. 6. The contract with Mammoth Industries would come to the PA's attention through enquiries of management and legal counsel, reading of the minutes of the meetings of the board of directors and shareholders, and examination of the contract. All important details of the contract should be disclosed in a note because of the great effect upon the corporation's future. The factors contributing to the entry into the contract need not be disclosed in the statements; while they might be of interest to readers, they may be considered as information to be kept private from competitors, and are not essential to make the statements not misleading. DC15-5 Lawyer’s letters a. This would be a scope limitation. The auditor is not being given access to all of the information necessary to audit the client’s financial statements. b. The auditor has to ensure that proper disclosure is made in the notes to the financial statements, not in the audit report. If information provided to the auditor by the second law firm showed that the claim can be a contingent liability, exisitence of contingent liability should be disclosed in the notes to the financial statements. c. Based on the given information, control risk is high. · The controller is not trusted enough to be made aware of an issue as important as a lawsuit for harassment, which must have some effect on the work environment. If the controller is not competent or trustworthy, then the risk of misstatements or fraud is increased. · The information does not explain how purchases up to $15,000 are authorized, but the president has the power to both authorize a payment above $15,000 and to sign the cheque, which is a clear lack of segregation of incompatible duties. · The accounting manager also has incompatible duties, preparing the bank reconciliation and deciding how journal entries are to be recorded. · Having monthly bank reconciliationsis a strength, but this is not strong enough to overcome the weaknesses noted above. Also there could be a concern that the accounting manager can misappropriate funds by altering smaller cheques and then altering the bank reconciliation to conceal this. DC15-6 Subsequent events, proforma disclosures Various subsequent events need to be analyzed and conclusions stated on how they would be treated in the year- end financial statements. A sample set of analyses and conclusions is outlined below. 1. Disclose and provide proformas, significant impact on future operations 2. Disclose, arose after year end and affects 20x2 results 3. Disclose, provide proformas if material to future operations 4. Restate, reflects resolution of an uncertainty that existed at year-end and was not accrued because of this uncertainty 5. Assuming the auditor can establish solid evidence of the impact of the change in market condition on the company’s future operations and sales, disclosure would be required and possibly pro forma presentation of impact if it is estimable. DC15-7 Franchising revenues Various approaches are possible depending on the assumptions made. The franchise fees audit procedures should include developing an understanding of internal controls, including computer controls, assessment of control risks and procedures for all control objectives/assertions, a decision on whether to test and rely on controls, and a complete plan of substantive procedures that cover all the assertions including relevant and efficient analytical procedures. DC15-8 Lawyer's Letter Responses a. The four "responses" were based on AU 337 and its interpretation in section 9337 (US GAAS), and these are used as guidance relevant to answering part a.: Response Audit Interpretation 1. The action involves unique characteristics wherein authoritative legal precedents bearing directly on the plaintiff's claim do not seem to exist. We believe the plaintiff will have serious problems establishing the Omega's liability; nevertheless, if the plaintiff is successful, the damage award may be substantial. Too vague for adequate information. More evidence needed. 2. In our opinion, Omega will be able to defend this action successfully, and if not, the possible liability to Omega in this proceeding is nominal in amount. According to AU 9337, this means "remote likelihood of material loss." 3. We believe the plaintiff's case against Omega is without merit. According to AU 9337, this means "remote likelihood of losing the lawsuit." 4. In our opinion, Omega will be able to assert meritorious defenses and has a reasonable chance of sustaining an adequate defense, with a possible outcome of settling the case for less than the damages claimed. "Meritorious" does not mean "strong" or "adequate." The phrases "reasonable chance," "adequate defense," "less than the damages claimed" all indicate problems. More information needed. b. Plaintiff's counsel would probably assert the merits of the plaintiff's case, suggesting that the auditor's auditee (defendant) will certainly lose large damages. Auditors never obtain lawyers’ confirmations from the other side of a lawsuit. DC15-9 Revenue, audit procedures The question involves audit of revenues using analytical procedures. Recognition of the impact of changing business conditions on Galloways’s reported financial statement numbers, management decisions and management motivations regarding debt covenant constraints and bonuses is required to fully assess the situation. The evidence is analytical in nature. If the analysis results conform to expected results this is persuasive but not conclusive. Analysis from a number of different perspectives and using a variety of independent data sources can build to a conclusive level if all the findings are consistent with each other and the conclusion. Generally, analysis results indicate questions that should be asked and further evidence that should be gathered. When the analysis suggests unexpected situations, further follow up is necessary to gather sufficient evidence. In this case, while higher sales and higher receivables are consistent with an increase in sales dollars, an alternate explanation is that the sales are fictitious and thus so are the receivables and they will not be collected. Confirmation of existence and valuation of recorded receivables will be required to provide sufficiently conclusive evidence in this case. The audit documentation should include relevant lead sheet indicating the work papers where the evidence gathering is documented, the program of planned procedures indicating how they respond to the assessed risk of material misstatement at the assertion level, and using cross-references to the supporting working papers. It should be evident on the lead sheet or a summary of the audit work what the auditor’s conclusion is regarding the fair presentation of the information in the financial statements, and the basis for that conclusion in the audit evidence obtained. This provides a key link between the risk assessed for the account (CAS 315) and the procedures that obtain evidence in response to the risks (CAS 330). Any misstatements discovered in the work should be clearly noted in the documentation, and referenced forward to the summary of accumulated misstatements in the front section of the audit files. DC15-10 Revenues, general journal entries The question provides an exercise in professional skepticism and requires knowledge of the accounting model and record-keeping systems to be applied to creatively analyze the scenario and generate explanations that the auditor should consider following up on. A sample analysis is outlined below. a) Taking all the facts together (use of general journal entries, immaterial amounts, non-cash entries, impact on current working capital ratio and earnings, lack of reasonable explanation or support) these may be fictitious entries designed to avoid an impending debt covenant violation by TCC. Other possible explanations can be generated. b) Analysis of income statement components, cash flows, general ledger account activity, etc. CHAPTER 16 Applying Professional Judgment to Form the Audit Opinion and Issue the Audit Report SOLUTIONS FOR REVIEW CHECKPOINTS 16-1 The overall objectives of an auditor of an organization’s financial statements is • to express an opinion based on reasonable assurance the financial statements are not materially misstated • whether the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework, • e.g. “GAAP” • The auditor should plan and perform an effective audit • to reduce audit risk to an acceptably low level that is consistent with the objective of an audit. • Audit risk is the risk of giving an inappropriate opinion that f/s are fairly stated, when in fact they materially misstated such that they likely are misleading to users • per CAS 200 11. 16-2 Management makes judgments about how to apply accounting policies, developing accounting estimates, and how they will present information in the financial statement and notes disclosures. 16-3 Consultations facilitate full sharing of information among audit team members and an exchange of views that can reduce the potential for people to be biased, to base decisions on incomplete or incorrect data, or to hold to incorrect conclusions. 16-4 Recommended adjustments and note disclosures may be written by the auditors, but the auditee must take primary responsibility for the financial statement numbers and disclosures. The auditor's responsibility is for the audit report and not for the financial statements. 16-5 Uncorrected misstatements are those that are known or estimated by the auditor to exist based on the audit evidence obtained. They exclude misstatement discovered that the auditee management has approved and adjusted in the company’s financial statements. Uncorrected misstatements can be classified into known, likely and possible further categories. Known misstatements are those actually found during the audit, so there is no uncertainty about their existence. The uncorrected misstatements can be compared to the materiality level set for the audit to evaluate whether the financial statements are materially misstated. Likely misstatements are those that probably exist based on audit evidence examined, such as the projected effect of misstatements identified in representative samples, or management accounting estimates or policy choices that the auditor considers unreasonable. Further possible misstatements are those that could possibly exist over and above the sum of identified and likely misstatements because of the fundamental limitations of auditing, such as sampling and non-sampling risks (as discussed in Chapter 10), forecasting uncertainties in accounting estimates, and minimum review accounts (those subjected to minimal verification as they have a very low assessed risk of misstatement). Even though amount of further possible misstatement cannot be precisely quantified, in forming an opinion on whether the financial statements are materially misstated, the auditor must exercise professional judgment in addressing this possibility, particularly when the sum of identified and likely misstatement approaches materiality, or when misstatements appear to be due to general control breakdowns rather than isolated instances. However, it is unlikely that auditees will adjust for amounts estimated by the auditor as likely or further possible misstatements, because these amounts are not substantiated. So this creates a difficult decision for the auditor, since the s/he may believe the level of assurance is not high enough to accept the financial statements. In this situation, a solution may be for management to correct all the uncorrected misstatements so that total of known, likely and possible misstatements is reduced to a more acceptable level at which the auditor will feel it is appropriate to provide a clean opinion. However, if the high possible misstatement level is due to high forecast uncertainty, the auditing standards currently do not support giving a qualified opinion, but do provide for one or more EOM paragraphs to be used to expand the auditor’s communication regarding this problematic situation. 16-6 To form an opinion on whether the financial statements are presented fairly, in all material respects, in accordance with GAAP, the auditor uses professional judgment to: • decide whether the audit team has obtained sufficient appropriate audit evidence that provides reasonable assurance about whether the financial statements as a whole are free from material misstatement due to fraud or error • decide if any uncorrected misstatements are material, either individually or in aggregate. • consider the results of the final overall financial statement analysis to assess whether the overall presentation, structure, and content of the financial statements and notes represent the underlying transactions and events fairly from the perspective of users • decide whether the information presented in the financial statements is relevant, reliable, comparable, and understandable • decide whether the financial statements adequately disclose the significant accounting policies selected and applied so that users can understand the effect of material transactions and events on the information in the financial statements, including whether the terminology used and the titles of financial statements are appropriate and understandable • assess the qualitative aspects of the accounting used, including indicators of possible management bias in selecting accounting policies and making accounting estimates. 16-7 The four types are: 1. general purpose fair presentation 2. general purpose compliance 3. special purpose fair presentation 4. special purpose compliance. IFRS and ASPE are both considered to be fair presentation frameworks since they require management to provide appropriate disclosures to ensure the financial statements are accurate, complete, relevant, relaible and understandable. Most often they would be used in financial statements intended to be general purpose, that is intended for use by a wide, undefined range of users rather than a specifically defined user group. Wide distribution to an undefined user group is another reason that makes fair presentation desirable. 16-8 The following requirements need to be met for a fair presentation framework: (i) The framework acknowledges explicitly or implicitly that, to achieve fair presentation of the financial statements, it may be necessary for management to provide disclosures beyond the specific requirements of the framework (CAS 200, 13.); or (ii) The framework acknowledges explicitly that, in extremely rare circumstances, it may be necessary for management to depart from a specific requirement of the framework to achieve fair presentation of the financial statements (CAS 200. 13.). (iii) CAS 700 (para. 10) specifies that a fair presentation framework (as opposed to a “compliance” framework) “embodies sufficiently broad principles that can serve as a basis for developing and applying accounting policies that are consistent with the underlying requirements of the framework”(CAS 200, A6) (emphasis added). 16-9 The auditor must give a modified opinion in the auditor’s report in accordance with CAS 705 if, based on the audit evidence, the auditor concludes that the financial statements are not free from material misstatement (GAAP departure), or if she/he is unable to obtain sufficient appropriate audit evidence to conclude that the financial statements are free from material misstatement (scope limitation). The four types of modified reports are: Qualified (scope limitation) Disclaimer (pervasive scope limitation) Qualified (GAAP departure) Adverse ( pervasive GAAP departure) When the auditor concludes that the financial statements are presented fairly in all material respects in accordance with GAAP, an unmodified opinion can be expressed. 16-10 Dual dating the audit report is used: (1) To provide a means of inserting important information in the financial statements even when the related event occurred after audit report date, while at the same time (2) to inform users that the auditor takes full responsibility for subsequent events only up to the end of the audit report date and for the specifically identified later event, but does not take responsibility for other events which may have occurred after the audit report date and before the date of the specifically identified subsequent event. 16-11 "Subsequent events" are material events that occur after the balance sheet date but before the audit report date that require disclosure in the financial statements and related notes. Auditors (and management) are responsible for gathering evidence on these subsequent events and evaluating the proposed disclosure. "Subsequent discovery of facts existing at the audit report date" is knowledge gained after the audit report is issued about an event or condition that existed at the audit report date. Auditors have no responsibility to search for these facts (as they do for subsequent events); however, once brought to the auditors' attention, their responsibility is to determine if the financial statements (and thus their report) are misstated and take appropriate action. 16-12 The actions the auditor should take if the auditee consents to disclose the information (which existed at the audit report date and materially impacts the financial statements) is to determine the method and timing of disclosure. The actions the auditor should take if the auditee refuses to make disclosure are: * Notify the auditee that the auditors' report must no longer be associated with the financial statements. * Notify regulatory authorities that the auditors' report should no longer be relied upon. * Notify users known to be relying on the financial statements that the auditors' report should no longer be relied upon. For publicly listed entities, such notification may be to the security market regulators and the stock exchanges. 16-13 Once auditors have reported on audited financial statements, they have no responsibility to carry out a retroactive review of their work. However, post-issuance review may be made in connection with a firm's internal engagement quality control monitoring program, peer review or otherwise, and the omission of an auditing procedure may be discovered. In general, if an omitted procedure is found, the auditors should consult legal counsel and take the following actions: * Assess the importance of the omitted procedure to the present ability to support the previously expressed opinion. * Review the audit files in detail to assess the reasons for the omission and ensure no other omissions occurred * Determine if there are persons currently relying or likely to rely on their report. * If the omitted procedure impairs present ability to support the previously expressed opinion, the omitted procedure should be applied or alternative procedures applied that would provide a satisfactory basis for the opinion. * If, as a result of subsequent application of the omitted procedure or alternative procedures, the auditors become aware of facts that existed at the date of their report, they should refer to professional auditing standards for guidance. * The audit firm should review its policies and procedures to determine how the error occurred and take appropriate remedial action if required. In this case the omitted procedure caused the auditor to fail to discover a material understatement of liabilities. Assuming they had previously provided an unqualified audit opinion on this matter, the new information would make their previous report inappropriate, since the financial statements are materially misstated. The auditor would need to notify the auditee that the financial statements need to be recalled and restated to reflect the additional loan, and a new audit report on them issued. If the auditee refuses to recall and correct the financial statements, the actions required are: * Notify the auditee that the auditors' report must no longer be associated with the financial statements. * Notify regulatory authorities that the auditors' report should no longer be relied upon. * Notify users known to be relying on the financial statements that the auditors' report should no longer be relied upon. For publicly listed entities, such notification may be to the security market regulators and the stock exchanges. 16-14 EOMs refer to information that is presented or disclosed in the financial statements. OMs relate to information which is not included in the financial statements. 16-15 An example where an EOM paragraph would be used with an unmodified audit opinion is when when a material uncertainty regarding the going concern assumption is properly disclosed. 16-16 The auditor to communicate with those charged with governance, usually an audit committee, regarding the significant audit findings and the planned form of audit report. Those charged with governance are responsible for ensuring that the organization is accountable to its stakeholders. The organization’s financial statements are a key component of this accountability obligation, and those charged with governance must take responsibility for them before the auditor is in a position to issue his or her audit report. Important matters that should be communicated to the audit committee by the auditor include the following: 1. auditor responsibility under GAAS 2. planning of the current audit 3. material weaknesses in internal controls 4. illegal acts 5. fraud 6. significant accounting principles and policies selected by management 7. management judgments and accounting estimates 8. misstatements, adjusted and uncorrected 9. other information in annual reports (e.g., narrative information) 10. disagreements with management 11. consultation with other accountants by management 12. significant findings of the audit 13. difficulties encountered in performing the audit (e.g., unreasonable delays in obtaining information from management) 14. effects of new developments in accounting standards, or of legislative or regulatory requirements, on the auditee’s financial reporting 15. use of experts 16- audit and nonaudit services that the auditor is providing to the auditee 17. summary of the audit approach 16-17 Those charged with governance are responsible for ensuring that the organization is accountable to its stakeholders. The organization’s financial statements are a key component of this accountability obligation, and those charged with governance must take responsibility for them before the auditor is in a position to issue his or her audit report. The findings of the audit are an important factor to consider for those changed with governance in deciding whether the financial statements are acceptable to approve. 16-18 The auditor would communicate all non-trivial control deficiencies noted in the audit to management at an appropriate level of responsibility. This communication is often referred to as a “management letter” or “internal control letter.” A control deficiency exists when a necessary control is either missing or is designed, implemented or operated in such a way that it is unable to prevent, or detect and correct, misstatements in the financial statements on a timely basis. Any significant deficiency or combination of deficiencies in internal control relevant to the audit that, in the auditor’s professional judgment, is of sufficient importance to merit the attention of those charged with governance would be reported to them in addition to being reported to management. The communication should include a description of the deficiencies and an explanation of their potential effects, though the auditor need not quantify those effects. This communication with management is an element of using due care in conducting the audit as it helps ensure that management is aware of control deficiencies that can increase the risk of material misstatement so they are in a position to address them. By communicating in writing the audit has documented evidence that due care was used. The management letter may indicate further services that a PA firm can provide to the auditee to assist with internal control improvements, or other efficiency improvements. However new oversight laws and monitoring of public company auditors (e.g. CPAB, CSA NI-52-110 and independence standards, or in the US Sarbanes Oxley/PCAOB) restrict the kinds of non-audit services auditors are allowed to provide to audit clients, so the PA firm doing the audit would be prohibited from providing any additional non-audit services that the management letter indicates would be helpful. 16-19 Related party transactions are not at arms-length and so may be transacted at amounts that would not arise in a normal business transaction. This can affect the asset valuation as the ‘cost’ of the transaction is less reliable as an indicator of the asset’s value at the transaction date. SOLUTIONS FOR EXERCISES AND PROBLEMS EP16-1 Misstatements, adjustments This is an exercise in determining the accounting effect of audit findings and the requirement for adjusting entries. One set of assumptions, interpretations and adjustments is outlined below. Other valid approaches are also possible. a) In reality, there IS $44,000 of cash still on hand so cash is understated, and this amount of accounts payable still owing so accounts payable is understated. There is no income effect, but depending on the impact on current assets and liabilities it could affect the current ratio. This issue could be addressed through the bank reconciliation, depending on materiality and other considerations, or it could be adjusted as follows: Dr Cash 44000 Cr A/P 44000 b) The sales and related cost of sales are not valid (overstated). The income is also overstated by $26,000. The error would be adjusted as follows: Dr Sales 79000 Cr A/R 79000 Dr Inventory* 53000 Cr Cost of sales 53000 * Note that the inventory balance would correctly include this amount as this was determined by a physical count, but the book-to-physical adjustment for the year end would be affected by this entry which adjusts the inventory ‘book’ value, not the physical count value. c) Legal expenses and accrued liabilities are both understated (incomplete). The error would be adjusted as follows: Dr Legal expenses xxx Cr Accrued liabilities xxx d) Assessing whether the provision is excessive depends on how reliably expected bad debts can be estimated, and other factors. Materiality of the difference is also a consideration in deciding whether an adjustment is required. If adjusted, the entry would be Dr Allowance for estimated bad debts 70000 Cr Bad debt expense, other expense/income 70000 e) Assuming there is no basis for recognizing a percentage of revenue at this point in the contract (i.e. assuming nothing that is required to be performed under the contract has been performed, such as pre-construction work on plans, approvals, materials sourcing and purchasing, etc.) the revenue is overstated (invalid) by $250,000 and costs of the contract overstated(invalid) by $40,000. The income is overstated by $210,000. Assuming the original revenue recogntion entry was to increase Accounts receivable and Construction revenues, the adjusting entry would be as follows: Dr Construction revenues 250000 Cr Accounts receivable 250000 Dr Construction costs/WIP 40000 Cr Cost of Construction 40000 EP16-2 Professional judgment a) Professional judgment is used at every stage from beginning to end. Examples include: • client engagement acceptance or continuance • assessment of management integrity • assessment of auditee’s financial condition • choosing the wording of the engagement letter • whether analytical review results are unusual • assessing risk of material misstatement • identifying the significant components of the financial statements • determining the need for experts • determining materiality • assessing audit, inherent and control risks and the risk of material misstatement at the financial statement level and at the assertion level for balances, classes of transactions and disclosures • deciding on compliance, combined or substantive audit strategy • choosing the nature, extent, selection and timing of evidence gathering audit procedures • assessing whether audit findings indicate misstatements • deciding whether audit evidence gathered is sufficient and appropriate to support a clean opinion • assessing whether combined misstatements suggest the financial statements are materially misstated. • determining need for modification in audit report, its nature and how to word it, etc. b) Various CAS 200 requirements could be referred to (see Chapter 2 and Exhibit 2-1), for example: Generally Accepted Auditing Standards (CAS 200) are as follows: Objective of an Audit of Financial Statements The overall objective of the audit is to enable the auditor to express an opinion on whether the financial statements are prepared, in all material respects, with an applicable (acceptable) financial reporting framework. Ethical standards The auditor should comply with relevant ethical requirements relating to audit engagements. - through understanding and application of the ethical requirements junior auditors are assured of working with competent trained colleagues and can learn from them Performance standards 1. The auditor should conduct an audit in accordance with Canadian Audit Standards (CASs) 2. In determining the audit procedures to perform in accord with CASs “scope of and audit” the auditor should comply with each CAS relevant to the audit. - observing the application of professional judgment to this assessment helps junior auditors to develop their own experience from a range of situations to develop their own judgment 3. The auditor should obtain reasonable assurance that the financial statements taken as a whole are free from material misstatement, whether due to fraud or error. 4. The auditor should plan and perform an audit to reduce audit risk to an acceptably low level that is consistent with the objective of an audit. - junior auditors will have the ‘big picture’ of the audit by reviewing the audit plan documentation and will gain experience in how auditor assesses audit risk and what is an ‘acceptable low level’, what the objectives of the audit are, and will be directed and supervised by more experienced auditor so they can learn - understanding of the auditee’s business helps junior auditors to see how risks are identified in the specific context of the auditee’s operations and management organization. It helps show the impact of auditee specific characteristics and risk on how the audit procedures are planned and performed to give audit evidence that reduces the risk of misstatement to an acceptable level Reporting standards 1. The report should identify the financial statements and distinguish between the responsibilities of management and the responsibilities of the auditor. - this aspect of the report helps the junior auditor to understand the necessary limitations of the audit work - we cannot audit everything - and to appreciate the relation between the limited scope that results in an unqualified opinion vs. the more severe limitation that will result in a qualified opinion or a denial of opinion 2. The auditor should determine whether the financial reporting framework adopted by management in preparing the financial statements is acceptable. - this aspect of the audit process helps junior auditors to stay focussed on the ultimate goal of audit work - to support an opinion on whether the financial statements are fairly stated or in compliance with an acceptable reporting framework based on the evidence obtained 3. The auditor should refer to CAS 700 and CAS 705 when expressing an opinion on a complete set of general purpose financial statements prepared in accordance with a financial reporting framework that is designed to achieve fair presentation. - these reporting considerations can help junior auditors develop judgment in assessing when an unqualified opinion is not appropriate, and the range of problems that can arise and how audit standards guide auditors reporting decisions in these cases. in particular, the need for consistency in how all auditor word their reports can become more clear to the junior auditor from a critical consideration of the qualifications sources and how they are communicated in the audit report. Skepticism The auditor should plan and perform an audit with an attitude of professional skepticism recognizing that circumstances may exist that cause the financial statements to be materially misstated. - careful attention to wording used in the audit opinion helps junior auditors to understand their role and their relation to management, in particular how to have the skepticism required to be objective in gathering and evaluating audit evidence. - many other relevant points could be raised by referring to other CAS requirements. EP16-3 Auditor communication with entity and liability This question would be suitable for a class discussion in which the instructor can provide insights into the relevant standards discussed in the solution. The solution also draws on the detailed coverage of auditor liability cases provided in Capter 20, so instructors may prefer to defer this question until that chapter has been studied. This critical thinking question requires one to use the CAS 260 material as the analysis perspective for an issue of auditor liability from shareholders vs. from auditee. A useful approach is to consider the auditor’s exposure to both sides as resulting from the 3 party accountability relationship, i.e., how does this standard reduce auditor liability risk from both sides? In review, the main requirements of CAS 260, Communication With Those Charged With Governance, that can be applied to this analysis are as follows: The scope of CAS 260 covers the auditor's responsibility to communicate with those charged with governance in relation to an audit of financial statements. Although CAS 260 applies irrespective of an entity's governance structure or size, particular considerations apply where all of those charged with governance are involved in managing an entity, and for listed entities. This CAS does not establish requirements regarding the auditor's communication with an entity's management or owners unless they are also charged with a governance role. CAS 260 has been drafted in terms of an audit of financial statements, but may also be applicable, adapted as necessary in the circumstances, to audits of other historical financial information when those charged with governance have a responsibility to oversee the preparation and presentation of the other historical financial information. Thus it has implications for auditor liability consideration for various types of positive/high assurance engagements. Recognizing the importance of effective two-way communication during an audit, this CAS provides an overarching framework for the auditor's communication with those charged with governance, and identifies some specific matters to be communicated with them. Additional matters to be communicated identified in other CAS, which complement the requirements of CAS 260 include those listed below. Other communication may also be required in some cases, based on consideration of the requirements and related application and other explanatory material in CAS in a particular audit. Further matters, not required by this or other CAS, may be required to be communicated by laws or regulations, by agreement with the entity, or by additional requirements applicable to the engagement, for example, the standards of a national professional accountancy body. Nothing in this CAS precludes the auditor from communicating any other matters to those charged with governance. • CSQC 1, "Quality Control for Firms that Perform Audits and Reviews of Financial Statements, and Other Assurance Engagements" – paragraph 36(a) • CAS 200, "Overall Objective of the Independent Auditor, and the Conduct of an Audit in Accordance with Canadian Auditing Standards" – paragraphs 7 and 8 • CAS 240, "The Auditor's Responsibilities Relating to Fraud in an Audit of Financial Statements" – paragraphs 21, 38(c) and 40-42 • CAS 250, "The Auditor's Responsibilities Relating to Laws and Regulations in an Audit of Financial Statements" – paragraphs 12, 14, 17 and 21-23 • CAS 315, "Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and Its Environment" – paragraph 32 • CAS 330, "The Auditor's Responses to Assessed Risks" – paragraph 19 • CAS 450, "Evaluation of Misstatements Identified during the Audit" – paragraphs 15-17 • CAS 510, "Initial Audit Engagements — Opening Balances" – paragraph 6 • CAS 550, "Related Parties" – paragraphs 16, 23(e), 27 and 28 • CAS 560, "Subsequent Events" – paragraphs 7(b), 9, 10(a), 13(b), 14(a) and 17 • CAS 570, "Going Concern" – paragraphs 24 and 25 • CAS 580, "Written Representations" – paragraph 19 • CAS 600 (Revised and Redrafted), "Special Considerations — Audits of Group Financial Statements (Including the Work of Component Auditors)" – paragraph 49 • CAS 705, "Modifications to the Opinion in the Independent Auditor's Report" – paragraphs 14, 16 and 30 • CAS 706, "Emphasis of Matter Paragraphs and Other Matter(s) Paragraphs in the Independent Auditor's Report" – paragraph 10 The objectives of the auditor are to: (a) Communicate clearly with those charged with governance the responsibilities of the auditor in relation to the financial statement audit, and an overview of the planned scope and timing of the audit; (b) Obtain from those charged with governance information relevant to the audit; (c) Provide those charged with governance with timely observations arising from the audit that are significant and relevant to their responsibility to oversee the financial reporting process; and (d) Promote effective two-way communication between the auditor and those charged with governance. For purposes of the all the CASs, the following terms have the meanings attributed below: Those charged with governance – The person(s) or organization(s) (e.g., a corporate trustee) with responsibility for overseeing the strategic direction of the entity and obligations related to the accountability of the entity. This includes overseeing the financial reporting process. For some entities in some jurisdictions, those charged with governance may include management personnel, for example, executive members of a governance board of a private or public sector entity, or an owner-manager. In some cases, those charged with governance are responsible for approving the entity's financial statements. In other cases, management has this responsibility. Who holds this responsibility is critical or the auditor to determining when those with authority have approved the financial statements, as this determines the date of the auditor’s report. (Further discussion of the diversity of governance structures that may be found in practice are provided in A5-A12 of CAS 260). Management – The person(s) with executive responsibility for the conduct of the entity's operations. For some entities in some jurisdictions, management includes some or all of those charged with governance, for example, executive members of a governance board, or an owner-manager. Management is responsible for the preparation of the financial statements, overseen by those charged with governance and, in some cases, management is also responsible for approving the entity's financial statements. In other cases, those charged with governance have this responsibility. (As above, note that who has this authority in an entity is critical in determining when the final ‘evidence’ has been obtained to complete the audit, i.e., that those responsible for the entity’s financial reporting have approved the financial statements. Until this date, the auditor cannot have sufficient evidence to support an independent audit opinion on whether the financial statements are fairly stated.) CAS 260 requires the auditor to communicate with those charged with governance on the following: (a) The auditor's views about significant qualitative aspects of the entity's accounting practices, including accounting policies, accounting estimates and financial statement disclosures. Open and constructive communication about significant qualitative aspects of the entity's accounting practices may include comment on the acceptability of significant accounting practices. For example, if management has chosen a significant accounting practice that is acceptable under GAAP, but the auditor considers not to be most appropriate in the particular circumstances of the auditee, the auditor must explain to those charged with governance why the auditor holds this position. Financial reporting frameworks ordinarily allow for the entity to make accounting estimates, and judgments about accounting policies and financial statement disclosures. Matters that may be included in this communication also include the following:. Accounting Policies • The appropriateness of the accounting policies to the particular circumstances of the entity, having regard to the need to balance the cost of providing information with the likely benefit to users of the entity's financial statements. Where acceptable alternative accounting policies exist, the communication may include identification of the financial statement items that are affected by the choice of significant accounting policies as well as information on accounting policies used by similar entities. • The initial selection of, and changes in significant accounting policies, including the application of new accounting pronouncements. The communication may include: the effect of the timing and method of adoption of a change in accounting policy on the current and future earnings of the entity; and the timing of a change in accounting policies in relation to expected new accounting pronouncements. • The effect of significant accounting policies in controversial or emerging areas (or those unique to an industry, particularly when there is a lack of authoritative guidance or consensus). • The effect of the timing of transactions in relation to the period in which they are recorded. Accounting Estimates • For items for which estimates are significant (issues discussed in CAS 540): o Management's identification of accounting estimates. o Management's process for making accounting estimates. o Risks of material misstatement. o Indicators of possible management bias. o Disclosure of estimation uncertainty in the financial statements. Financial Statement Disclosures • The issues involved, and related judgments made, in formulating particularly sensitive financial statement disclosures (e.g., disclosures related to revenue recognition, remuneration, going concern, subsequent events, and contingency issues). • The overall neutrality, consistency, and clarity of the disclosures in the financial statements. Related Matters • The potential effect on the financial statements of significant risks, exposures and uncertainties, such as pending litigation, that are disclosed in the financial statements. • The extent to which the financial statements are affected by unusual transactions, including non-recurring amounts recognized during the period, and the extent to which such transactions are separately disclosed in the financial statements. • The factors affecting asset and liability carrying values, including the entity's bases for determining useful lives assigned to tangible and intangible assets. The communication may explain how factors affecting carrying values were selected and how alternative selections would have affected the financial statements. • The selective correction of misstatements, for example, correcting misstatements with the effect of increasing reported earnings, but not those that have the effect of decreasing reported earnings. CRITICAL ANALYSIS OF AUDITOR LIABILITY IMPLICATIONS: Based on this review of the auditor communication requirements of CAS 260, a critical analysis of the impact on auditor liability to shareholders could consider that since those charged with governance are being well informed by the independent auditor of the most contentious and subjective areas of accounting principles the entity has used in its financial information, their responsibility for any misstatement or inappropriate presentation and disclosure is made clearer. This suggests their liability for any misstatement would be easier to prove than if they could prove they were unaware of these issues. On the other hand, by requiring such extensive communications of an auditor, the auditor’s responsibility, and liability, for any auditor omission that becomes evident in later discovery may suggest the auditor has not complied with the requirements of GAAS, increasing the auditor's exposure to liability for negligence. It is clear from CAS 260 that auditors will need to document many more reasons for choices in financial reporting, in particular the effects on measurement uncertainty. On balance, the requirement of this CAS will lead to more transparency in the understanding of those charged with governance about any contentious financial reporting issues, and enhance their opportunity to ensure shareholders are adequately informed by the financial statements. But this greater transparency comes at the price of greater responsibilities for auditors. Greater responsibilities to identify biases and appropriate reporting of measurement uncertainties and estimates. These uncertainties can be influenced by the significant accounting policies chosen and thus affect the appropriateness of the policies in the particular circumstances of the auditee. We feel that the accounting risk concept is a useful tool to guide the kinds of professional judgments in financial reporting that is the focus of CAS 260 (e.g., see chapter 7 for an illustration of the accounting risk concept). The issues raised here ultimately relate to the fundamental question of what is fair presentation using GAAP in the specific circumstances of the auditee. For example, management may prefer high accounting risk estimates with less disclosure of the sources of accounting risks in the notes to the financial statements whereas investors may prefer much less accounting risk and more disclosures on the sources of the risks in notes to the financial statements. From the perspective of auditor liability to management, the requirement to communicate directly with those charged with governance can strengthen an auditor’s ability to negotiate over contentious accounting choices with management. Essentially, to comply with GAAS, the auditor must ‘go over management’s head’ in any matter of significant concern. Since in many cases ‘those charged with governance’ will be an audit committee specifically charged with working with the auditor and ensuring that the entity’s financial reporting process meets up to standards and provides fair presentation to shareholders, this standard should benefit the overall objectivity and fairness of financial reporting. It is difficult to think of a situation where an auditor’s liability to management would be increased by the application of the CAS 260 communications. However, this analysis does raise the question of where management and those charged with governance fit in the three party accountability model with auditors and users. In the particular case of small entities where management and those charged with governance are the same, this is clearly the accountable party set out in the three party model. But in larger entities where these roles have been separated, it is possible that dividing this liability may actually make it harder to hold either party liable, and potentially lead to higher residual liability that can come back on the auditor. With greater responsibility comes greater liability! Thus this CAS may lead to higher legal liabilities as discussed. EP16-4 Form of opinion, misleading financial statements a. 1) Disclaimer 2) Adverse 3) qualified (scope limitation) 4) Qualified (GAAP departure) b. Emma would probably resign without reporting since the integrity of management is questionable. If she is unable to resign for some reason, she would issue an adverse opinion in this case since the overall impact of the misstatements has a pervasive effect and results in the financial statements being misleading. EP16-5 Form of opinion, EOM for going concern uncertainty a. Since the long term debt is due in two months it must be classified as a current liability. Since the president had no firm commitment from a bank to extend the loan beyond the two months, and the cash flow of the company has dried up its future earning potential is severely reduced. Overall it seems very unlikely that Profile will survive as a going concern. Profile should provide a disclosure about the going concern uncertainty. Assuming there is some chance it will be able to get the needed financing, it would probably be sufficient to disclose the uncertainty, and but to continue reporting under GAAP for this year. b. Courtney would provide an unmodified opinion if she concludes the financial statements disclosure of the uncertainty is sufficient make them fairly presented. CAS 706 would require her to also include an EOM - emphasis of matter paragraph to draw users’ attention to the uncertainty disclosure. SOLUTIONS TO DISCUSSION CASES DC16-1 Warranty provision audit issues The case involves changing business conditions and requires assessing their impact on accounting estimates for warranty provisions for Breton Inc. The auditee’s estimation methods need to be considered. The case also suggests management may have higher motives to increase income through accounting choices, suggesting a greater inherent risk for the related financial statement items than in past. Thus the audit risk increases and the auditors need to respond appropriately to ensure the financial statements are not materially misstated. Points that can be discussed in the analysis include the following. a) the increase in competition and price pressures require changes in the assumptions underlying the method of estimating expected future warranty costs and developing the warranty liability accrual. b) The CFO can argue the extended warranty policy is new and more experience is needed before its impact on warranty costs, if any, can be estimated. This supports leaving the method as is until need for a change is better established by business experience. c) The auditor may be able to analyze the five-year review data to assess the potential impact of extending the warranty, however the review is several years old now and may not reflect current conditions well. DC16-2 Fixed asset dispositions, accounting misstatements The question requires an analysis of the impact of recording errors on financial statements and consideration of audit procedures that can detect fixed assets recording errors. a) Fixed assets will be overstated by about $100,000 as the net book value of the assets sold has not been taken off the books. Sales revenues are overstated by $400,000, and ‘Gain on sale of capital assets’ is understated by about $300,000. b) The error would most easily be detected through scrutiny of cash transactions and sales journals and investigating large, unusual entries. Analytical review of gross margins may also indicate a discrepancy that, upon follow up, may reveal the recording error. Physical inspection procedures to test the existence of fixed assets may also indicate this equipment is no longer in the company’s possession. Changes in insurance coverage, reviewed in connection with accrued liabilities and contingencies, may also uncover the asset sale if appropriately followed up. c) The following approach can be used to develop an appropriate adjusting entry to correct and error. First, identify the correct entry that should have been made: dr Cash 400,000 dr Acc Deprec 900,000 cr Equipment, cost 1,000,000 cr Gain on sale equipment 300,000 Then take note of the incorrect entry that was made into the books: dr Cash 400,000 (this part is okay) cr Sales revenue 400,000 (incorrect) Determine the entry required to reverse what was entered incorrectly, and set up what should have been entered: dr Sales Revenue 400,000 dr Acc. Deprec. 900,000 cr Equipment, cost 1,000,000 cr Gain on sale equipment 300,000 Explanation: This entry is to correct the entry made to record the sale of the equipment, by reversing the amount credited to Sales in error, and recording the disposal of the equipment by removing its costs and accumulated depreciation from the books, and recording the difference between the proceeds of sale of $400,000 and the net book value of $100,000 as a gain on sale. The auditor could propose the above adjusting entry to correct this error. DC16-3 Going concern uncertainty and audit reporting Failure to properly disclose the going concern is a non-compliance with GAAP situation. Most likely it would be considered so material and pervasive that an adverse opinion is warranted. An added paragraph between the scope and opinion paragraph explaining the impact on the financial statements is required. The opinion paragraph would say “except for” and reference to the reservation paragraph and state the opinion that “these financial statements do not present fairly.” If the auditee was persuaded by the auditor to provide adequate disclosure of the uncertainty, a clean opinion could have be provided under Canadian GAAS prior to the CAS coming into effect. The CAS require an emphasis of matter paragraph to be added drawing attention to the going concern disclosure, eliminating what had been a difference between Canadian GAAS, and US or International GAAS. If management agrees that the going concern assumption is no longer valid, GAAP financial statements are no longer appropriate. Management would be required to present the company’s financial position based on its liquidation values. DC16-4 Scope limitation and audit reporting a) Type - Audit report should contain a qualified opinion, modified for a scope limitation because the balance is MATERIAL. If the assumption was made that the amounts were so material they are pervasive throughout the financial statements then disclaimer would also be an acceptable answer. Format - Scope paragraph would start with “Except as explained in the following paragraph,…” Additional paragraph between scope and opinion paragraph would be added explaining that the company has restricted the scope of the auditor and the auditor was not able to satisfy him or herself by alternative procedures. Opinion paragraph contains modification: “In my opinion, except for the effects of adjustments, if any, which I might have determined to be necessary had I been able to confirm the accounts receivable specified in the preceding paragraph,…” If disclaimer is recommended, scope and additional paragraph would be modified as above, opinion paragraph would be worded as : “In view of the possible material effects on the financial statements of the matters described in the preceding paragraph, I am unable to express an opinion whether these financial statements are presented fairly…” b) Confirmation with outside parties provides highly reliable evidence regarding assertions: existence, valuation and completeness of accounts receivable. Specific audit objectives include: - are receivables valid debts owed by real customers? - are all receivables outstanding included in company’s records? - does the net realizable value of the receivable reflect likelihood that customers will actually pay? c) Alternative procedures such as verifying subsequent receipts or examining client documents cannot prove the customer or the debt is real with a high degree of reliability because confirmation is highly objective, independent evidence, and it is not easily to falsify because auditors can control the confirmation process. So failure to obtain confirmations in this case means an essential piece of evidence is missing. DC16-5 Subsequent discovery of facts and audit reporting The scenario in this case suggests the auditors have become aware of facts subsequent to the issue of the audited financial statements that indicate the statements and their report were incorrect. The facts given also indicate that the auditors appear to have omitted necessary procedures, as they did not obtain sufficiently independent evidence regarding the investments of the mining companies. The auditors responsibilities in this situation are set out in the requirements of CAS 560. When, after the financial statements have been issued, a fact becomes known to the auditor that, had it been known to the auditor at the date of the auditor's report, may have caused the auditor to amend the auditor's report, CAS 560 requires the auditor to discuss the matter with management and, where appropriate, those charged with governance. In this case, management and those charged with governance appear to be one in the same, the Blues brothers, and they appear to have fled the country. When management does not take the necessary steps to ensure that anyone in receipt of the previously issued financial statements is informed of the situation and does not amend the financial statements in circumstances where the auditor believes they need to be amended, CAS 560 requires that the auditor notify management and, unless all of those charged with governance are involved in managing the entity, those charged with governance, that the auditor will seek to prevent future reliance on the auditor's report. If, the auditors are unable to contact the Blues brothers, this is then a case where management and those charged with governance do not take these necessary steps, so the auditors must take appropriate action to seek to prevent reliance on the auditor's report. The auditor's course of action depends upon the auditor's legal rights and obligations. Consequently, the auditor may consider it appropriate to seek legal advice. Note that the financial statements are the responsibility of management and so the auditor’s legal rights to act in respect of those financial statements require a legal opinion. CSQC-1 standards are also relevant here. Upon discovery that necessary audit procedures were omitted during the performance of the engagement, the firm should determine what further action is appropriate to comply with relevant professional standards and regulatory and legal requirements. It should also consider obtaining legal advice for this matter. Overall, in this case the auditors have made mistakes in their conduct of the engagement that have put them in a difficult situation professionally and legally. DC16-6 Management Letter Issues, Internal Audit This is a comprehensive case that would be best suited to an in-class discussion to bring out the comprehensive issues a. and b. The response should recognize that the work performed on the internal audit will not satisfy the auditors, and recommend improvements to GPL’s controls and processes. A sample response memo from PA is given below, with some summary comments on the key issues that should be discussed. To: Joey From: PA Re: External auditor’s management letter We need to respond to the management letter we received from the auditors. You asked me to look at the memo Sandra drafted in response and address any concerns I might have. Comment on overall reporting structure for responding to this letter Before I offer advice on how to improve GPL’s internal controls, I must comment on the reporting structure that you have set up for responding to the letter. You asked Sandra to respond to the letter and me to comment on her response. However, it is management’s responsibility to address the comments made in the letter and design and implement the necessary internal controls. As manager of financial reporting, my role should be to respond, as a representative of management, to the points raised in the letter. Sandra should then be responsible for reviewing those comments from an internal audit perspective. In terms of the permanent reporting structure, internal audit (Sandra) should be reporting directly to the audit committee rather than to you, to ensure independence. Part of the problem with the current reporting structure may be that Sandra does more than just internal audit, making it hard to separate her roles when she reports to you in many areas. The reporting lines for her internal audit work should be clarified: she should report directly to the audit committee on these matters to ensure she remains independent. (The response should comment on process followed by GPL to respond to the management letter. In this process, Sandra should not have been involved in the preparation of the response. The comment should also discuss the need for direct reporting to an audit committee.) It is not my role to audit the controls of the company. However, I do not believe Sandra has done sufficient work in testing the actual controls to conclude that they are operating properly. She appears to have done more substantive testing around the areas the auditors verified, which does not ensure that GPL’s control deficiencies have been properly addressed. The fact that the auditors were able to perform additional substantive procedures to ensure that there were no material misstatements in the financial statements does not relieve GPL of its responsibility to have proper controls in place. Just because the auditors did not find financial statement errors does not mitigate the fact that GPL does not appear to have appropriate controls in place and that there is potential for material misstatement as a result of the deficiencies. Sandra needs to let management put the necessary controls in place before she evaluates them. The purpose of internal audit is to ensure that internal controls are designed and operating effectively so that the CEO or CFO can assert that good internal controls are in place. As a result, the key purpose of performing internal auditing is to ensure procedures are being followed and that exceptions are noted and dealt with accordingly. Substantive testing, which is what Sandra performed, does not accomplish this. Also, the concept of materiality doesn’t really apply in these circumstances. For example, Sandra’s response to the fixed asset software concerns raised by the auditor is that the differences between her rates and those in the software were immaterial. The fact is that incorrect rates appear to be used in the software program and they should therefore be corrected. The dollar impact is not the issue. There is the possibility that a future error resulting from using the wrong rate could be large enough to be material. (It is important to recognize that Sandra’s responses were based on substantive procedures and explain how the underlying control deficiencies had not been addressed through her extra work.) Control Deficiencies We need to address the control deficiencies as soon as possible since our remediation plans should be communicated as part of our response to the auditor’s management letter. I have reviewed the specific issues noted by the auditors and have set out detailed recommendations on control procedures and remediation steps that we should put in place immediately. The recommendations outlined below should be discussed with the audit committee. Amortization Because of the lack of controls in the software system, including controls for employee knowledge, up-todate information, and independent review, the validity of the amortization expense is at risk. The errors are likely not material due to the few additions and disposals during the year. I recommend that the following processes and controls be put in place: • To ensure the system operates correctly, employees who will use the software should be trained on how to use it properly as soon as possible. Appropriate training programs should be developed and offered regularly to employees who use the software, and manuals should be made available to them. • Reconciliations between the fixed asset continuity schedules and the balances (asset costs, additions, disposals) recorded in the amortization system should be performed to ensure that the balances the system is using as the basis for its calculations are correct. • On an annual basis, the rate and asset class information used in the system should be compared to the appropriate accounting policy to ensure it is correctly applied. Application controls should be integrated to ensure access is limited, and access should be monitored to ensure there are no unapproved changes to core information, such as depreciation rates. The accounting policies that determine the amortization rates should be reviewed periodically and updated in the system. • On at least a quarterly or annual basis, a reasonability test should be performed by someone in house to ensure the amortization expense recorded is reasonable. This could be performed either through an overall reasonability test similar to the one performed by the auditors or through detailed calculations on a sample basis. • In cases where the detailed cost build-up of individual assets was not being tracked by the software for new acquisitions, the prior balances must be fixed. We should ensure training includes how to “componentize” the assets in order to meet IFRS requirements. (In addressing this issue, responses should recognize that the software is unable to track purchases and disposals, but they must also discuss the deficiencies in the amortization process that the auditors had raised in the management letter (for example, appropriate application of amortization policies, reasonability check of balances, etc.).) Sales contracts There are significant business risks, and a risk of improper revenue recognition, due to the lack of review, which could result in a material misstatement (as proven by the $900,000 error in revenue recognition found in Q1). I recommend that the following processes and controls be put in place: • Incorporate standard policies relating to dollar thresholds and standardized versus non-standard contracts. • The legal, tax, and sales vice-presidents should review the contracts. • Incorporate a contract checklist — no contract should be signed without the checklist attached. • Purchase orders should not be filled without a signed sales agreement and checklist. • Accounting should ensure all approvals are in place as part of the recording of a transaction, and they should follow up on any control breakdowns to ensure they are not repeated. (In addressing this issue, recognize that Sandra’s test of details on a few contracts did not sufficiently address the control deficiency, then discuss the implications of the lack of controls in this area and make appropriate recommendations that clearly address the deficiency.) We should attempt to address the auditor’s concern regarding segregation of duties rather than discount it on the basis that the department is short staffed. We should look into the possibility of reallocating duties between staff members so that contract modifications and deposits are not made by the same person. If that is not possible, then we should consider what compensating controls we might be able to put in place to ensure that the risk of fraud is reduced to a minimum. (Note that segregation of duties is an important issue, but PA should also comment on Sandra’s response that nothing could be done to address this issue. Recommendations should be supported and practical, noting that the organizational structure makes some allocations of duties and the organizational structure inappropriate (e.g., “Joey should make the bank deposits”).) Internal audit Lack of testing has no direct impact on the financial statements, but it can result in us missing breakdowns in controls. Sandra appears to be charged with many different tasks. Being the only person doing internal audit, particularly when it does not appear to be her area of training, is perhaps asking too much of her. In addition, since internal audit is one of her many tasks, Sandra could end up auditing her own work and procedures, which would not be appropriate and results in a lack of independence in internal audit. We should discuss the need to formalize a separate internal audit group, particularly since good controls are essential in order for a public company to meet its regulatory sign-offs. As a public company, is it crucial that our controls, particularly those to do with the production of financial information, remain strong. One way to verify this is to test them on a regular basis. (If Sandra enjoys doing internal audit work, you should perhaps consider offering her the internal audit work exclusively. With the transition to IFRS, there will likely be enough work to keep her busy just doing internal audit testing. However, she would require more training in order to be able to take on the role.) (PA should focus on the implications of Sandra having many tasks as they relate to her internal audit role, rather than speculating on her lack of qualifications or questioning her ability to perform her job functions appropriately, culminating in a recommendation to hire a qualified accountant for her position. It might also be notices that Sandra could be auditing her own work.) Consolidation procedures The issue of consolidation procedures may become more important in the future since we have just purchased another company that will require consolidation, which will complicate the process. It is therefore important that we establish a process to test the spreadsheet, particularly if there are changes to the formulas and it is being maintained by only one person, since a financial statement error could easily result from an error in the spreadsheet. In addition, we should find out why differences need to be adjusted. It may be due to an error in the spreadsheet, or it may be due to an error by the manager. The amounts appear to be small, but there is a risk that at some point a large error will be missed as a result of an adjustment or due to a calculation error in the spreadsheet. The following processes and controls should be put in place: • All changes made to the spreadsheet formulas should be verified by another person. • The monthly/quarterly/yearly consolidation results should be reviewed by someone more senior as a reasonability check, since the spreadsheet is a manual process that has a high risk of error associated with it. • Consider alternatives to using a spreadsheet; a high number of financial statement errors are the result of using spreadsheets. Perhaps the accounting program can be expanded to perform the consolidation. Looking into this option will be especially important if GPL continues to make acquisitions. (The issues related to the current consolidation procedures may be addressed by commenting on the implications of the control deficiencies and Sandra’s procedures, and making appropriate recommendations for improvement.) c. If not addressed, this will raise a number of concerns in accepting to continue the engagement for the following year. By disregarding important comments and recommendations, the attitude of management towards having a strong control environment have to be assessed as being very poor. This concern will enter into the decision on whether to continue as auditor the following year. The control risks in relation to the various processes affected by the weak controls will like have to be assessed as high, and not provide any basis for reliance. This would mean there would be no reason to reduce the substantive work the auditors will need to plan on performing in comparison to what they did this year. CHAPTER 17 Other Public Accounting Services and Reports-Reviews and Compilations SOLUTIONS FOR REVIEW CHECKPOINTS 17-1 The influence and pressures that led to creation of the Compilations and Review Engagement Standards include: (1) general social dissatisfaction with "big business," (2) small PA firms want to give service and less-than-audit assurance for unaudited statements, (3) small PA firms want to get away from the complicated standards involved in unaudited engagements, (4) small PA firms want to avoid the negativism of the unaudited statement disclaimer, (5) small businesses do not appreciate the legal liability worries of PAs and want something more positive than the unaudited statement disclaimer, and (6) Congressional critics (Moss, Metcalf) accused the AICPA of hampering the business services of small PA firms. 17-2 A PA should ask why a client is requesting the engagement in order to determine the level of assurance needed by the client. Sometimes a client’s needs are best met through a review, compilation or other non-audit engagement. That’s why these engagements evolved in the first place. Also see chapter 2 for more discussion in the client acceptance/retention decision. 17-3 Since the PA is not claiming in the Notice to Reader that the financial statements are in conformity with any particular basis of accounting but the PA does not want to be associated with misleading financial information, the best way to resolve this is to insist on appropriate disclosure of the basis for preparing the financial information either through the title of the statements or in the notes to the statements. Failing that the PA should not be associated with the financial information. The reason for this is to minimize any chance of being associated with false or misleading information. 17-4 Both review and compilation engagements are less than an audit. A comparison of the three amounts to a hierarchy of assurance: 1. Audit engagement Auditor obtains sufficient competent evidence that serves as a basis for an opinion on financial statements. The auditor obtains reasonable assurance within the inherent limitations of the audit process. 2. Review engagement Accountant obtains limited assurance through analytical procedures that there are no material modifications that should be made to financial statements. 3. Compilation engagement Accountant puts client information in financial statement form without obtaining any assurance (because no significant procedures are performed) that material modification should or should not be made to the financial statements. Additionally, an accountant who is not independent may report on a compilation service (providing that lack of independence is disclosed), but not on a review service or audit engagement. 17-5 Yes, interim financial information should be in accordance with GAAP. Some regulators, such as the SEC, may require interim financial information. Thus in reports filed for such regulators, omission of interim information or failure to review it must be noted in an explanatory paragraph. 17-6 A review of interim financial information is similar to a review of the unaudited annual financial statements in these respects: 1. Both reviews are less in scope than a GAAS audit. 2. Procedures in both are limited to inquiry and analytical procedures. 3. In the report, an audit opinion is disclaimed 4. In the report, the level of assurance is "negative assurance." 17-7 An audit report on annual financial statements would be modified with respect to the interim financial information in these circumstances: 1. The interim information is omitted (SEC companies only). 2. The review cannot be completed (SEC companies only). 3. The interim information departs, including adequate disclosures. 4. In the note to the annual financial statements, the management indicates the auditor performed procedures without also saying the auditor expresses no opinion. 5. Management fails to label interim financial information note "unaudited" 17-8 Yes, the final conclusion in a public internal control report is an opinion ("positive assurance") on the controls, although the report itself contains heavy cautionary language about the use and understanding of the report on control. 17-9 Auditing standard require communication of reportable conditions, control deficiencies and communications about a variety of matters that reflect the cooperation auditors received from management before and during the audit. The "management letter" giving advice on various matters is not required. 17-10 Written reports on internal accounting control (IAC) for external use. Type of Engagement Character of Report Special IAC study (nonderivative report of AuG 13, example B discussed in Appendix 16A). Report on IAC with opinion on IAC system taken as a whole. Service auditor engaged to report for benefit of user auditor and their mutual client (service organization audits discussed in Appendix 16A). An audit of internal control over financial reporting in conjunction with an audit of financial statements. A special-purpose report on IAC can take special forms, the main feature of which includes an opinion relating to the controls applied by the service organization to the client organization's transactions. Two opinions on internal control—an attest opinion on management’s written assertion regarding internal control over financial reporting (internal control statement), and a direct reporting opinion on the state of internal controls. It is thus possible to say management presents fairly the state of internal control, yet this fair presentation indicates that the controls are weak. SOLUTIONS FOR EXERCISES AND PROBLEMS EP17-1 Compilation Presentation Alternatives Jimmy has no accounting staff and has little expertise in preparing financial statements himself. However, he needs them occasionally, apparently for credit purposes. Three kinds of compiled financial statements are available: 1. Compilation Without Independence. Brother Bill can prepare the compiled financial statements (with or without all disclosures), but he will need to disclose in this report his lack of independence. He also has a responsibility to not be associated with misleading information of which he is aware of. This is why the title, description and note disclosures of the compiled financial information are so important in fulfilling these responsibilities. 2. Compilation With Full Disclosure. PA Bert can compile the statements and present them in the complete form used for audited financial statements. 3. Compilation That Omits Substantially All Disclosures. PA Bert can compile statements without footnote disclosures, but the financial statement title should indicate these omissions. PA Bert has an obligation to not be associated with misleading information (of which he is aware of). EP17-2 Negative Assurance in Review Reports a. Yes, this is a negative assurance. b. Negative assurance is generally prohibited in audit reports because the profession wishes such reports to contain positive assertions based on evidence instead of negative statements based on "what did not come to my attention." c. A review service is less than an audit, hence the report can be less than positive assurance. Clients get what they pay (less) for. EP17-3 The question requires a discussion of the distinctions among transaction-based audits, ‘strategic systems’ audits and reviews. Some points that can be discussed include the following. Both types of audits result in a positive assurance in the form of an opinion on whether or not financial statements are presented fairly in accordance with GAAP (or other disclosed basis of accounting). The review provides a lower level of assurance, or ‘moderate’ assurance, in the form a statement that the nothing has come to the public accountant’s attention to suggest the financial statements are not ‘in accordance with GAAP’. No reference to fair presentation is made in the review engagement report. While it is reasonable to expect that an audit requires a higher level knowledge of the business than a review, it is interesting to note that the CICA review standards specifically set out the requirement for the accountant to have adequate knowledge of the business to conduct the review. In contrast, the GAAS examination standards make no reference to a requirement for the auditor to have an adequate knowledge of the business to conduct the audit. Perhaps the GAAS imply this requirement in the general standard of performing the audit with ‘due care’, and recommendations are provided elsewhere in the Assurance Handbook but it is not explicit in the standards themselves. GAAS do include a requirement for the auditor to obtain an understanding of internal control, which also may imply a good understanding of the business operations. There are no formal professional standards governing ‘strategic systems’ audits, but the description in the text implies that this approach involves obtaining an intense understanding of the business, its operations, risks and strategic decisions and applying this understanding to achieve audit efficiencies by performing substantive procedures only when the understanding suggests a high risk of error. Finally, a discussion of how much knowledge and how much evidence is ‘enough’ involves considering the ubiquitous role of professional judgment in all assurance engagements. Factors such as those used to set audit risk, and assess inherent and control risks can be elaborated on in the context of different assurance objectives, as well as the role of experience, training, supervision and other practical factors. EP17-4 The case involves assessing the costs and benefits of various ‘audit’ type procedures in review engagements and considering factors used in exercising profession judgment in assurance engagement decisions. A possible approach is outlined below. a) The report can discuss the opportunity to reduce costs by not performing procedures that are not specifically required in the review engagement standards. Another perspective to include is that the procedures mentioned in the case are fairly low cost, and can provide a high level of assurance regarding misstatements in many aspects of the financial statements since cash transactions are only one side of the entries. These procedures can also provide some comfort on overall controls in the organization and may provide a valuable service in a small company by allowing a segregation of duties and independent review over a key control, the control over cash. b) In light of the analysis developed in a), this part requires one to consider why the partners are doing what they are doing, given they have the most experience and are the ones taking the risk of providing assurance. EP17-5 The question addresses the need for independence in different small company public accounting engagements. One possible analysis is outlined below. a) The compilation report that states that the accountant is not independent of the client company is likely required (e.g., see Exhibit 16-2), but this can depend on the extent to which the accountant has any financial interest in her sister’s company, is involved in the accounting decisions and other aspect of managing the business. b) Providing assurance to users that financial statements are in accordance with GAAP will likely require more assurance that the accountant is independent. While factors may indicate the accountant is independent in fact, the appearance of independence becomes more important as the possible reliance of users on the report implies higher trust in the figures. EP17-6 The question requires application of judgment in determining appropriate communication with a successor auditor. Factors such as professional conduct, confidentiality and other assumptions about relevant issues not provided in the scenarios need to be considered to support the recommended communication. From the predecessor auditor viewpoint: in all cases request permission from client to communicate with successor auditor regarding the points at issue. If client refuses, the refusal should be communicated to the successor. From the successor auditor viewpoint, assuming the predecessor is allowed to communicate the point at issue: situation a—ask for progress payments, situation b—most likely refuse the engagement as too risky, situation c— decide on the basis of whether or not you agree with the client’s judgment given the fact circumstances, situation d—most likely refuse the engagement as too risky. If the client refuses to allow communication with the predecessor auditor, this is normally an important sign of an overly risky client. EP17-7 The case requires understanding and describing typical review engagement procedures in the context of a quarterly review, and the relation between audit procedures and review reporting for the same client. Procedures can be listed for part a) and part b) that assess the extent to which on-going audit procedures for the client cover some of the review procedures, such as obtaining a knowledge of the business, its accounting systems, reviewing minutes and other key documents, and analytical procedures relating to reported financial information. SOLUTIONS TO DISCUSSION CASES DC17-1 Most U.S. companies, e.g., IBM, Microsoft, GE use COSO as the suitable criteria for evaluating internal control. The importance of COSO is also reflected in the CICA’s HB Section 5925 examples (e.g., Exhibit 16-15). The most common criteria used to evaluate internal control in the US is COSO. For example see the IBM, Microsoft, and GE websites. DC17-2 Yes, there is some relationship but it is not straightforward. A material misstatement in the financial statements generally means there is a material weakness in internal control. A material weakness in internal control, however, does not necessarily mean that there is a material misstatement in the audited financial statements. The auditor may have detected and corrected the material misstatements that were allowed by weaknesses in the internal controls. The PCAOB provides some good discussion summaries based on their monitoring of audits of internal control over financial reporting. See www.pcaobus.org/standards/Standard_Advisory_GroupMeeting clicking on background paper or background info for the meetings of June 8, 2005 and June12-13, 2006. CHAPTER 18 Professional Rules of Conduct Details and Auditor Responsibilities SOLUTIONS FOR REVIEW CHECKPOINTS 18-1 Ethical responsibility for acts of nonmembers under a member's supervision. A member shall not permit others to carry out on his behalf, either with or without compensation, acts which, if carried out by the member, would place him in violation of the Rules of Conduct. 18-2 An incorporated practice is substantially different with respect to limited liability of owners. A professional corporation is not substantially different from a practice organized as a partnership, but owners' legal liability is not effectively limited. Both corporate forms are generally prohibited from having non-PA owners. Neither can entrust management of professional matters to non-CPAs. Employees in both must observe the Rules of Conduct. However, a limited liability corporation protects PA's assets from lawsuits (unless the PA is directly involved in malpractice wrongdoing). 18-3 Contingency fees are professional fees having two characteristics: 1. The terms must be contracted for before any services are performed; and 2. The amount paid for the performance must be directly affected by the results obtained. Obviously, contingency fees should be prohibited for assurance engagements, but what about other PA services? The Charter of Rights forced the CICA to give up the prohibitions of commissions and contingent fees. The courts considered these rules an unwarranted restraint on competition. Unfavorable publicity over PAs' apparent loan excesses caused the profession to enact restrictions to curb excess and recover public acceptance, also to protect appearance of independence. According to the Schultz article, contingency fee prohibitions of non-attest services does not serve the public interest and, in fact, causes conflict with some statutory law. 18-4 Confidentiality rules prevent auditors from reporting suspicions to the appropriate authorities unless the auditor is required by law to act as whistle blower. Auditors should consult with their legal counsel whenever they have concerns about client illegal activities. 18-5 Suspension from practice before Canada Revenue Agency, and in extreme cases legal action. 18-6 Rules of conduct for practising public accounting come from: Provincial Institutes or Associations of PA’s For practicing internal auditing: The Institute of Internal Auditors 1. Rules of Conduct 2. Certified Internal Auditor Code of Ethics For practicing management accounting National Association of Accountants (NAA) Standards of Ethical Conduct for Management Accountants For Fraud Examiners--The National Association of Certified Fraud Examiners 18-7 This question is about self-regulation penalties. Provincial Institutes and Associations can Admonish a violator (slap on the wrist) Suspend the violator's membership Expel the violator from membership in the Institute or Association Require CPE hours to be undertaken by the violator Publish the violator's name in a report of proceedings (e.g., in Check Mark Publication of ICAO) 18-8 CPAB was created by the provincial securities commissions, the Office of the Superintendent of Financial Institutions (OSFI) and the CICA to promote high-quality audits of entities that are reporting issuers (i.e., public companies under CSA National Instrument 52-108) in Canada. Following each inspection, CPAB sends the accounting firm a private report that includes findings, recommendations, and other observations. Firms are expected to implement the recommendations to CPAB’s satisfaction within a prescribed period of time—normally 180 days. When a stronger message is needed, CPAB imposes requirements instead of recommendations. If a firm failed to do what had been recommended or required, CPAB would consider making that fact public and, in certain cases, could choose to impose restrictions or sanctions on that firm. If CPAB imposed restrictions upon an audit firm, the firm would be required to notify the Canadian securities regulators. If CPAB were to impose sanctions upon an audit firm, the firm would be required to notify Canadian securities regulators and the Audit Committees of its reporting issuer audit clients. In the most extreme case, CPAB could declare that an audit firm is not in good standing, meaning that firm could no longer audit public companies in Canada. (From CPAB 2011 Inspection Report, dated April 3, 2012). More generally this question is about public regulation by quasi-government agencies. Provincial or state associations or institutes of accountancy can: 1. Report to Institute or Association disciplinary committee 2. Suspension from practice before the agency. 3. Legal action The U.S. Securities and Exchange Commission can deny (temporarily or permanently) the privilege of practice before the SEC with a "Rule 2(e)" proceeding. (The SEC can also "censure" a PA, which amounts to a slap on the wrist and settle for an injunction in which the PA promises not to violate the rules of conduct in the future.) SOLUTIONS FOR EXERCISES AND PROBLEMS EP18-1 General and Technical Standards Cases a. Forecast standards The PA failed to observe the forecast/projection because his report apparently did not state "The character of the work performed by the member and the degree of responsibility he is taking." The PA should give a disclaimer relating to the achievability of the forecast. b. The PA has not violated any rules yet, but he will if he fails to consult with the company's current PA firm before calling his friend back. Kim must ascertain that he is aware of all the facts. His friend may have had a disagreement with his PA firm and may be "shopping around." c. Handbook Section 5510 and Rule 206 d. Use of PA Designation by Member Not in Public Practice. The PA can perform audits and write reports in his capacity as employee. However, he is not really an independent auditor in the sense of being in public practice. Therefore: * He may use his PA title so long as his status of employee is made clear. * His reports should be issued on Aggregate Corp.'s letterhead. * His reports should make no reference to generally accepted auditing standards (which imply audits made by non-employee independent auditors). * If the reports are used outside Aggregate, the CPA should make sure his employment status and title are clearly understood. e. Interpretation - Controller, Preparation of Financial Statements. The PA erred. The work done by the controller is not an independent audit (because the controller is not independent) and the PA cannot accept it as being in accordance with GAAS. The subsidiary appears to be material to the consolidated financial statements. EP18-2 Responsibilities to Clients (Confidential Information and Contingent Fees) a. Rules 202, 209, and 210. Retaining an outside mail service to handle confirmation of accounts receivable for the PA is not acceptable practice. The confirmation of receivables is an important part of the audit, and therefore cannot be delegated to a nonaccountant, unsupervised by the auditor. Such an arrangement would violate Rule 202 concerning the observance of Generally Accepted Auditing Standards, especially the General Standard and the Examination Standards. In addition, the use of an outside mailing service for this work would be a violation of Rule 210 concerning the confidentiality of information obtained from the client's records. The auditor would be making available to outsiders (the mailing service's personnel) a list of the client's customers and their outstanding balances. b. Rules 209 and 210. The PA has apparently violated the rule. (In the author's opinion, however, the violation has some justification. While justification does not necessarily excuse rule-breaking completely, any penalty for doing so should be light in a case like this one.) The PA should seek client permission to disclose information to anyone (including a successor auditor). The banker should ask Candentoe to permit the PA to speak to him, and refusal should itself raise questions and cautions for the banker. c. Rule 210 Turning over work papers and business correspondence to a purchaser of a public accounting practice would be proper only if consent of the clients to whom such papers relate has been obtained. Otherwise, the action would be a violation of Rule 210 regarding the confidentiality of information obtained from clients. (A perspective purchaser may review the client files before purchasing the practice, but client permission must be obtained to turn them over to a new owner.) d. Rule 210, Information to Successor Accountant about Tax Return Irregularities Rule 210 is not intended to help an unscrupulous client cover up illegal acts or otherwise hide information by changing PAs. The former PA should at a minimum suggest that her PA friend (successor) ask Harvard Co. to permit the former PA to discuss all matters freely. If Harvard refuses, the successor PA can consider himself warned. Upon withdrawing, the fired PA should have stated all her reasons and her knowledge of irregularities in a letter to Harvard Co. Now in answer to the successor PA's inquiry she could suggest that he ask Harvard to show him the letter. (Author's note: Notwithstanding the rule of confidentiality, the fired PA could do her colleague a great disservice if she did not make sufficient effort to put him on guard.) e. Rule 216. 1. PA cannot receive a commission from a nonattest client. 2. The PA violates no Code rules by charging professional consulting rates. f. Rule 215 still prohibits contingent fees on non attest engagements including uncontested tax matters - original and amended returns. g. Since the rules say auditors are not independent if they have received a contingent fee "during the period covered by the financial statements," then the PA cannot be Faddle's independent auditor. EP18-3 Other Responsibilities and Practices a. Interpretation, Acts Discreditable. The lien under provincial law does not matter for Rule 201. The PA violates Rule 201 if he does not return the cash disbursement journal. As long as the fee is unpaid, the PA is entitled to retain the adjusting entry working papers and the inventory analysis, and all other working papers. b. The PAs violated no rules of conduct. c. Information about the PA's firm, his educational background and his professional affiliations is permitted under Rule 217. Testimonials are permitted, but the comparisons with other PAs are inadvisable since they are probably not based on verifiable facts. d. The rules of conduct do not prohibit dual practice, and the dual letterhead description is permitted. The PA should also determine whether such practice and letterhead description is permitted by the State Bar. e. Referral fees are permitted, as long as they are disclosed. f. Member's Firm Paying Employees' Bonus'. No rules prevent sharing the profits (fees) of professional work with employees. No rule is designed to prevent a firm from having bonus or profit-sharing plans which include recognition of practice development. g. Association of Accountants Not Partners. Others could assume a partnership existed. Any reports issued under the joint heading would violate Rule 401. A letterhead should not be used showing the names of two accountants when a partnership does not exist. h. Rule 403 permit retention of the retired partner's name in the name of the successor partnership. i. Under Rule 401 and most provincial laws governing professional corporations, a non-PA cannot be a stockholder in a PA P.C. (Caution: New rules about PA corporate ownership may change this restriction.) SOLUTIONS FOR DISCUSSION CASES DC18-1 Rules of Professional Conduct Rule 301.2, which prohibits CA’s from soliciting professional engagements entrusted to others, has been violated. There are circumstances under the rules where the mailing of brochures to non-clients is not considered solicitation. However, the mailing of these brochures to “all the top candidates” and then contacting them to discuss their accounting and auditing needs is considered solicitation. It is likely that these companies already have CA’s performing these duties. Rule 217.1 prohibits advertising in a manner which is false or misleading, contravenes professional good taste, reflects unfavourably on other CA’s or includes unsubstantiated statements. Describing the firm “as the CA firm where clients come first” reflects unfavourably on CA’s because it implies that other CA’s do not put their clients first. Also, this statement cannot be substantiated. The firm is allowed to issue brochures provided that the wording is appropriate and proper. Rule 215 prohibits CA’s engaged in public practice from representing that they perform a professional service without a fee. The only exception to this rule is for work of a charitable or benevolent nature. Since the brochure states that new audit clients will not be charged fees for management, consulting services in the first year, rule 215 has been violated. DC18-2 Conflict of Interest These press clippings are a good illustration of the way an accounting practice matter gets handled by the press, and a good illustration of the way PAs handle criticism. The public watchdogs are in a mild uproar, while the PAs calmly say "no problem." The PAs often rely on their unshakable insistence on objectivity no matter what the outside appearances or other relationships. The public interest representatives and the newspaper writers and editorialists are equally dependent upon the view they can see. Students are unpredictable: Sometimes they quickly side with the press and the public spokespersons; other times they stoutly defend the CPA point of view ("We can do everything right, trust us.") Observations: Conflict of Clients' Interests If Jack and Jill gang up on Bill, Jon may lose the work that goes to Phil. Despite the bad poetry, this situation raises a typical "Who's the client?" question. Unfortunately, the relevant relationships are Jon's individual engagements with Jack and Bill--because Jon would have essentially the same problem if Oneway Corporation were not a client. The situation is "unfortunate" because Jon is in a no-win situation. If he keeps Bill informed, he might save the Oneway engagement and Bill's friendship (not to mention the well-being of little Otto, his godchild), but he will suffer the guilt of having engaged in industrial espionage and might face an ethics complaint for having thumbed his nose at the rule of accountants' confidentiality. If Jon keeps quiet, he might lose the engagement and a significant portion of his personal income at least temporarily, Bill will probably suffer and life just won't be the same. If Jon believes rules are the most important element of ethical behavior and the consequences of action or inaction must fall where they may, he will refuse Bill's request with an eloquent and sympathetic explanation of the professional reasons for not discussing other clients' business affairs. A happy outcome for this approach depends upon Bill's understanding the difficult situation he has created for Jon. (After all, Bill created the situation by asking Jon to give him the information. Friendship runs both ways, and in this case Bill has unintentionally been "unfriendly.") If Jon believes in weighing the "good and evil consequences" of ethics-related choices, he will need to decide which ultimate outcome is most desirable: Bill's well-being (and his own income) or Jack's and Jill's well- being, whatever it may be. Choosing to tell Bill about Jack's plans could be construed as a selfish act on Jon's part. Professional "selfishness" may not be against the rules, but in this case, different avenues of analysis seem to suggest the rule is a good one, even in this difficult personal situation. DC18-3 The case involves issues of independence, and the responsibilities of management and the public accountant. Some of the points that can be discussed include the following ▪ the impact on independence of the client lacking the management expertise to make its own decisions, which the PA can then provide assurance on. A key principle here is that people cannot objectively assess their own work. If the company management lacks the expertise to make accounting decisions it is not possible for them to take responsibility for the statements and therefore it is not possible for PA to provide assurance on them ▪ the PA has recently become aware that he/she is probably not acting independently enough to perform a review. Independence requirements are even higher for an audit so it would be difficult to accept the audit engagement under the current circumstances. If Pinto were to hire a qualified CFO this situation would probably change. DC18-4 a. The sequence of steps which has been proposed as a way in which an auditor might go about trying to resolve an ethical dilemma are as follows: i) Obtain the relevant facts. ii) Identify the ethical issues from the facts. iii) Determine who is affected and how each person or group is affected by the outcome of the dilemma. iv) Identify the alternatives available to the person who must resolve the dilemma. v) Identify the likely consequences of each alternative. vi) Decide the appropriate action. b. The two broad aims of the CGA Code of Ethics are: i) ensuring and safeguarding the quality of services provided by CGAs; ii) maintaining ordered and dignified relationships among members in the conduct of their profession. c. The three mechanisms by which the CGA Code of Ethics and Rules of Professional Conduct works are: i) the Code provides a set of standards which members can regard as a minimum level of acceptable conduct. ii) the Code provides assurance to the public that the CGA profession is imposing on itself high standards by which it is willing to be judged. iii) the Code forms the basis of disciplinary procedure through which allegations of professional misconduct are addressed. DC18-5 a. The practice to which Ray is referring is “low-balling” or tendering an extremely low bid (perhaps even below cost) to acquire a new client. The auditor may do so in the expectation that this will be compensated by the ability to earn excess profits from the engagement in later years. b. Audit quality could be compromised because the reduced fees to be received from the engagement could create pressure for reduced costs in the conduct of the examination and result in insufficient audit effort. Auditor independence could be compromised because once having obtained a client with an artificially low bid, the auditor has a clear incentive to try to retain the client to recover his or her “investment”. This could lead to the auditor being more susceptible to pressure to acquiesce to the client’s wishes. c. Theoretically a client firm could take advantage of this competitive situation by frequent auditor switching--going from one lowball bid from prospective auditors to another. The reason that this might not work, at least not for long, is that auditors will come to anticipate this behaviour. When bidding to perform an audit for a company which changes auditors frequently, the present value of excess profits for any audit firm goes to zero and there is no economic incentive to discount the bid. d. The CGA-Canada Code of Ethics states that “CGAs shall endeavor to eliminate the practice of competitive bidding for professional engagements” while at the same time allowing members to respond to “an unsolicited written invitation to tender”. DC18-6 Sample Response From the situation in the question the following ethical issues have been identified and are discussed in the context of the ICAO rules of professional conduct. ▪ actual audit strategies should not be disclosed to the client since one is looking for errors and does not want the client to “pre-audit” material. ▪ “lowball” bids and “fixed fee quotes” should not be used since fees should be based on the time required to perform the service One of the factors an auditor should consider before accepting an audit is whether they have adequate knowledge and expertise in a field. If the auditors were ‘apprehensive’, then they perhaps should not have accepted the job ▪ Stan Biggs may lack independence and objectivity, real and apparent. He may have loyalty to his old company especially since he was the controller and will be auditing his own work. The fact that he still has investments in the company further creates independence problems ▪ the auditor’s objectivity may further appear to be impaired if he agrees to appear in the ad, particularly the type of ad suggested by Edgar ▪ to accept gifts and fringe benefits from clients beyond what employees receive - further impinges on the auditor’s apparent independence ▪ it is the responsibility of all members of the profession to report any incompetent work to the Institute. The auditor should determine if the quality of work of the previous auditor is bad enough to warrant reporting them to the professional conduct committee. DC18-7 Some points that could be raised include ▪ the extent of tax evasion is a significant cost to the government and tax preparers are in a key position to reduce it by refusing to assist clients who appear to be reporting fraudulent or misleading tax information ▪ the enforcement and penalties imposed by professional accounting bodies may not provide severe enough disincentives for tax preparers to look the other way on a revenue generating tax preparation job DC18-8 The case situation is a contingency fee, which is prohibited by the provincial accounting association’s rules of professional conduct. So it is not appropriate. The reason for this rule is that contingency fees may impair the PA’s objectivity because they give the PA a personal interest in the outcome of the engagement. DC18-9 From a public service perspective, the objectivity and due care of the PA is most important and imposing unlimited liability provides a greater incentive for PAs to comply with standards and not perform negligently. However, public accounting is also a practice from which PAs earn a living, so keeping costs of potential liability and liability insurance in reasonable bounds is also important. The viability of public accounting as a livelihood for practitioners is an important consideration since otherwise people would not want to provide this critical service to the public. In an unlimited liability partnership a partner can lose his/her personal wealth because of another partner’s negligence. This is difficult to plan for personally and may deter people from entering the profession. The limited liability partnership and professional corporation limit liability so a partner/PA is only unlimitedly liable for his/her own personal negligence, and beyond that only the assets of the partnership/corporation are at risk, not the other partners’ personal wealth. There are also tax advantages to LLPS and corporate forms of business. DC18-10 The case presents the fundamental dilemma of public accounting, the conflict between providing an essential public service that requires the public’s trust and earning a living from what is a highly valuable skill that takes many years to learn. Recent accounting and auditing scandals can be related to this conflict. Various alternatives to the current set up can be generated and evaluated using a costs-benefits or pros-cons framework to point to a recommendation for action and change. DC18-11 If the dominant principle were to not serve the public interest, the profession would lose its relevance. Everything, including confidentiality follows from the public interest objective. The prime way of serving the public interest given the auditor’s role is to not be associated with misleading information. DC18-12 Critical thinking means searching for the truth on an issue. This means considering all the perspectives, identifying the controversial points, and justifying a conclusion incorporating all this. Lack of independence means you cannot provide a proper justification to others because of conflicts with your own self interests. This failure to be able to provide a logical justification (as opposed to a rationalization) prevents the PA from following the critical thinking framework. Hence real critical thinking implies independence. DC18-13 Acceptable reasons for an audit opinion are implied by the auditor’ responsibilities as stated in the auditor’s report. For example, see Exhibit 1-3. The 2 key reasons are: 1. Obtain sufficient, appropriate evidence on which to base an audit (i.e., there is no audit deficiency); and 2. evaluating the appropriateness of the financial reporting (i.e., there is no accounting deficiency). If there is an accounting or auditing deficiency and the auditor issues an unqualified opinion, then they audit report itself may be fraudulent. That is, the auditor has intentionally misrepresented the responsibilities he or she has met in the audit report. Without good reasons the auditor cannot say that he or she has met those responsibilities. DC18-14 Can you provide good reasons why the following scenarios are morally different? Note in both cases you save 5 lives at the cost of 1. Case 1. You see a runaway train hurtling out of control towards 5 people walking on the tracks, who don’t see the train coming up behind them. If you pull the switch next to you can direct the train to a different track that has only 1 person walking on it. Should you pull the switch? Case 2. Same as case 1 except now the only way to divert the train off the track is to throw a heavy object in the train’s path. You are standing on a bridge over the track and the only suitably heavy object is the fat man standing next to you. Should you push the man over the bridge? Based on an internet survey of over 100,000 people around the world, 90% of people are willing to pull the switch in Case 1 but hardly anyone is willing to push the fat man in Case 2. When pressed for a reason most people can’t explain it, including philosophers. This illustrates that some aspects of moral reasoning are hard-wired in our brains and reflected in our emotions. There seems to be a fundamental principle about not using people as a means to an end, and physically manhandling them to achieve those ends. Solution Manual for Auditing: An International Approach Wally J. Smieliauskas, Kathiryn Kate Bewley 9780071051415