UNIT V APPLICATION OF THE RISK-BASED AUDIT PROCESS PHASE Ill- REPORTING Chapter 21 Evaluation of Audit Evidence and Completion of the Audit 22 Forming an Opinion and Reporting on Financial Statements 23 Modifications to the Opinion in the Independent Auditor's Report 24 Preparation of Financial Statements Searoed th canscannet,Chapter EVALUATION OF AUDIT EVIDENCE AND COMPLETION OF THE AUDIT Expected Learning Outcomes After studying this chapter, you should be able to: 1 2. Understand the need to evaluate audit evidence gathered to support the conclusions for the auditor's report. Know how to evaluate audit evidence for sufficiency and appropriateness. Know the various issues that the auditor considers in completing the audit Describe the letter of inquiry to client's legal counsel. Discuss the contents of the representation letter obtained from client management. nN ss ‘Seana wth CamS:anerCHAPTER 21 EVALUATION OF AUDIT EVIDENCE AND COMPLETION OF THE AUDIT . THE REPORTING PHASE OF THE RISK-BASED AUDIT PROCEgg INVOLVES: A. Evaluating the Audit Evidence to determine what additional audit wo, (if any) is required (Chapter 21) B. Forming an Opinion based on audit findings and preparing the auditory report (Chapter 22). Chapter 21,covers the procedures in evaluating audit evidence that will serve as the basis in forming an opinion on the financial statements. Each audit is unique, but the approach to all audits is essentially the same Management makes assertions in financial statements about the existence, completeness, rights or obligations, valuation and presentation of financial data Those assertions are examined during an audit. The strength of an audit depends on the relevance and reliability of the evidence gathered. Relevance is determined by the assertions tested; that is, some evidence will be relevant to an existence assertion but only tangentially relevant to a valuation assertion. Reliability relates to the quality of the evidence gathered and is affected by the independence of the evidence from the influence of the client or by the quality of the client's overall control structure. The auditor uses the risk assessments to assist in determining the potential reliance on internally generated audit evidence. An effective audit combines relevant and persuasive audit evidence to provide reasonable assurance that the financial statements are free of material misstatement when the auditor renders an opinion on the financial statements. It is also important to perform each audit as efficiently as possible without jeopardizing quality. Determining the sufficiency and appropriateness of evidence is a matter of professional judgment. After the planned audit procedures have been performed an evaluation of results will take place. This will include a review of the audit documentation discussion with the engagement team and any changes to the audit plans * result of the procedures performed. ‘Seanad wth CamS:anerEvaluation of Audit Evidence .._ 619 ‘ate audit evidence has been The auditor should be satisfied that sufficient appropri 10 be issued. obtained to support the conclusions reached for the auditor’s report t Auditors should evaluate with professional skepticism the evidence obtained in relation to their accumulated knowledge of the client and the industries in which it operates. Professional skepticism is especially important when managemcrt is pressured for results and is also called for when the financial statements before they are audited show unusually favourable results. EVALUATING THE SUFFICIENCY AND APPROPRIATENESS OF AUDIT EVIDENCE Sufficient Appropriate Audit Evidence ‘The auditor should obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base the audit opinion. Sufficiency and appropriateness are interrelated and apply to audit evidence obtained from both tests of control and substantive procedures. ‘Sufficiency is the measure of the quantity of audit evidence; appropriateness is the measure of the quality of audit evidence and its relevance to a particular assertion and its liability. Ordinarily, the auditor finds it necessary to rely on audit evidence that is persuasive rather than conclusive and will often seek audit evidence from different sources or of a different nature to support the same assertion. inion, the auditor does not ordinarily examine all of the sions can be reached about an account 1 by way of using judgmental or statistical In forming the audit opi information available because conclu balance, class of transactions or contro! sampling procedures. ‘The auditor's judgment as to what is sufficient appropriate audit evidence is influenced by such factors as the: assessment of the nature and level of inherent risk at both the © Auditor's ¢ account balance or class of transactions financial statement level and th level. Nature of the accounting and internal control systems and the assessment of control risk. © Materiality of the item being examined. Experience gained during previous audits. © Results of audit procedures, including fraud or error which may have been found. © Source and reliability of information available. ‘Seana wth CamS:aner620 Chapter 2 . When obtaining audit evidence fom fests of conte, the auditor shoul go the sulticieney anil appropriateness ofthe audit evidence {0 support the agra level of control risk, The aspects of the accounting and internal control Syste bout which the auditor would obtain audit evidence are: ms a Desig the accounting and internal control systems are suitably desi to prevent and/or detect and corre material misstatements; and b, Operation: the relevant period. ystems exist andl have operated effectively throughout h When obtaining, audit evidence from substantive procedures, the auditor shou consider the sufficiency and appropriateness of audit evidence from Such, procedures together with any evidence from tests of controls to support financial statement assertions, Competence or Appropriateness of Evidence The competence or appropriatene believability, The of evidence refers to its trustworthiness or wctors that determine the competence of evidence are: Relevance of the evidence to the particular assertion being tested idence must be relevant to the assertion being tested. For example, observing the taking of inventory provides evidence concerning existence of the inventory, but it is not relevant to determining ownership. 2. Objectivity of the evidence Evidence can be objective or subjective. In general, the more objective the evidence, the more reliable and competent it is. Conversely, the more subjective evidence is, the less reliable it is. The greater the judgment required on the part of the provider of the information, the more subjective the information will be, An example of objective evidence is information obtained by physically counting cash or footing the accounts receivable subsidiary ledger. Examples of subjective evidence are attorney's statement about a client's contingency and a credit managers statement about the collectibility of an account. The more subjective tht evidence, the more important the auditor's experience in evaluating it. iim ‘Seana wth CamS:anerThe following hierarchy relative competence and persuasi hierarchy starts with the strongest Evaluation of Audit Evidence 621 3, Qualifications of the provider of the evidence Evidence obtained from independent external reliability than evidence obtained within the entity. Evidence an auditor obtains directly through his or her own work is more reliable than information obtained through the work of others. Confirmation responses from a business are more reliable than confirmations from a -household. And accounting data and financial statements developed in an entity in which internal control is satisfactory are more reliable than data and statements developed in an entity with unsatisfactory internal control. | sources has greater 4. Timeliness of the evidence Timeliness is particularly important with respect to accounts that change rapidly (either because the total balance changes or because the peso value of the transactions that flow into and out of the account is large). Evidence gathered about a year-end account balance provides more evidence about a year-end balance than does ev! idence gathered about the balance at another date. of evidential matter will help one understand the ive power of different kinds of evidence. The form of evidence and proceeds to the weakest. obtained through physical ‘An auditor's direct, personal knowledge, computations, is generally observation and his or her own mathematical considered the most competent evidence. Documentary evidence obtained directly from independent external sources (external evidence) is considered competent. Documentary evidence has originated outside the client's data processing system but which has been received and processed by the client (external— imernal evidence) is generally considered competent. However, the circumstances of internal control quality are important. Internal evidence consisting of documents that are produced, circulated, and finally stored within the client's information system is generally considered low in competence. However, internal evidence is used extensively when it is produced under satisfactory conditions of internal control, Sometimes, internal evidence is the only kind available. ‘Seana wth CamS:anerOo | 622 Chapter 21 5. Verbal and written representa h officers, dire owners, and employees are generally considered the least com tors, evidence. Such representations should be corroborated with other ye evidence. Pes of Sufficiency of Evidence Sufficiency of audit evidence refers to the amount or quantity of eViden, gathered. The concept of sufficiency recognizes that the Accumulation of evidence should be persuasive rather than convincing. This concept is consistent with the idea that the auditor is not free to Collect unlimited amounts of evidence since he must work within economic limits, Cost cannot, however be the sole basis for the quantity or quality of audit procedures Auditors use professional judgment to determine the extent of tests necessary to obtain sufficient evidence... In exercising their professional judgment, auditoy consider both the (1) materiality (e.g., peso amount) of the item in question as well as the (2) relative risk of the item (¢.g., cash due to its liquidity, may have higher relative risk than certain property, plant and equipment do). Since the competency of evidence depends upon the financial statement assertion under consideration, the auditor should attempt to gather sufficient quantity of competent evidence at a minimum cost. An audit of financial statements is a cumulative and iterative process. As the auditor performs planned audit procedures, the audit evidence obtained may cause the auditor to modify the nature, timing, or extent of other planned audit procedures. Information may come to the auditor's attention that differs significantly from the information on which the risk assessment was based. For example: ° The extent of misstatements that the auditor detects by performing substantive procedures may alter the auditor's judgment about the risk assessments and may indicate a material weakness in internal control. © The auditor may become aware of discrepancies in accounting records. of conflicting or missing evidence. ° Analytical procedures performed at the overall review stage of the audit may indicate a previously unrecognized risk of material misstatement. ‘Seanad wth ComsatEvaluation of Audit Evidence 623 In such circumstances, the auditor may need to reevaluate the planned audit procedures, based on the revised consideration of assessed risks for all or some of the classes of transactions, account balances, or disclosures and related assertions. The auditor cannot assume that an instance of fraud or error is an isolated occurrence. Therefore, the consideration of how the detection of 8 misstatement affects the assessed risks of material misstatement is important 1” determining whether the assessment remains appropriate The auditor's judgment as to what constitutes sufficient appropriate audit evidence is influenced by such factors as the following: «Significance of the potential misstatement in the assertion and the Iikelihood of its having a material effect. individually or aggregated with other potential misstatements, on the financial statements. «Effectiveness of management's responses and controls to address the risks. © Experience gained during previous audits with respect t0 similar potential misstatements. «Results of audit procedures performed, including whether such audit procedures identified specific instances of fraud or error. © Source and reliability of the available information. « Persuasiveness of the audit evidence. «© Understanding of the entity and: its environment, including the entity's internal control The evaluation of the audit evidence obtained would address the following matters. 1. Materiality The auditor shall assess whether the amounts established for overall and performance materiality are still appropriate in the context of the entity's actual financial results. If a lower materiality than that initially set is appropriate, the auditor is required to determine: Whether it is necessary to revise performance materiality; and © Whether the nature, timing and extent of the further audit procedures remain appropriate. ‘Seana wth CamS:aner624 Chapter 21 Risks The auditor shall determine whether in the light of the audit fin, assessed risks of material misstatement at the assertion ley ing el i appropriate. If not, the risk assessments would be revised and fut planned audit procedures modified. Misstatements The auditor shall determine the effect on the audit of identify misstatements and whether there is a need to perform additional audy procedures. Revisions to the audit strategy and detailed audit plans may be required when: © The nature or circumstances of identified misstatements indicate tha, other misstatement(s) may exist that, when aggregated with known misstatements, could exceed performance materiality; or © The aggregate of identified and uncorrected misstatements comes close to or exceeds performance materiality. Fraud The auditor through the performance of analytical procedures shall assess whether previously unrecognized risks of material misstatement due to fraud are present. Also, he/she shall determine whether the identified misstatements are indicatives of fraud. Evidence The auditor shall determine whether sufficient appropriate evidence hes been obtained to reduce the risks of material misstatement in ihe financial statements to an acceptably low level. He/she shall consider whether there is a need for further procedures to be performed. Analytical Procedures The auditor shall assess whether the analytical procedures performed * the final review stage of the audit: e Corroborate the audit findings; or e Identify previously unrecognized risks of material misstatement. ‘Seana wthCamS:anerEvaluation of Audit Evidence .._625 FACTORS TO CONSIDER The following factors shall be considered in evaluating the sufficiency and appropriateness audit evidence: (a) Materiality of misstatements ficant, and what is Is a misstatement in the assertion being addressed sign 3 :ombined the likelihood of it having a materially effect (individually or c with other potential misstatements) on the financial statements? (6) Management responses is management responsive to audit findings, and how effective is the internal control in addressing risk factors? Quality of information ‘Are the sources of available information relial supporting the audit conclusions? @ ble and appropriate for (d) Persuasiveness Is the audit evidence persuasive or convincing? (e) Previous experience What has been the previous experience in performing similar procedures, and were any misstatements identified? (D Results of performed audit procedures Do the results of performed audit procedures support the objectives, and is there any indication of fraud or error? (g) Understanding the entity Do the evidences obtained support or contradict the results of the risk assessment procedures (which were performed to obtain an understanding of the entity and its environment, including internal control)? ‘Seana wth CamS:aner soiaaillat st ail ‘—" Chapter 21 FINAL ANALYTICAL PROCEDURES Analytical procedures help auditors assess the overall presentation op financial statements. Auditing standards require the use of analytical prog, in both the planning phase and the final review phase of the audit to gaat” identifying account relationships that are unusual. At the conclusion of the a the audit team analyzes the data from an overall business perspective 1h reviewers are not only looking at the trends and ratios but are asking jy questions about whether the company's results make sense in relationship 4, industry and economic trends. ° Analytical procedures are carried out to: © Identify a previously unrecognized risk of material misstatement; * Ensure that the conclusions formed during the audit on individu components or elements of the financial statements can be corroborated: and © Assist in arriving at the overall conclusion as to the reasonableness of the financial statements. DOCUMENTATION The final step in the evaluation process is to record all the significant findings or issues in an engagement completion document. This document may include all information necessary to understand the significant findings or issues, as well as cross-references, as appropriate to other available supporting audit documentation This document-would also include conclusions about information the auditor has identified relating to significant matters that are inconsistent with or contradict the auditor's final conclusions. Nature and Objective of Audit Documentation PSA 230 "Audit Documentation" establishes standards and provides guidance regarding audit documentation in the context of the audit of financial statements. The standard on documentation requires that the auditor should prepare 0" * timely basis, audit documentation that provides: ; (a) A sufficient and appropriate record of the basis for the auditor's repo (b) Evidence that the audit was performed in accordance with PSAs applicable legal and regulatory requirements. | sal ‘Scand wthCamSsanerAudit Evidence 627 Evaluation ¢ tion with Those Charged with Governance” requires that basis with those charged with he financial statement PSA 260 "Commun the auditor shall communicate on a timel governance the responsibilities of the auditor in relation to t audit, including tha uditor is responsible for forming and expressing an opinion o the (a) The by management with the financial statements that have been prepared oversight of those charged with governanee; and (b) The audit of the financial statements does not relieve management OF those charged with governance of their respons auditor of the procedures nd the pertinent documentation of Audit working papers are the records kept by the applied, the tests performed, the information obtained a conclusions reached in the engagement. They represent the audit evidences collected and evaluated. is preparing sufficient and to help enhance the quality of aluation of the audit ¢ auditor's report is performed is likely to The primary objective of audit documentation appropriate audit documentation on a timely bas the audit and to facilitate .the effective review and © evidence obtained and conclusions reached before th finalized, Documentation prepared at the time the work is be more accurate than documentation prepared subsequently. mentation Form, Content and Extent of Audit Do The auditor shall prepare audit documentation that is sufficient to enable an experienced auditor, having no previous connection with the audit, to understand: (a) The nature, timing, and extent of the audit procedures performed to comply with the PSAs and applicable legal and regulatory requirements; (b) The results of the audit procedures performed, and the audit evidence obtained; and (6) Significant matters arising during the audit, the conclusions reached thereon, and significant professional judgments made in reaching those conclusions. The form, content and extent of audit documentation depend on factors such as: © The size and complexity of the entity. © The nature of the audit procedures to be performed. The identified risks of material misstatement. ‘Seana wth CamS:anera om 628 Chapter 21 © The significance of the audit evidence obtained. © The nature and extent of exceptions identified. The need to document a conclusion or the basis for a conclusion not determinable from the documentation of the work performed pt) evidence obtained. audit © The audit methodology and tools used. In documenting the nature, timing and extent of audit procedures performed auditor shall record: the (a) The identifying characteristics of the specific items or matters tested: (b) Who performed the audit work and the date such work was compleeg and , (c) Who reviewed the audit work performed and the date and extent of su review. The auditor shall the audit, documentation in an audit file and complete the administrative process of assembling the final audit file on a timely basis after the date of the auditor's report. After the assembly of the final audit file has been completed, the auditor shall not delete or discard audit documentation of any nature before the end of its retention period. In circumstances other than those mentioned in paragraph 13 of PSA 230 where the auditor finds it necessary to modify existing audit documentation or add new audit documentation after the assembly of the final audit file has been completed auditor shall, regardless of the nature of the modifications or additions, document: (a) The specific reasons for making them; and (b) When and by whom the weremade and reviewed. ‘Seanad wth CamS:anetEvaluation of Audi Evidence 629 TYPES OF WORKING PAPERS ‘An example of a file index for a current-year audit is shown below. INDEX — YEAR-END AUDIT FILE a | Finalization of Audit | 1) Audit fle closing 8) Engagement parinerisole | practitioner review - 2) Financial statementsiauditors report | 7) Adjusting ‘and closing journal entries 3)_Final analyfical review (8) Working Wal balance __ 4) Reviewers checklist Qualty control 9) Correspondence, discussions, and review (if EQCR applicable) notes — Representation letter 10) Discussions with management and others Management letter Notes and queries 5) Financial statement presentation and disclosure review _| Audit Acceptance 11) Audit engagement acceptance | 12) Understanding the enfity and ts checklist — environment — New or continuing client Information Client profile Documents to request from predecessor's files ” Engagement letter” | Overall Audit Strategy 21) Establishing the overcll audit 25) Assessing inherent risks strategy checklist 22) Determining materiality | 26) Determining whether the ‘isks Evaluating misstatements indicate the need for an EQCR 23) Identifying risks using analytical 27) Audit budget — Time and Fees procedures Schedule ef documents to be prepared by client 24) Conducting an audit team planning 28) Overall audit strategy meeting ‘Seana wth CamS:aner*hapter 21 as Assessing Risks of Material Misstatement 31) Assessing the risks of material | misstatement checklist 32) Inquiries for management, for those responsible for govemance, for those responsible for internal audit, and for others in the entity 33) Evaluating the control environment 36) Testing controls **: — > Revenue, receivables, ang Teceipts | Purchases, payables, and | payments | Payroll Inventory, cost of sak | production a Financing and equity 37) Review of minutes of all meetings Appointment of auditor (acy resolution) 38) Review of client's annual report or other document that will include the audited financial statements 34) Evaluating managements use of estimates, including fair value 39) Risk assessment summary 35) Information systems and internal control: General IT system and IT controls Revenue, receivables, and receipts Purchases, payables, and payments Payroll Inventory, cost production of sales, and Financing and equity ‘Seana wthCamS:anerEvaluation of Audit Evidence 631 Financial Statement Checklists, Analytical Procedures and Tests of Balances 1 |_ Balance Sheet/Statement of Financial Position 4 A Cash and cash equivalents [NN _| EquityiNet assets | B Trade and other receivables [SS _| Joumal entries | C__| Inventories TT | Responding to indications of fraud | D__| Prepaid expenses ‘UU__| Going concem | E _| Investments ‘W | Foreign currency translation | F Property, plant and equipment | WW | Accounting estimates. | (BUS) | | G Capital assets (NPO) | Changes in Zecounting policies and | | correction of prior period errors_| H Goodwill and intangible assets | XX T Related party transactions | (BUS) | | AA _ | Short-term andiong-term debt | Significant transactions outside the normal course of business | BB | Accounts payable and accrued | YY Contingencies and comer liabilities obligations EE | Taxes payable | ZZ_| Economic dependence | HH _ | Other liabilities | | Income Statement/Statement of Operations | | 100 | Revenue 300 | Expenses 200 | Costof sales 400 _| Other income and expenses | | Substantive Tests of Transactions * | 500 Revenue, receivables, and receipts Inventory, cost of sales, and | Purchases, payables, and production | payments Financing and equity | Payroll * May be in permanent file ** May be in interim file ‘Seana wth CamS:aner632_Chapter 21 Figure 21-1 shows an example of a letter sent to management and those with governance, charge Figure 21-1: Mustrative Communication of Audit Matters of Governance Interest Valderama & Co., CPAs a, Ayala Avenue, Makati City | March 15, 20X6 Mr. Jun Manalo, Managing Director Metro Express, inc Tandang Sora, Quezon City (02) 875-0316 Dear Mr. Manalo: The matters raised in this report arise from our financial statement audit and relate to matters that we believe need to be brought to your attention. We have substantially completed our audit of Metro Express’ financial statements in accordance with professional standards. We expect to release our audit report dated March 20, 20X6 as soon as we obtain the signed letter or representation. Our audit performed to obtain reasonable assurance whether the financial statements are free from material misstatements. Absolute assurance is not possible due to the inheren! limitations of an audit and of intemal control, resulting in the unavoidable risk that some material misstatements may not be detected. In planning our audit, we consider internal control over financial reporting to determine the nature, extent, and timing of audit procedures. However, a financial statement audit does 0) provide assurance on the effective operation of internal control at Metro Express, ne However, if in the course of our audil, certain deficiencies in intemal control come to ou attention, these will be reported to you. Because fraud is deliberate, there are always risks that material misstatements, fraud, at other illegal acts may exist and not be detected by our audit of the financial statements. ‘Seanad wthCamS:anerEvaluation of Audit Evidence -.- 633 The following is a summary of findings resuling from the performance of the audit. 1. We didnot ieny any material mates ote han the identified misstatements been ussed with you and have now been corrected) that need to brought (0 your 2. We reosied good cooperation fom management and emloees during out audit. To tof our knowledge, we also had complete access to the accounting records other documents that we needed in order to cary out our audit. We did not have any disagreements with management, and we have resolved all auting accounting, and disclosure issues to our satisfaction. We would also like to draw the following matters to your attention: 1. Changes during the period in professional pronouncements. 2. Other matters identified that may be of interest fo management. Please note that the Philippine Auditing Standards do not require us to design procedures for the purpose of identifying supplementary matters to communicate with those charged with govemance. Accordingly, an audit would not usually identify all such matters. ation of management and is not intended This communication is prepared solely for the information to a third party who uses this for any other purpose. We accept no responsibility communication. Yours truly, en Alvin Monico Valderama & Co., CPAS ‘Seana wth CamS:aner634 Chapter 21 COMPLETING THE AUDIT ~ Almost every audit engagement has a deadline for issuance of audit repon release of audited financial statements. Thus, audit procedures need n°! completed in time to allow for adequate review and evaluation of working pr. and the financial statements before the opinion is signed. The various issues) tne auditor considers in completing his audit examination include: 1, Related party transactions; 2. Subsequent events review: : 3. Letters of inquiry/review of contingent liabilities; 4. Evaluating going concem status: 5. Management representation; 6. Perform final analytical procedures; Review the minutes of stockholders and Board of Directors; and 8. Evaluating findings, formulating an opinion and drafting the audit repon, Related Party Transactions Transactions with related parties are important to auditors because they will be disclosed in the financial statements if they are material. PAS/PFRS require disclosure of the nature of the related-party relationship, a description of transactions. including peso amounts; and amounts due to and from related parties. Management is responsible for the identification and disclosure of related parties and transactions with such parties. This responsibility requis management to implement adequate accounting and internal control systems ensure that transactions with related parties are appropriately identified in the accounting records and disclosed in the financial statements. Once related parties are identified, examination of related party transactions © pursued during examination of relevant account balances or classes transactions. The auditor should apply procedures to give adequ consideration to the possibility that the other party to material transactions related. An example which might indicate the existence of a related FS transaction is borrowing or lending on an interest-free basis or at 3 ™ a ra he significantly different than prevailing market rates at the time of " transaction. ‘Seanad wth CamS:anerThe cedar teu prow uct prosedurs dened obtnin sufficient Sa amenTOl evidence regarding the identification and disclosure by ement of related parties and the effect of related party transactions that are material to the financial statements. However, an audit cannot he expected to detect all related party transactions, Subsequent Events Review ‘The auditor has a responsibility to review transactions and events occurring ine whether anything after the statement of financial position date to determi occurred that might affect the valuation or disclosure of the statements: being, audited. ‘Two types of subsequent events require consideration by management and evaluation by the auditor: 1) Those that provide further evidence of conditions that existed at period end; and 2) Those that are indicative of conditions that arost end. ¢ subsequent to period When the auditor becomes aware of events which materially affect the financial statements, the auditor should con der whether such events are properly accounted for and adequately disclosed in the financial statements. Figure 20-2 summarizes the auditors’ responsibilities for subsequent event with respect to the balance sheet date, the date of the audit report, and the date the auditors grant the client permission to use the audit report — the report release date. ‘Seana wth CamS:aner636 Chapter 21 Figure 20-2: Subsequent Events Interim Period Type Conditions Existing on or before Balance Sheet Date ' Subsequent Period Type 2 Conditions Arising after Balance Sheet Date | i Subsequent Events Adjust Financial Consider for Statement Amounts | Disclosure Beginning Balance Date of of Current Sheet the Ault Year's Audit Date Report Work i i ' Perfonn Audit t Responsible ' Procedures 1 Oniytor be 10 Search for. ——pte— information pt t Subsequent 1 “Coming to i Events {auditors ' 1 Attention Letters Of Inquiry / Review For Contingent Liabilities A contingent liability is a potential future obligation to an outside party for an unknown amount resulting from activities that have already taken place. For a contingent liability to exist, the following three (3) conditions must be prese Certain contingent liabilities are of considerable concer to the auditor: ~ 3. There is a potential future payment to an outside party that resulted from an existing condition; There is uncertainty about the amount of the future payment; and The outcome will be resolved by some future event or events. Income tax disputes Product warranties Pending litigation for patent infringement, product liability or actions ‘Seanad wth CamS:aner udEvaluation of Audit Evidence 63% « Notes receivable discounted © Guarantees of obligations or others «Unused balances in outstanding letters of credit An audit inquiry letter (also called a lawyer's letter) is sent by the auditor to the client's lawyer as a primary means of corroborating the information management provides about litigation, claims. and assessments. The objective Of the letter is 0 obtain information to facilitate the auditor's understanding of 8 client's contingencies. Evaluation of Going Concern Assumption PSA 570 requires the auditor to evaluate whether there is a substantial doubt about a client's ability to continue as a going concern for at least one year after statement of financial position date, This assessment is initially made as part f planning but is revised whenever significant new information is obtained. |A final assessment is desirable after all evidence has been accumulated and proposed audit adjustments have been incorporated into the financial statements Analytical procedures are one of the most important types of evidence to assess going concer. Discussions with management and a review of future plans are important considerations in evaluating the analytical procedures. The knowledge of the client's business gained throughout the audit is important information used to assess the likelihood of financial failure within the next year. Management Representations Obtaining appropriate management representation is also a subsequent events procedure required in an audit examination. The auditor should obtain evidence that management acknowledges its responsibility for the fair presentation of the financial statements in accordance with the relevant financial reporting framework, and has approved the financial statements. The auditor can obtain evidence of management's acknowledgment of such responsibility and approval from relevant minutes of meetings of the board of directors or similar body or by obtaining a written representation from management or a signed copy of the financial statements. ‘Seana wth CamS:aneres The auditor would ordinarily include in audit working: papers Management's representations in the form of a summary of oral with management or written representations from management O38 Chapt ©Videncg discus t Wsion, A writen representation is beter audit evidence than an oral representa " 1 can take the form of “ (a) A representation letter from management; (0) A letter from the auditor outing, the auditor's understanding g managements representations, duly acknowledged and confined by management; or (c) Relevant minutes of meetings of the board of directors oF sin a signed copy of the financial statements: Ia body Perform Fi al Analytical Procedw Analytical procedures are normally used as a part of planning. the audit, ding the performance of detailed tests in each cycle, and at the completion of the audit. Analytical procedures performed as part of the overall review assist the auditors in assessing the validity of the conclusions reached, including the opinion to be issued. They are useful as a final review for material misstatements or financial problems and to keep the auditor take a final “objective look" at the financial statements. It is usual for a partner to do the analytical procedures during the final review of working papers and financial statements. Knowledge of the client's business combined with, effective analytical procedures help identify possible oversights in "an audi Review the Minutes of Mee! Bs The auditors should review the minutes of meetings of stockholders a! directors, including important subcommittees of directors such as the audit committee and the investment committee. This review includes meetings be through the date of the audit report. In completing the audit, the auditors sho" determine that they have considered all minutes, including, those for meine subsequent to year- ine end. They also will obtain written representation fr management that all minutes have been made available. ‘Seanad wth ComsatEvaluation of Audit Evidence .._ 639 as Findings, Formulating an Opinion and Drafting the Audit epo Making a Final Assessment of Materiality and Audit Risk The auditor's assessment of materiality and audit risk may be different at the time of initially planning the engagement from at the time of evaluating the results of audit procedures. This could be because of a change in circumstances or because of a change in the auditor's knowledge as a result of the audit. When completing the audit, the auditor must reconsider materiality and determine a material amount to be used in evaluating the estimated misstatement in the financial statement. Audit risk should also be reconsidered In evaluating whether the statements are presented fairly, an auditor should aggregate any uncorrected misstatement to be able to consider them in relation to the financial statement as a whole. The aggregation should include not only the known but also the likely misstatement. Known misstatements are individual misstatements specifically identified by an auditor. Likely misstatements are an auditor's best estimate of misstatement based on a projection of the misstatements detected during sampling. If audit risk increases due to numerous events and conditions while the audit is being undertaken, the auditor should evaluate whether additional substantive procedures need to be performed. The auditor then determines whether the Pecumulated evidence indicates that the level of audit risk is appropriately low such that the auditor can render an opinion Evidence Supports Auditor's Opinion To evaluate whether the financial statement are fairly stated, errors uncovered in the audit are summarized. Whenever the auditor uncovers errors that are in themselves material, adjustments should be made on the trial balance to correct the statement. There may also be a large’ number of immaterial errors discovered that are not adjusted at the time they are found. It is necessary to combine individually immaterial errors to evaluate whether the combined amount is material that may require adjustment. ‘Seana wth CamS:aner640 Chapter 2 If the auditor believes that he 5, ee Je of she has sufficient evidence, but it doeg ES warrant a conclusion of fairly presented financial statements, the auditor ny either: y (a) Require the client to revise the statements to the auditor's satisfaction o 1 or (b) Issue either a qualified or an adverse opinion. On the basis of these evaluations, the audit report is issued for the Financia, statements. REVIEW QUESTIONS AND PROBLEMS Questions Ll 6 In the final stage of the risk-based audit process, how shall the engagement pariner or sole practitioner know that sufficient appropriate audit evidence has been obtained to support the conclusions reached for the auditor's report to be issued Explain briefly the relevance of the following areas in connection with the final evaluation of the audit evidence obtained: (a) Materiality (b) Risk (c) Misstatements (d) Fraud (e) Evidence (A) Analytical Procedures In what instances will the auditor be required to revise the audit strategy and detailed audit plans, Give and explain briefly at least 8 sources of misstatements of financial statements items: Give and explain at least 8 factors to consider in evaluating the sufficiency and appropriateness of audit e Give examples of audit matters that should be communicated by the auditor to those charged with governance. ree a ‘Seanad wth CamS:anera Evaluation of Audit Eve Problems Problem 1 The field work for the June 30, 20X7, audit of Tracy Brewing Company wis finished August 19, 20X7, and the completed financial statements. accompanied by the signed audit reports. were mailed September 6, 20X7. In | cach of the highly material independent events (a through i), state the ; appropriate action (1 through 4) for the situation and justify your response. The alternative actions are as follows | 1) Adjust the June 30. 207. financial statements 2). Disclose the information in a footnote in the June 30, 20X7, financial statements. 3) Request the client to recall the June 30, 20X7, statements for revision. 4) No action is required The events are as follows: a. On December 14, 20X7, the auditor discovered that a debtor of Tracy Brewing went bankrupt on October 2. 20X7. The sale has tahen place April 5, 20N7. but the amount appeared collectible at June 30, 20X7 and August 19, 20X7 b. On August 15, 20X7, the auditor discovered that a debtor of Tracy Brewing went bankrupt on August 1, 20X7. The most recent sale had taken place April 2, 20X6, and no cash receipts had been received since that date. ¢. On December 14. 20X7. the auditor discovered that a debtor of Tracy Brewing went bankrupt on July 15, 20X7 due to declining financial health. The sale had taken place January 15, 20X7. d. On August 6. 20X7, the auditor discovered that a debtor of Tracy Brewing went bankrupt on July 30. 20X7. ‘The cause of the bankruptey was an unexpected loss of a major lawsuit on July 1S, 20X7, resultin from a product deficiency suit by a different customer. fe. On August 6, 20X7, the auditor discovered that a debtor of Tracy Brewing went bankrupt on July 30, 20X7, for a sale that took place July 3, 20X7. The cause of the bankruptcy was a major uninsured fire on July 20. 20X7. F ba ‘Seana wth CamS:anerTracy Brewing that had originated on February 28. 20X7 On July 20. 20X7, Tracy Brewing settled a lawsuit out of coun © originated in 2014 and is currently listed as a contingent hiabitiny h. On September 14, 20X7. Tracy Brewing lost a court case they originated in 20X6 for an amount equal to the lawsuit. The June 20X7. footnotes sate that in the opinion of legal counsel there wily, favorable settlement . i. On July 20, 20X7, a lawsuit was filed against Tracy Brewing for a pac, infringement action that allegedly took place in early 20N7 jy g. opinion of legal counsel, there is a danger of a significant loss to y. client Problem 2 In connection with his examination of Flowmeter. Inc.. for the year endss December 31, 20X6. Flores, CPA. is aware that certain events ani transactions that took after December 31. 20X6, but before he issos his report dated February 28. 20X7. may affect the company’s financal statements. The following material events or transactions have come to kis attention 1) On January 3, 20X7. Flowmeter. Inc., received a shipment of materials from Laguna. The materials had been ordered in October and shipped FOB shipping point in Novernber 20X6. On January 1S. 20X7, the company settled and paid a personal iajur. claim of a former employee as the result of an accident that occurred # March 20X6. The company had not previously recorded a liability for ti claim 3) On January 25. 20X7, the company agreed to purchase for cash outstanding shares of Poner Electrical Co. The acquisition is likely © double the sales volume of Flowmeter. Inc. On February 1. 20X7. a plant owned by Flowmeter, Inc., was damage! bf a flood resulting in an uninsured loss of inventory. On February 5. 20X7, Flowmeter. Inc.. issued and sold to the gem public P2 million in convertible bonds. 4 ‘Seana wih CamS:anerEvaluation of Audu Evidence. 643 ds For each of the event or transactions just described. indicate the audit procedures that should have brought the item to the attention of the auditor and the form of disclosure required in the financial statements, including the reasons for such disclosures. Requi Arrange your answers in the following format [— Mem No. | Audit Procedures | _ Required Disclosure and Reasons I I (AICPA Adapted) Problem 3 In connection with your examination of the financial statements of Olars Mfg. Corporation for the year ended December 31, 20X6, your review of subsequent events disclosed the following items: 1) January 3. 20X7: The government approved a plan for the construction of an express highway. The plan will result in the expropriation of a portion of the land owned by Olars Mfg. Corporation. Construction will begin in late 20X7. No estimate of the condemnation award is available. January 4, 20X7: The funds for a P25,000 loan to the corporation made by Mr. Olars on July 15, 20X6, were obtained by him by a loan on his personal life insurance policy. The loan was recorded in the account “loan from officers." Mr. Olars' source of the funds was not disclosed in the company records. The corporation pays the premiums on the life insurance policy, and Mrs. Olars, wife of the president, is the beneficiary. January 7, 20X7: The mineral content of a shipment of ore en route on December 31, 20X6, was determined to be 72 percent. The shipment was recorded at year-end at an estimated content of 50 percent by a debit to raw material inventory and a credit to accounts payable in the amount of P20,600. The final liability to the vendor is based on the actual mineral content of the shipment. January 15, 20X7: Culminating a series of personal disagreements between Mr. Olars, the president, and his brother-in-law, the treasurer, the latter resigned, effective immediately, under an agreement whereby the corporation would purchase his 10 percent share ownership at book value as of December 31. 20X6. Payment is to be made in two equal ‘Seana wth CamS:aner644 5 6 | Chapter 21 amounts in cash on April 1, 20X7 and October 1, 20X7. In Decern the treasurer has obtained a divorce from his wife, who was Mr, Olan, sister. January 31, 20X7: As a result of reduced sales, production was cungj in mid-January and some workers were laid off. On February 5, 20x5 all the remaining workers went on strike. To date the strike is unsettle" February 10, 20X7: A contract was signed whereby Lopez Enterprises purchased from Olars Mfg. Corporation all of the latter’s fixed ase, (including rights to receive the proceeds of any property condemnation, inventories, and the right to conduct business under the name "Oz; Mfg. Division." The effective date of the transfer will be March 1, 20x7. The sale price was P500,000 subject to adjustment following the taking of a physical inventory. Important factors contributing to the decision enter into the contract were the policy of the board of directors of Lopez Enterprises to diversify the firm's activities and the report of a suney conducted by an independent market appraisal firm that revealed 2 declining market for Olars' products. Required: Assume that the items described above came to your attention prior to completion of your audit work on February 15, 20X7. For each item: a. Give the audit procedures, if any, that would have brought the item your attention. Indicate other sources of information that may have revealed the item. Discuss the disclosure that you would recommend for the item, listing details that you would suggest should be disclosed. Indicate those tems or details, if any, that should not be disclosed. Give your reasons Ls recommending or not recommending disclosure of the items or details. (AICPA Adopted ics, | ‘Seana wth CamS:amerEvaluation of Audit Evidence. Os Problem 4 The following situations represent excerpts from the responses to audit quires of external egal counsel of XYZ Co. during the annual audit of year | (“legal response”), For each excerpt, select the in st appropriate financial statement effect and audit respor Each excerpt is independent. Responses may be used once, more than once, or not at all a, The client's yearend is December 31, year | b. The anticipated audit report date is February 15, year 2. atements. ¢ Allamounts are material to the financia Financial Statement Effect Audit Response No impact on financial statement (7) Legal response is appropriately amounts or notes. dated. Disclosure in notes relating to (8) Update legal response. nature of litigation, nut no amount disclosed. Disclosure in notes relating 10 (9) Update audit report date. nature of litigation, including loss amount Potential tigation settlement accrued in financial statements Potential litigation settlement accrued in financial statement, amount disclosed in notes (6) Verify amount due attomey is recorded in financial statement (1 (2) Q (a 6) amounts. a Financial Audit ‘Situations _ | Statement Effect| Response’ Letter dated February 14, year 2. ind since December 31, year 4,1 7 (a) ) “advice you that at ar have not been engaged to give substantive attention to, or represent, XYZ Co. in connection with any pending oF threatened litigation, claims, or assessment, nor am | aware of any loss contingencies. No amounts were due to this office for services provided at December 31, year 1.” ‘Seanad wthCamS:anet646 Chapter 21 TO Situations Letter dated January 21, year 2. “1 advice you that al and since December 3, year 1,1 have not been engaged to give substantive attention to, or represent, XYZ Co. in connection with any pending or threatened tigation, claims, or assessments, nor am | aware of any loss contingencies. There were fees outstanding of P3,675 due to this office for services provided at December 31, year 1" Letter dated February 26, year? K. Brosas v. XYZ Co. This matter commenced in December, year 1. The plaintiff discrimination felating to his termination on November 7, year 1 The Company intends to defend this case vigorously. At this time, we are unable to evaluate the likelihood of an unfavorable outcome or estimate the amount or range of potential loss. Letter dated March 16, year 2. J. Martin v. XYZ Co.: This matter commenced in March, year 2. The plaintiff alleges discrimination relating to his termination on November 17, year 1. The company intends to defend this case vigorously. At this time, we are unable to evaluate the likelihood of an unfavorable outcome. The plaintf is demanding P50,000 Tetter dated February 14, year 2 R. Red v. XYZ Co. This matter commenced in November, year 1. The plaintiff alleges discrimination relating to his termination on March 17, year 1. It is reasonably possible that the case will be settled for approximately P35,000 | Letter dated February 14, year 2: L. Perez v. XYZ Co. This matter commenced in November, year 1. The Plaintiff alleges discrimination relating to his termination on March 17, year 1. The case is tentatively settled for P35,000. ‘Scand wth CamS:aner — —— —. Financial Aude __| Statement Ettect! Resp [a () @ | | Cc [4 (e) a} (9) () (i i | (k) oo) | | eee _Problem 5 For each of the account balances and associated assert audit procedure from the list provided that provides the most ap} audit evidence for the account assertion. 647 Evaluation of Audit Evidence ions below, select the propriate | Procedure accounts Review confirmation of to receivable balances and agree accounts receivable subledger. b. Review list of accounts written off dunng year. jc. Review schedule of bad debt expense. id. Trace individual customer account transactions to sales invoice. e Trace sales invoice and shipping documents just before year-end to customer account transactions. a. Examine invoices from suppliers. b. Examine invoices paid subsequent to year-end and trace to subsidiary ledger. Select items from inventory listing and locate the items in the warehouse. | a. Select items located in the inventory warehouse and trace to inventory listing. e. Trace sales invoices and shipping documents just before year-end to customer accounts. Account | Balances__|__ Assertion 1. Accounts Completeness receivable | Z Inventory Valuation and allocation | | 3, Fixed assets | Rights and obligations ‘a. Interview plant manager regarding fixed asset additions during the year. b. Recalculate partial year depreciation for fixed asset acquisitions. c. Trace fixed asset item to fixed asset master control listing. d. Vouch fixed asset acquisitions to purchase invoices. e. Vouch fixed asset acquisitions © telated cash disbursement. ‘Seana wth CamS:aner648 Chapter 21 _ Accounts payable Cash Completeness Compare aging of account prior periods. 'S Payal } Confirm accounts payable suppliers. Palace wa Examine invoices paid sul | year-end and trace o ane ledger. 1 Trace individual payable transaction ty | purchase order. Vouch invoices for the purchase a! suppliers to receiving documents. | Agree bank statement to the subsidiary ledger. | Agree cash balance per the bark feconciliation to the year-end bank statement. ] Agree cash balance to online year-end bank statement. | Recalculate bank statement balance including interest receivable. Trace deposit per the bank statement | to the cash subsidiary ledger. ‘Seana wth CamS:aner