Who is resonsible to make sure that litigation, claims and assessments have been recorded properly in the financial statements?
Legal counsel’s expertise does not extend to accounting matters. Legal counsel evaluates whether claims may be asserted and the likelihood and magnitude of the outcomes. These evaluations bear upon accounting and reporting decisions, for example, whether disclosure only or recognition of a contingent liability is required. But all claims do not necessarily require recognition, and legal counsel does not have information about the content of financial statements that have not been issued.
What is a primary means of corroborating management's info concerning litigation, claims, and assessments?
Inquiring of company’s outside counsel.
A letter of inquiry to a client’s legal counsel is the auditor’s primary means of corroborating information provided by management about litigation, claims, and assessments. Evidence obtained from the client’s legal department may provide the needed corroboration, but it does not substitute for information that external legal counsel may be unable to provide. Thus, the auditor should request management to send a letter of inquiry to legal counsel with whom management consulted. Without the client’s consent, legal counsel may not respond.
Which of the following statements about litigation, claims, and assessments extracted from a letter from a client’s legal counsel is most likely to cause the auditor to request clarification?
A.“I believe that the action can be settled for less than the damages claimed.”
B.“I believe that the plaintiff’s case against the company is without merit.”
C.“I believe that the possible liability to the company is nominal in amount.”
D.“I believe that the company will be able to defend this action successfully.”
“I believe that the action can be settled for less than the damages claimed.”
The letter of inquiry requests, among other things, that legal counsel evaluate the likelihood of pending or threatened litigation, claims, and assessments. It also requests that legal counsel estimate, if possible, the amount or range of potential loss. Thus, the auditor is concerned about the amount of the expected settlement as well as the likelihood of the outcome. The statement that the action can be settled for less than the damages claimed is an example given in AU-C 501 of an evaluation that is unclear about the likelihood of an unfavorable outcome.
The refusal of a client’s legal counsel to provide a representation on the legality of a particular act committed by the client is ordinarily
Does legal counsel have the ability to evaluate if the client can continue as a going concern if a verdit of litigation is unfavorable?
Legal counsel does not have the expertise or appropriate information to make a judgment about the client’s ability to continue as a going concern. The auditor normally makes that judgment.
If deemed necessary, the auditor should request that an audit client send a letter of inquiry to those attorneys who have been consulted regarding litigation, claims, or assessments. The primary reason for this request is to provide
AU-C 501 states that a letter of inquiry to the entity’s legal counsel is the primary means of corroborating information provided by management about material litigation, claims, or assessments. The auditor should send the letter after it has been prepared by management.
The auditor’s search for unrecorded liabilities should include:
The auditor’s search for unrecorded liabilities should include reading contracts, loan agreements, leases, correspondence from governmental agencies, and any legal documents in the client’s possession.
A CPA has received legal counsel’s letter in which no significant disagreements with the client’s assessments of contingent liabilities were noted. The resignation of the client’s legal counsel shortly after receipt of the letter should alert the auditor that
Undisclosed unasserted claims may have arisen.
Legal counsel may be required to resign from an engagement (under his or her Code of Professional Responsibility) if the client disregards advice about financial accounting and reporting for litigation, claims, and assessments. Because the response to the letter of inquiry stated that the client’s assessment of contingent liabilities was satisfactory, the source of disagreement may be undisclosed, unasserted claims.
If the auditor determines that an inquiry of a client’s external legal counsel is necessary, who should make the inquiry?
A letter of inquiry to a client’s legal counsel is the auditor’s primary means of corroborating information furnished by management about litigation, claims, and assessments. Evidence obtained from the client’s legal department may provide the needed corroboration, but it does not substitute for information that external legal counsel may refuse to furnish. Thus, the auditor should request management to send a letter of inquiry to legal counsel with whom management consulted. Without the client’s consent, legal counsel may not respond (AU-C 501).
The primary source of information to be reported about litigation, claims, and assessments is the
“Management is responsible for adopting policies and procedures to identify, evaluate, and account for litigation, claims, and assessments as a basis for the preparation of financial statements in accordance with the requirements of the applicable financial reporting framework.” The auditor should discuss with management its policies and procedures for identifying and evaluating these matters.
Who is responsible for adopting policies and procedures for identifying, evaluating, and accounting for litigation, claims, and assessments?
Management is responsible for adopting policies and procedures for identifying, evaluating, and accounting for litigation, claims, and assessments. Thus, the auditor inquires of management about these matters. The auditor also obtains written representations that all known actual or possible litigation, claims, and assessments that should be considered in preparing the statements have been disclosed and accounted for in accordance with the applicable reporting framework.
“In connection with an audit of our financial statements, management has prepared, and furnished to our auditors, a description and evaluation of certain contingencies.” The foregoing passage most likely is from a(n)
Audit inquiry letter to legal counsel.
The scope of an audit is not restricted when legal counsel’s response to an auditor as a result of a client’s letter of inquiry limits the response to
Matters to which the legal counsel has given substantive attention in the form of legal representation.
Two limitations on an entity’s external legal counsel’s response are not scope limitations. The response may be limited to matters to which the legal counsel has given substantive attention in the form of legal consultation or representation. Also, the response may be limited to matters that are individually or collectively material, such as when the entity and the auditor have agreed on materiality limits, and management has stated the limits in the letter of inquiry.
The appropriate date for the client to specify as the effective date in the audit inquiry to legal counsel is
As close to the date of the auditor’s report as possible.
The date of legal counsel’s response should be as close to the date of the auditor’s report as practicable. The auditor is concerned with events occurring through the date of the report that may require adjustment to, or disclosure in, the financial statements. The date of the report is the date on which the auditor obtained sufficient appropriate audit evidence on which to base the opinion. Moreover, the auditor should specify the earliest acceptable effective date of the response and the latest date by which it is to be sent to the auditor. A 2-week period between these dates generally suffices.
The auditor should perform procedures with respect to material events or transactions that occur after the balance sheet date but prior to the date of the auditor’s report. Procedures that should be performed include inquiring of management and those charged with governance about whether:
(1) increases in capital or issuances of debt have occurred, e.g., an issue of new shares or bonds, or
(2) an agreement about a merger or liquidation has been made (AU-C 560).
After year end but before completion of the audit, a major investment adviser issued a pessimistic report on Investee Co.’s long-term prospects. The market price for its common stock subsequently declined significantly. What is the effect of this event on the year-end statements?
A.Disclosure in a note to the financial statements.
B.Adjustment of the financial statements.
C.Disclosure by means of supplemental, pro forma financial data.
D.No financial statement disclosure necessary.
No financial statement disclosure necessary.
The market price of common stock is not a financial event that affects the fairness or interpretation of the financial statements. Accordingly, no revision of the statements is necessary for changes in the market price of the securities.
Subsequent events procedures include inquiring of management as to whether:
(1) subsequent events occurred that might affect the statements;
(2) new commitments, borrowings, or guarantees were made; (3) sales or acquisitions of assets occurred or were planned;
(4) capital increased or debt was issued;
(5) developments regarding contingencies occurred;
(6) any events occurred (a) casting doubt on the appropriateness of accounting policies or (b) that are relevant to the measurement of estimates or the recovery of assets;
(7) any unusual accounting adjustments were made or considered; and
(8) changes occurred in the current status of items that were accounted for on the basis of preliminary or inconclusive data.
An auditor is concerned with completing various phases of the audit after the balance sheet date. This subsequent period extends to the date of the
Subsequent events procedures should be performed to cover the period from the date of the financial statements to the date of the auditor’s report (or as near as practicable to it) (AU-C 560).
Subsequent events are defined as events that occur subsequent to the
Balance sheet date but prior to the auditor’s report date.
Subsequent events occur between the date of the financial statements and the date of the auditor’s report. The auditor should perform procedures to determine whether subsequent events that require adjustment of, or disclosure in, the statements are appropriately reflected in the statements in accordance with the applicable financial reporting framework (AU-C 560).
Advertiser Co.’s directors voted immediately after year end to double the advertising budget for the coming year and authorized a change in advertising agencies. What is the effect of this event on the year-end statements?
No financial statement revision.
Changing of budgets and other managerial decisions made by the directors or management are not significant subsequent events. Hence, no financial statement revision (disclosure or adjustment) is necessary.
Subsequent events procedures include:
(1) reading the latest subsequent interim statements, if any;
(2) inquiring of management and those charged with governance about the occurrence of subsequent events and various financial and accounting matters;
(3) reading the minutes of meetings of owners, management, and those charged with governance;
(4) obtaining a letter of representations from management;
(5) inquiring of client’s legal counsel; and
(6) obtaining an understanding of management’s procedures for identifying subsequent events.
Some subsequent events provide evidence of conditions not in existence at the balance sheet date. Under U.S. GAAP, some of these events are of such a nature that disclosure is required to keep the financial statements from being misleading. Adequate disclosure of these events may include
Pro forma financial statement presentation.
What are subsequent events?
Subsequently discovered facts become known to the auditor after the date of the auditor’s report. Had they been known to the auditor at that date, they might have caused the auditor to revise the auditor’s report.
If the financial statements have been issued, they have been made available to third parties, along with the auditor’s report. Accordingly, the auditor should:
(1) discuss the matter with management (and, possibly, those charged with governance);
(2) determine whether the statements need revision; and
(3) if so, inquire how management intends to address the matter. To determine whether revision is needed, the auditor considers
(1) the applicable reporting framework and
(2) whether persons are currently relying or likely to rely on the statements who would attach importance to the subsequently discovered facts (AU-C 560).
Subsequent events that provide evidence of conditions that arose subsequent to the date of the financial statements
May require disclosure in notes to the financial statements.
According to U.S. GAAP, subsequent events that provide evidence of conditions arising after the balance sheet date but before the statements are issued or available to be issued are not recognized. However, a nonrecognized subsequent event may be of such a nature that it must be disclosed to keep the statements from being misleading.
What audit procedure is ordinarily performed last?
Obtaining a management representation letter.
Who should the management representation letter be signed by?
CEO and CFO
What date should the management rep letter be signed as?
The date of the representation letter should typically be the same as the audit report.
The written representations should be (1) addressed to the auditor, (2) dated as of the date of the auditor’s report, and (3) signed by responsible and knowledgeable members of management. The CEO and the CFO usually should sign the representations.
A written management representation letter is most likely to be an auditor’s best source of corroborative information of a client’s intention to
A.Discontinue a line of business.
B.Terminate an employee pension plan.
C.Make a public offering of its common stock.
D.Settle an outstanding lawsuit for an amount less than the accrued loss contingency.
Answer (D) is incorrect.
An inquiry of legal counsel provides better evidence about settlement of litigation.
Discontinue a line of business.
Written management representations complement, but do not substitute for, other auditing procedures. However, the plan for discontinuing a line of business is an example of a matter about which other procedures may provide little evidence. Accordingly, the written representation may be necessary as confirmation of management’s intent.
Management should make specific representations about:
(1) acknowledgment of its responsibility for designing, implementing, and maintaining internal control to prevent and detect fraud;
(2) knowledge of fraud or suspected fraud affecting the entity involving management, employees with significant roles in internal control, or others if the fraud could materially affect the financial statements; and
(3) knowledge of allegations of fraud or suspected fraud affecting the entity obtained in communications from employees or others.
A purpose of a management representation letter is to reduce
The possibility of a misunderstanding concerning management’s responsibility for the financial statements.
Management’s written representations should be in the form of a representation letter addressed to the auditor. The auditor should have possession of the letter before release of the auditor’s report. Among other things, the auditor should request that management provide a written representation that it has met its responsibilities stated in the terms of the audit engagement. These responsibilities include those for (1) the preparation and fair presentation of the statements in accordance with the applicable reporting framework and (2) the design, implementation, and maintenance of the relevant internal control.
Which of the following statements ordinarily is included among the written management representations obtained by the auditor in an audit of a nonissuer?
A.Sufficient appropriate evidence has been made available to permit the expression of an unmodified opinion.
B.Management acknowledges that internal control has no material weaknesses.
C.All transactions have been recorded in the accounting records.
D.Instances of fraud involving management that exceeded the materiality limits have been acknowledged.
All transactions have been recorded in the accounting records.
AU-C 580 lists the concerns ordinarily addressed in management representation letters, if applicable. The list includes disclosures about the recording of all transactions.
Which of the following management roles would typically be acknowledged in a management representation letter?
A.Management’s knowledge of fraud is communicated to the audit committee.
B.Management’s compensation is contingent upon operating results.
C.Management communicates its views on ethical behavior to its employees.
D.Management has the responsibility for the design of controls to detect fraud.
Management has the responsibility for the design of controls to detect fraud.
Management has the responsibility to design, implement, and maintain internal control to prevent and detect fraud. The auditor is required to request that management provide written representations acknowledging this responsibility and disclosing other fraud-related matters (AU-C 580).
The CEO and the CFO usually sign the management representation letter. They state that they have no knowledge of any fraud or suspected fraud affecting the entity involving:
(2) employees having significant roles in internal control, or
(3) others if the fraud could materially affect the financial statements.
If the current management was not present for a part of the audit, through what period should the current management sign the management's letter?
if current management was not present during all periods covered by the auditor’s report, the auditor should nevertheless obtain written representations from current management for all such periods (AU-C 580).
What are some mitigating factors in regards to ability to continue as a going concern?
Mitigating factors include plans to
(1) dispose of assets,
(2) borrow money or restructure debt,
(3) reduce or delay expenditures (e.g., by leasing, not purchasing), or
(4) increase equity ownership (AU-C 570).
After considering management’s plans, an auditor concludes that there is substantial doubt about a client’s ability to continue as a going concern for a reasonable period of time. The auditor’s responsibility includes
Considering the adequacy of disclosure about the client’s possible inability to continue as a going concern.
The auditor considers (1) identified conditions and events in the aggregate that raise going-concern issues, (2) management’s written representations, and (3) management’s plans for coping with their adverse effects. The auditor then may conclude that a substantial doubt exists about the entity’s ability to continue as a going concern for a reasonable period of time. In that case, the auditor should consider the possible effects on the financial statements and the adequacy of disclosure. The auditor also should include an emphasis-of-matter paragraph in the report.
AICPA standards require the auditor to evaluate whether the entity is a going concern for a reasonable period. For U.S. GAAP, the reasonable period is:
For U.S. GAAP, the reasonable period is 1 year after the date that the financial statements are issued or are available to be issued.
The ISAs require consideration of going concern issues extending to at least, but not limited to, 1 year beyond the date of the financial statements.
The procedures typically employed to identify going-concern issues include:
(1) analytical procedures,
(2) review of subsequent events,
(3) review of compliance with debt and loan agreements,
(4) reading minutes of meetings,
(5) inquiry of legal counsel, and
(6) confirmation with related and third parties of arrangements for financial support.