chapter 14 activities required in completing a quality audit

A U D I T I N GA RISK-BASED APPROACH TO

CONDUCTING A QUALITY AUDIT

9th Edition

Karla M. Johnstone | Audrey A. Gramling | Larry E. Rittenberg

Copyright © 2014 South-Western/Cengage Learning

CHAPTER 14ACTIVITIES REQUIRED IN COMPLETING A

QUALITY AUDIT

Copyright © 2014 South-Western/Cengage Learning 14-2

Learning Objectives

1. Review, summarize, and resolve detected misstatements and identified control deficiencies

2. Review and assess the appropriateness of the client’s accounting for and disclosure of loss contingencies

3. Review and assess the appropriateness of the client’s significant accounting estimates

4. Review the adequacy of disclosures5. Review and assess the implications of noncompliance

with laws and regulations


Learning Objectives

6. Review the appropriateness of the going-concern assumption using relevant professional guidance

7. Perform final analytical review procedures8. Review management representations in

certifications required under the Sarbanes-Oxley Act (for public clients) and describe the contents of a management representation letter

9. Review subsequent events that occur after the balance sheet date and assess proper treatment


Learning Objectives

10. Determine how to address situations in which omitted audit procedures come to the auditor’s attention after the audit report has been issued

11. Assess the adequacy of supervision and perform an engagement quality review

12. Identify issues to communicate to the audit committee

13. Identify issues to communicate to management via a management letter


Learning Objectives

14. Describe the process by which audit firms make client acceptance and continuance decisions

15. Identify the requirements concerning mandatory partner rotation and mandatory audit firm rotation for publicly traded audit clients

16. Apply the frameworks for professional decision making and ethical decision making to issues involved in completing the audit


THE AUDIT OPINION FORMULATION PROCESS


PROFESSIONAL JUDGMENT IN CONTEXT - A Case of Poor Review Quality and Improper Professional Conduct

• The Practice Office Assurance Director for BDO’s Philadelphia office assigned an audit manager to the audit of Hemispherix Biopharma Incorporated • BDO’s internal quality control review team selected

Hemispherix for inspection • Led to the director forcing the manager to sign the audit

papers in spite of the papers not being reviewed

• PCAOB detected the fraud and barred the director from performing audits of public companies for at least one year



• During the conduct of the audit engagement, reviews of work performed by lower-level staff are necessary to be sure that audit steps have been competently completed. Toward the end of the audit, what other types of reviews should be conducted? (LO 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11)• Why are engagement quality reviews important? (LO

11)



• Why were the director’s actions harmful to the BDO and the Hemispherx audit? (LO 11, 16)• What was the ethical dilemma faced by the

manager? (LO 16)• What alternative courses of action could the director

have taken when he discovered that the engagement had not been reviewed and that it was about to be inspected during the engagement quality review? (LO 10, 11, 16)


Review, summarize, and resolve detected misstatements and identified control

deficiencies

Learning objective 1


Reviewing, Summarizing, and Resolving Detected Misstatements

• Misstatement may be:• Difference between the amount reported in the

financial statements and what should be reported under Generally Accepted Accounting Principles (GAAP)• Omission of an amount that should be disclosed in

accordance with GAAP


Categories of misstatements


Resolving Detected Misstatements

• Audit firms use a schedule to:• Accumulate known and projected misstatements• Carryover effects of prior-year uncorrected

misstatements• Immaterial misstatements are waived (left

uncorrected)


EXHIBIT 14.1 - Summary of Possible Adjustments

14.1.png


Resolving Detected Misstatements

• Materiality of a misstatement is based on:• Quantitative amount of the misstatement• Nature of misstatement to determine the qualitative

features that would make it material


Auditing in Practice - The PCAOB Position on Management Bias in Correcting Detected

Misstatements

• Decide whether refusal to correct a detected misstatement is indicative of intentional bias• Management bias should lead auditors to reevaluate:• Risk assessments• Risk of fraud


Additional Considerations for an Integrated Audit

• Assessing whether financial statement misstatements were a result of:• Significant deficiencies in internal control• Material weaknesses in internal control

• Evaluating severity of each individual control deficiency to determine whether it is a material weakness• Accumulating deficiencies less severe than material

weaknesses, on a summary work sheet


REVIEW AND ASSESS THE APPROPRIATENESS OF THE CLIENT’S ACCOUNTING FOR AND

DISCLOSURE OF LOSS CONTINGENCIES



Reviewing Contingencies

• Categories of potential losses • Probable• Reasonably possible• Remote

• Management is responsible for designing and maintaining policies and procedures to identify, evaluate, and account for contingencies• Auditor is responsible for determining that client has

identified, accounted for , and disclosed contingencies


Auditing in Practice - Contingent Liabilities at British Petroleum (BP)

• In July 2010, BP released its second quarter earnings report discussing:• Risks associated with ongoing events and cleanup

effort in the Gulf of Mexico due to an oil spill associated with BP

• BP’s auditors should have obtained assurance that the contingency in connection with oil spill was accurately reported and disclosed


Sources of Audit Evidence related to Contingencies

• Description and evaluation of contingencies• Assurance that accounting

and disclosure requirements have been met• Information about major

contracts in which contingencies may be present

• Documentation of communication the legal counsel of the client• Documentation of

contingent liabilities contained in:• Corporate minutes and

bank confirmations• Correspondence from

governmental agencies


Letter of Audit Inquiry

• Letter that the auditor asks the client to send to its legal counsel to gather corroborative evidence concerning litigation, claims, and assessments• Legal counsel should be instructed by the client to

respond directly to the auditors• Scope limitation - If a lawyer refuses to furnish the

requested information


REVIEW AND ASSESS THE APPROPRIATENESS OF THE CLIENT’S SIGNIFICANT ACCOUNTING

ESTIMATES



judgmental estimates included in Financial statement balances

• Fair value of many assets• Net realizable values of inventory and receivables• Property and casualty insurance loss reserves• Revenues from contracts accounted for by

percentage-of-completion method• Warranty expenses and associated liabilities• Depreciation and amortization methods• Impairment of depreciable assets and goodwill


judgmental estimates included in Financial statement balances

• Useful lives and residual values of productive facilities, natural resources, and intangibles• Valuation and classification of:• Financial instruments• Pensions• Other postretirement benefits

• Compensation in stock option plans


Reviewing Significant Estimates

• Auditors should be alert to period-end adjusting journal entries• They are responsible for providing assurance that:• Estimates are reasonable• Estimates are presented in conformity with GAAP• Disclosure about estimates is adequate



• Management estimates are based on:• Subjective factors• Objective factors

• Events or transactions useful in identifying and evaluating reasonableness of estimates occur:• After balance sheet date• Before audit report date



• Auditor should focus on factors and assumptions that are:• Significant to accounting estimate• Sensitive to variations• Deviations from historical patterns• Subjective and susceptible to misstatement and bias• Inconsistent with current economic trends


Auditing in Practice - PCAOB Fines Ernst & Young for an Issue Involving Accounting Estimates

• Medicis’ management convinced their audit partners that their revenue recognition policy was acceptable • Even though it violated GAAP

• National-level consultation experts suggested that partners involved in the Medicis audit were incorrect• After investigation PCAOB imposed a penalty on:• Ernst & Young • Individual partners on Medicis engagement


Review the adequacy of disclosures



Reviewing the Adequacy of Disclosures

• Auditor’s report must indicate if disclosures are not reasonably adequate• Disclosures can be made:• On face of financial statements • In form of classifications or parenthetical notations

• In notes to statements


Auditing in Practice - Related Party Disclosures at OAO Gazprom

• Company’s International Financial Reporting Standards (IFRS) based disclosures led to difficulty for PwC due to: • Complex nature of related-party transactions • High-level interrelationships between executives in

companies operating in the Federation


Reasonable assurance that auditors should have When assessing adequacy of disclosures

• Disclosed events and transactions have occurred and pertain to the entity• All disclosures that should have been included• Disclosures are understandable to users• Information is disclosed accurately and at

appropriate amounts


Review and assess the implications of noncompliance with laws and regulations



AUDITORS’ RESPONSIBILITIES REGARDING CLIENTS’ NONCOMPLIANCE WITH LAWS AND REGULATIONS

• Noncompliance: Acts of omission or commission, either intentional or unintentional, contrary to prevailing laws or regulations• Limitations in an auditor’s ability to detect material

misstatements• Information systems relating to financial reporting may

not capture noncompliance


AUDITORS’ RESPONSIBILITIES REGARDING CLIENTS’ NONCOMPLIANCE WITH LAWS AND REGULATIONS

• Management may: • Act to conceal noncompliance• Override controls• Intentionally misrepresent facts to the auditor

• Legal implications of noncompliance are ultimately a matter for legal authorities to resolve


Auditing in Practice - Triton Energy and Noncompliance with Laws and Regulations

• When violations like these occur the auditor should notify audit committee about:• The violations • Their circumstance• The effect on the financial statements

• Consider whether risk assessments made prior to knowledge of violations are still appropriate


main provisions of FCPA for Companies with securities listed on U.S. markets

• Anti-bribery provision - No company may make a payment to a foreign official for obtaining or retaining business• Financial records should accurately reflect transactions • Adequate system of internal accounting controls

should be designed and maintained• Certain payments to foreign officials are acceptable• Grease payments - Made to an official to expedite

performance of his duties


Review the appropriateness of the going-concern assumption using relevant professional

guidance



Evaluating the Going-Concern Assumption

• Responsibility of management - Assessing company’s going concern status for a reasonable period of time• Reasonable period of time: A period of time not to

exceed one year beyond the date of the financial statements being audited

• Responsibility of auditor - Evaluating appropriateness of that assessment• Use of bankruptcy prediction models to analyze

whether a particular client might have a going-concern problem


EXHIBIT 14.3 - Going-Concern Process

14.3.png


Evaluating the Going-Concern Assumption

If substantial doubt about entity’s ability to continue as a

going concern is alleviated

Consider disclosure of conditions that initially

caused auditor to believe there was substantial

doubt

Consider possible effects of such conditions or

events, and any mitigating factors, including

management’s plans

If substantial doubt about entity’s ability to continue as a going concern for a reasonable

period of time remains

Include an emphasis-of-matter paragraph in

auditor’s report to reflect that conclusion

Audit report will include phrase - Substantial doubt

about entity’s ability to continue as a going

concern


Reasons auditors might resist issuing a going-concern audit opinion

• It can be a self-fulfilling prophecy that the company will go bankrupt• It is difficult to know beforehand whether a

financially distressed client will:• Cease operations • Pull itself away from that outcome


Indicators of Potential Going-Concern Problems

• Negative trends• Internal matters• External matters• Significant changes in:• Competitive market • Competitiveness of client’s products


Indicators of Potential Going-Concern Problems

• Altman Z-scores: Series of ratios that have predictive power in indicating the likelihood of bankruptcy• Five-ratio model - For publicly owned manufacturing

companies• Four-ratio model - For public or privately owned

manufacturing and service companies


EXHIBIT 14.4 - Altman Z-Score Models


Mitigating Factors for a going-concern problem

• Identify and assess management’s plans to overcome this problem • Identify factors most likely to resolve the problem

and gather independent evidence to determine success of such plans• Consider, and independently test, adequacy of

support for major assumptions


Mitigating Factors for a going-concern problem

• Evaluating reasonableness of other assumptions made by the management• Increasing prices or market share is analyzed in

relation to current industry developments• Cost savings related to a reduction in work force is

recomputed and evaluated • Selling off assets is evaluated in relation to current

market prices


Perform final analytical review procedures



Four-step process for using analytical procedures

Develop an expectation

Define when difference between auditor’s expectation and client’s balance would be considered significant

Compute the difference between auditor’s expectation and client’s balance

Follow up on significant differences


Techniques used for analytical procedures


Review management representations in certifications required under the Sarbanes-Oxley Act (for public clients)

and describe the contents of a management representation letter



Certifications Required under Sarbanes-Oxley Act of 2002 (SOX) for Public Companies

• Signing officers of publicly traded companies required to certify that financial statements are fairly presented in accordance with GAAP• Management representation letter: Letter to the

auditors that the client’s chief executive and chief financial officers are required to sign • Specifies management’s responsibility for the financial

statements • Confirms oral responses given to the auditor during

the audit


management representation letter

• Purpose is to help promote audit quality by:• Reminding management of its responsibility for

financial statements• Confirming oral responses obtained by auditor• Reducing the possibility of misunderstanding

• Management’s refusal to sign the letter:• Implies their untruthfulness in verbal representations• Considered a scope limitation


Review subsequent events that occur after the balance sheet date and assess proper treatment



Reviewing Subsequent Events and Subsequently Discovered Facts

• Events occurring after balance sheet date that require special audit attention• Those that provide evidence of conditions that existed

at the date of financial statements• Those that provide evidence of conditions that arose

after the date of financial statements


EXHIBIT 14.8 - Subsequent Periods


Review of Subsequent Events

• Subsequent events: Occur between the date of the financial statements and date of the auditor’s report• Subsequent events review: Review of events in the

period between the balance sheet date and the audit report date to determine their effect on the financial statements

• Type I subsequent events: Existed at the balance sheet date (adjustment to financial statements)• Type II subsequent events: Did not exist at balance

sheet date (disclosure)


Auditing in Practice - Deloitte, Ligand, and the PCAOB: A Case where Subsequent Events were Important

• Audit plan required procedure related to product returns• After year end• Before completion of audit

• Audit plan was not:• Executed by Deloitte personnel• Adequately reviewed by Fazio

• Deloitte resigned from Ligand engagement in 2004• Ligand restated its 2002, 2003, and some of its 2004

financial statements


Audit Procedures Concerning the Review of Subsequent Events

• Cutoff tests• Reviewing subsequent collections of receivables• Searching for unrecorded liabilities• Reading minutes of meetings • Reading and comparing interim financial statements

to audited financial statements• Inquire of management concerning:• Significant changes noted in the interim statements


Audit Procedures Concerning the Review of Subsequent Events

• Existence of significant contingent liabilities or commitments at balance sheet date or date of inquiry• Significant changes in working capital, long-term debt,

or owners’ equity• Status of items for which tentative conclusions were

drawn earlier in audit• Any unusual adjustments made to accounting records

after balance sheet date


Dual Dating

• Awareness of an event occurring after audit report date but before report release date• Report release date: Grant of permission to the entity

to use the auditor’s report in connection with financial statements

• Options for dating the audit report:• Using date of this event as date of audit report• Dual-date the report


Subsequently Discovered Facts That Become Known to Auditor after Report Release Date

• If facts had been know at the report date, then auditor should determine:• Reliability of new information• Whether development or event had occurred by

report date• Whether users are likely to still be relying on financial

statements• Whether audit report would have been affected had

facts been known at report date


Appropriate action for Subsequently Discovered Facts

• Key action - Notify users very soon so they do not continue to rely on incorrect information • If possible quickly revise and distribute financial

statements and audit report• Reasons for revision described in a footnote and

referred to in auditor’s report• Revision and explanation can be made in subsequent-

period audited financial statements if distribution is imminent



• If extended amount of time is needed to develop revised financial statements, notify users that: • Previously distributed financial statements and auditor’s

report should no longer be relied on• Revised statements and report will be issued as soon as

possible



• For clients who do not cooperate, notify:• Client and regulatory agency having jurisdiction over it

that audit report should no longer be associated with client’s financial statements• Users that audit report should no longer be relied on


DETERMINE HOW TO ADDRESS SITUATIONS IN WHICH OMITTED AUDIT PROCEDURES COME TO THE AUDITOR’S ATTENTION AFTER THE AUDIT REPORT HAS BEEN ISSUED



Consideration of Omitted Procedures Discovered after the Report Date

• Omitted procedure: After the audit report has been issued, auditor may discover that an important audit procedure was not performed• If previously issued audit report cannot be supported

in light of omitted procedures• Alternative procedures should be promptly performed

and documented


Assess the adequacy of supervision and perform an engagement quality review



Performing an Engagement Quality Review

• Engagement quality review (Concurring partner review): Review at the end of each audit conducted by an experienced auditor having appropriate competence, independence, integrity, and objectivity• To help make sure that audit and audit documentation

are complete and support audit opinion



• Procedures that reviewer should perform as part of the review process• Discussing with audit team significant matters related

to financial statements and internal controls• Evaluating judgments about materiality and disposition

of corrected and uncorrected identified misstatements• Reviewing evaluation of firm’s independence in

relation to engagement



• Reviewing related audit documentation to determine its sufficiency• Reading financial statements, management’s report on

internal control, and auditor’s report• Confirming with lead audit partner that there are no

significant unresolved matters• Determining if appropriate consultations have taken

place on difficult or contentious matters



• Evaluating whether:• Auditor documentation supports conclusions reached by

engagement team • Appropriate matters have been communicated to audit

committee members, management, and other appropriate parties• Appropriate levels of supervision and reviews of

individual audit tasks were completed


Identify issues to communicate to the audit committee



Reasons for External Auditors to Communicate with the Audit Committee

• Audit committee serves as an independent subcommittee of board of directors• Audit committee can assist auditor during a

disagreement between the auditor and management• Audit committee must be assured that auditor:• Is free of any restrictions • Has not been inappropriately influenced by the

management


typical communications between the auditor and the audit committee

• Auditor’s responsibility under generally accepted auditing standards• Overview and planned scope of audit• Independence• Significant accounting policies• Management judgments and accounting estimates• Significant audit adjustments• Judgments about quality of company’s accounting

principles


typical communications between the auditor and the audit committee

• Other information in annual reports• Disagreements with management• Major issues discussed with management before

retention• Internal control over financial reporting


Auditing in Practice - Guidance on Assessing the Quality, Not Just the Acceptability, of Significant Accounting

Policies

• Consistency of organization’s accounting principles and their application• Clarity and completeness of financial statements and

related disclosures• Presence of items that have an impact on the

representational faithfulness, verifiability, and neutrality of the accounting information included in the financial statements• Use of accounting practices by the company that are

not specifically addressed in the accounting literature


Identify issues to communicate to management via a management letter



Communicating with Management via the Management Letter

• Management letter: From the auditor to the client identifying any problems and suggested solutions to improve management’s efficiency or effectiveness• Used to make significant operational or control

recommendations to client


Issues Relating to Audit Firm Portfolio Management, Audit Partner Rotation, and Audit Firm Rotation

• Audit firm portfolio management - Deciding whether to:• Continue providing audit services to client • Begin providing services to a new client

• Consider mandatory partner rotation and mandatory audit firm rotation requirements for publicly traded audit clients


Describe the process by which audit firms make client acceptance and continuance decisions



Client Acceptance and Continuance Decisions

• Decisions taken by audit firms and individual engagement partners immediately before agreeing to conduct an audit or after completing audit • Called client acceptance and continuance decisions• Client acceptance decision: When a new client is

evaluated by the audit firm and individual engagement partner prior to being accepted into the audit firm’s portfolio of clients


EXHIBIT 14.9 - Audit Firm Portfolio Management


Client Acceptance and Continuance Decisions

• Client continuance decision: When existing clients are evaluated by the audit firm and individual engagement partner at the completion of the audit to determine whether the audit firm should continue to provide services again in the next period


Client Acceptance and Continuance-Related Risks

• Client entity characteristics• Independence risk factors• Third party /due diligence risk factors• Quantitative risk factors• Qualitative risk factors• Entity organizational or governance risks• Financial reporting risks


Reasons for not providing audit services to a client

• Client does not fit the profile that the firm requires to achieve its growth strategy• Client not in an industry that the firm wants to

emphasize• Client’s growth not feasible for firm anymore• Client being potentially problematic


Auditing in Practice - Why Might an Audit Firm Refuse to Continue Providing Services to a Client?

• Developments that undermine the ability of the audit firm to rely on the representations of management• Recently identified falsity of records • Deliberate interference by the management in the

audit process• Unlawful retention of audit files


Identify the requirements concerning mandatory partner rotation and mandatory audit firm rotation for publicly

traded audit clients



Partner Rotation and Audit Firm Rotation

• Familiarity threat occurs when auditor has a longstanding relationship with an important person associated with the client• Having a longstanding relationship with client could:• Aid audit quality • Knowledge that partner and members of engagement

team gain through time• Impair auditor’s willingness or ability to perform an

unbiased assessment of audit evidence


Auditing in Practice - KPMG andGeneral Electric Company

• The United Brotherhood of Carpenters Pension Fund, a shareholder, filed a letter and proposal to General Electric • Requesting to consider implementing an audit firm

rotation policy every seven years• Proposal was ignored by company, and was not put

to vote• Shows that General Electric and KPMG are not

supportive of the mandatory audit firm rotation


Partner Rotation and Audit Firm Rotation

• Differences exist internationally in terms of:• Requirement of rotation• Length of time:• Auditor or audit firm may serve before rotation• Of a cooling off period• Cooling off period: Number of years after which individual

auditor or audit firm may resume its prior role with audit client


EXHIBIT 14.10 - U.S. and International Guidance on Mandatory Audit Partner Rotation and Mandatory

Audit Firm Rotation

chapter 14 activities required in completing a quality audit

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