Solution manual auditing and services 2e by louwers louw11

Between the end of the year and the last day of fieldwork: 1 “roll-forward” work; 2 examination of revenue and expense accounts; 3 attorney letters; 4 management representations; 5 adjus

CHAPTER 11

Completing the Audit

LEARNING OBJECTIVES

ReviewCheckpoints

Exercises, Problems,and Simulations

1 Describe the approach used to examine major

2 Explain the use of the attorney letter during the

3 Identify why the auditor obtains management

representations and list the key components of

5 Identify the two major categories of subsequent

events and describe the proper handling of these

events by the auditor

17, 18, 19, 20 53, 54 (partial), 55, 56

6 Identify the auditor’s responsibility when, after

the issuance of the audit reports, the auditor

discovers (1) facts that may have existed at the

date of the auditor’s reports or (2) omitted audit

procedures

7 Summarize important communications made by

the auditor following completion of the audit and

issuance of the auditor’s reports

SOLUTIONS FOR REVIEW CHECKPOINTS

11.1 The four primary time periods in an audit examination and the tasks and activities that fall within each time

period are:

1 Between the beginning of the year and end of year: Interim tests of controls and substantive

procedures

2 Between the end of the year and the last day of fieldwork: (1) “roll-forward” work; (2)

examination of revenue and expense accounts; (3) attorney letters; (4) management representations; (5) adjusting journal entries; (6) audit documentation review

3 Between the last day of fieldwork and issuance of reports: subsequent events

4 Following issuance of the reports: (1) subsequent discovery of facts; (2) omitted audit procedures;

(3) management letters; (4) audit committee communications

11.2

Revenue and Expense

Sales revenue and sales

Dividend and interest

Gain or loss on asset

disposals Property, plant and equipmentReceivables

Investments

ProductionFinance/Investment

Finance/Investment11.3 In addition to work with the related balance sheet accounts and transaction cycles, the auditor (1) uses

analytical procedures to examine the revenue and expense accounts and (2) scans revenue and expense accounts for large and unusual entries

11.4 “Miscellaneous”, “other”, and “clearing” accounts may represent adjustments made by the client to meet

analysts’ earnings expectations (or earnings management)

11.5 a The responsibilities of client management are to (1) respond to the auditor’s inquiries regarding

litigation, claims, and assessments; (2) provide the auditor with a listing, description, and evaluation of litigation, claims, and assessments; and, (3) send letter to attorney (attorney letter) that includes information related to litigation, claims, and assessments

b The responsibilities of the auditor are to (1) inquire of client regarding the existence of litigation,

claims, and assessments; (2) perform various audit procedures regarding litigation, claims, and assessments; and, (3) initiate the request to the client for the attorney letter

11.6 Attorney letters ordinarily contain the following information:

 A listing of pending or threatened litigation, claims, or assessments

 A description of each item, including the nature of the case and management responses or intended

responses to the case

 An evaluation of the likelihood of an unfavorable outcome

 An estimate of the range of potential loss

11.7 In addition to attorney letters, the auditor would ordinarily perform the following with respect to litigation,

claims, and assessments:

 Obtain from management a description of litigation, claims, and assessments

 Examine documents in the client’s possession regarding litigation, claims, and assessments,

including correspondence and invoices from attorneys

 Obtain assurance from management that it has disclosed all material unasserted claims the

attorney has advised them of probable litigation

 Read minutes of meetings of stockholders, directors, and appropriate committees

 Read contracts, loan agreements, leases, and correspondence from taxing or other governmental

agencies

 Obtain information concerning guarantees from bank confirmations

 Review the legal expense account and cash disbursements records and invoices related to legal

services

11.8 The purpose of management representations is to impress upon management its primary responsibility for

establishing and maintaining effective internal control over financial reporting and for the fairness of the financial statements In addition, management representations may establish an auditor’s defense if a question of management integrity arises later

The following representations must appear in all management representations:

1 Management’s acknowledgement of its responsibility for the fair presentation of financial

statements in conformity with U.S generally accepted accounting principles

2 Availability of all financial records and related data and completeness of the minutes of meetings

of stockholders, directors, and important committees

3 Management’s acknowledgement of its responsibility for the design and implementation of

programs and controls to prevent and detect fraud

4 Disclosure of all significant deficiencies in internal control

5 Information concerning fraud involving management, employees who have significant roles in

internal control, or cases where the fraud could have a material effect on the financial statements

11.9 If the company is subject to the requirements of AS 2, the auditor should obtain the following management

representations related to internal control over financial reporting:

 Management has performed an assessment of the effectiveness of internal control over financial reporting based on criteria (for example, criteria established in Internal Control – Integrated

Framework issued by the Committee on Sponsoring Organizations of the Treadway Commission, or COSO criteria)

 Management’s conclusion with respect to the effectiveness of its internal control over financial reporting at year-end

 No control deficiencies communicated to the audit committee from prior engagements have not been properly resolved

 There are no subsequent changes in internal control over financial reporting or other factors that may significantly affect internal control over financial reporting

11.10 These communications are obtained near the end of fieldwork and dated on or near the audit report date to

ensure that the most current information has been considered and evaluated by the auditor

11.11 If the client refuses to furnish management representations, the auditor may either qualify or disclaim an

opinion, as with other scope limitations However, because of the importance of this communication, the auditor should be very skeptical if the client refuses to furnish management representations

11.12 Adjusting entries and note disclosures are labeled proposed because it is ultimately the client’s

responsibility to adjust the financial statements for these items

11.13 A waived adjustment is a proposed adjustment the auditors decide not to insist that the client make because

it does not have a material effect on the financial statements Auditors are required to communicate all adjustments and misstatements detected during the audit to the client’s audit committee, regardless of the materiality of these adjustments to the client’s financial statements

11.14 1 Upon completion, the audit documentation is reviewed by an audit supervisor and, sometimes,

audit manager The purpose of this review is to ensure that all appropriate steps in the audit program were performed, the referencing among audit documentation is clear, and the explanations contained in the audit documentation are understandable

2 Once this initial review has been completed, the audit manager and audit partner review the audit

documentation to ensure that the overall scope of the audit is appropriate and determine whether the overall conclusions in the audit documentation are sufficient to provide support for the opinion

on the financial statements

3 Finally, the audit documentation is reviewed by a partner who has not been involved with the audit

(known as a reviewing partner) The purpose of this review is to ensure that the quality of audit work and reporting is consistent with the firm’s quality standards

11.15 A second partner review is a review of audit documentation by a partner who is not involved with the audit

The purpose of this review is to ensure that the quality of the work and reporting is in keeping with the quality standards of the firm

11.16 Some of the benefits of audit documentation review are:

 To ensure the audit is conducted in accordance with generally accepted auditing standards

 To provide the firm with an opportunity to evaluate the overall quality of the firm’s audit practice

 To provide an important component of the evaluation of staff accountants

 To allow the firm to adhere to the first standard of fieldwork (that the work is adequately planned

and assistants, if any, are properly supervised)

11.17 A subsequent event is an event occurring between the balance sheet date and the last day of fieldwork.11.18 Procedures performed during the subsequent period include:

 Reading the latest interim financial statements and comparing them with the financial statements

being reported upon

 Inquiring of officers and other executives having responsibility for financial and reporting matters

about contingent liabilities or commitments; significant changes in capital stock, long-term debt,

or working capital since the balance sheet date; and unusual adjustments since the last balance sheet date

 Reading minutes of meetings of shareholders, directors, and appropriate committees

 Obtaining an attorney letter from any legal counsel engaged by the client

 Obtaining management representations

11.19 A Type I subsequent event provides new information about a condition that existed at the balance sheet

date Because the condition existed at the balance sheet date, a Type I subsequent event requires adjustment

of amounts already included in the client’s financial statements

A Type II subsequent event involves occurrences that had both their cause and manifestation after the balance sheet date These events should be disclosed in the financial statements and, for particularly

significant subsequent events, pro forma financial statements should be prepared (these statements present

the entire financial statements “as if” the event had occurred on the balance sheet date)

11.20 Dual dating an audit report provides a means of inserting important information in the financial statements

and footnote disclosures learned by the auditor after the last day of fieldwork A significant advantage of dual dating the report is that the auditor’s liability for events after the last day of fieldwork is limited to the event specifically identified in the report date

11.21 A subsequent event is an event occurring between the balance sheet date and last day of fieldwork

Depending upon the type of subsequent event, the auditor will either adjust the financial statements or disclose the subsequent event in the financial statements

A subsequent discovery of facts occurs when the auditor learns of events that existed at the balance sheet date following the issuance of the reports The auditor should require the client to disclose the facts and their impact on the financial statements to persons relying on the financial statements if certain conditions exist

11.22 If the client consents to the disclosure, the auditor should take actions to ensure that persons who are

continuing to rely on the financial statements and auditor’s reports are properly notified of the facts

If the client refuses to make the appropriate disclosures, the auditor should notify each member of the board

of directors that they will be notifying regulatory agencies having jurisdiction over the client (such as the Securities and Exchange Commission) as well as other persons who are relying on the reports

11.23 If an omitted procedure is found, the following courses of action would be taken:

1 Verify that (1) the omitted procedure is important in supporting the auditor’s opinion and (2)

individuals are currently relying on the client’s financial statements and reports

2 If both of the above conditions exist, the auditor should perform the omitted procedure or alternative

procedures If both do not exist, no further action is necessary

3 If performing the omitted or alternative procedures allow the auditor to support the

previously-expressed opinion, no further action is necessary However, if they do not, the auditor should formally withdraw the original reports, issue revised reports, and inform persons currently relying

on the financial statements

11.24 The auditor should communicate the following information to the audit committee:

 The auditor’s responsibility under generally accepted auditing standards

 Initial selection of and changes in significant accounting policies

 Methods used to account for significant, unusual transactions and transactions in a controversial or

emerging area with a lack of authoritative guidance or consensus

 Management judgments and accounting estimates

 Audit adjustments as well as uncorrected misstatements

 The auditor’s judgment about the quality of the client’s accounting principles

 The auditor’s responsibility for other information in documents containing the financial

statements

 Alternative accounting treatments permissible within generally accepted accounting principles

 Disagreements with management

 Consultation with other accountants

 Issues discussed with management in conjunction with the initial or recurring retention of the

auditor

 Difficulties encountered in dealing with management in the performance of the audit

11.25 Management letters contain a summary of recommendations to allow the client to improve the effectiveness

and efficiency of its operations They are not required by generally accepted auditing standards

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS

11.26 a Incorrect Interest income is related to the examination of notes receivable

b Correct Interest expense can be calculated from the notes payable information and is

examined in conjunction with that information

c Incorrect Notes payable are not related to goodwill amortization

d Incorrect Notes payable are not directly related to royalty revenue

11.27 a Incorrect Management representations do not shift responsibility to auditors for the

financial statements

b Incorrect Management representations should not substitute for other evidence sources

c Incorrect Management makes assertions directly in the financial statements and not as part

of the management representations

d Correct This responsibility is explicitly included in the management representations

11.28Note to Instructor: Since this question asks students to identify which audit procedure is not used to obtain

evidence about contingencies, the response labeled “correct” is not used to obtain evidence about

contingencies and those labeled “incorrect” are used to obtain evidence about contingencies.

a Correct Scanning expenses is unlikely to reveal any information about a contingency

b Incorrect Attorneys letters can provide information about contingencies

c Incorrect Minutes of board of directors’ meetings can provide information about

contingencies

d Incorrect Sales contracts can provide information about right of return that may need to be

disclosed as a contingency

11.29 a Incorrect The issuance of stock occurred after December 31

b Incorrect The injury related to the lawsuit was sustained after December 31

c Correct Since an estimate had been made as of December 31, the event giving rise to the

lawsuit had occurred, and the settlement introduced new information about the actual amount of the liability at December 31

d Incorrect The storm occurred after December 31

11.30 a Incorrect The report date is the last day of fieldwork, not the balance sheet date

b Correct The report date is the last day of fieldwork and the dual date is the date related

to the specific event

c Incorrect The report date is the last day of fieldwork, not the balance sheet date

d Incorrect The report date is the last day of fieldwork, not the date of the subsequent event

d Correct Under the 1933 Securities Act, the auditor’s responsibility extends to the

effective date of the registration statement

11.32 a Correct Subsequent discovery of facts refers to knowledge obtained after the issuance of

the audit reports

b Incorrect See (a) above These types of events are referred to as subsequent events

c Incorrect See (a) above These types of events are referred to as subsequent events

d Incorrect See (a) above These types of events do not require any special audit

consideration

11.33 a Incorrect Management representations are required under generally accepted auditing

standards

b Incorrect Attorney letters are required under generally accepted auditing standards

c Correct Management letters, while helpful, are not required under generally accepted

auditing standards

d Incorrect Engagement letters are required under generally accepted auditing standards

11.34Note to Instructor: Since this question asks students to identify which party would not participate in writing

the management letter, the response labeled “correct” would not participate in writing the management letter and those labeled “incorrect” would participate in writing the management letter.

a Correct The client’s attorneys would not ordinarily participate in drafting the

management letter, as this letter is concerned with helpful suggestions to increase the effectiveness and efficiency of the client’s operations

b Incorrect The client’s accounting and production managers would provide information

about current practices for the management letter

c Incorrect The audit firm’s team would play a major role in drafting the management letter

based on their observations during the audit examination

d Incorrect The audit firm’s consulting and tax experts would participate in drafting the

management letter, as they are in position to identify possible efficiencies and income tax savings

11.35 a Incorrect An engagement letter would be secured prior to the commencement of the audit

examination

b Incorrect Tests of controls would be performed prior to the end of the year under audit

c Incorrect A review for subsequent events would be performed after year-end but prior to

the end of fieldwork

d Correct Management representations would be obtained on the last day of fieldwork.11.36 a Incorrect Discovery of a subsequent event occurs after issuance of the auditor’s report on

the company’s financial statements

b Incorrect Dual dating the audit report occurs following the last day of fieldwork

c Incorrect The management letter is prepared and presented to the client following the

conclusion of the audit examination

d Correct The review of audit documentation occurs after the balance sheet date but before

the last day of fieldwork

11.37 Note to Instructor: Since this question asks students to identify which procedure is least likely to be

performed, the response labeled “correct” would not be performed and those labeled “incorrect” would be performed .

a Incorrect Analytical procedures would be used in conjunction with the examination of

revenue and expense accounts

b Correct The auditor would typically sample and investigate individual transactions in the

examination of the related balance sheet accounts, but not revenue and expense accounts

c Incorrect The auditor would consider evidence obtained in the examination of related

balance sheet accounts in the audit of revenue and expense accounts (see b above)

d Incorrect The auditor would scan revenue and expense accounts for large and unusual

debit and credit entries

11.38 a Incorrect This statement would typically be included in management representations and

not an attorney letter

b Incorrect While this statement is related to communication with attorneys, it would not be

appropriate for the attorney to directly inform the auditor of omitted unasserted claims or assessments

c Incorrect This statement would ordinarily be included in a management letter and not an

attorney letter

d Correct The attorney letter would request that the attorney furnish this information to the

auditor

11.39 a Incorrect Prior to performing the omitted procedure or an alternative procedure, the

auditor would determine that the omitted procedure is important in supporting the opinion on the company’s financial statements

b Incorrect Prior to notifying the board of directors and regulatory agencies who are

currently relying on the auditor’s reports, the auditor would determine that the omitted procedure is important in supporting the opinion on the company’s financial statements

c Correct This is the initial course of action that would be taken upon the discovery of an

omitted audit procedure

d Incorrect A quality assurance review may reveal the omission of an audit procedure, but

would not be performed in response to an omitted procedure

11.40 Note to Instructor: Since this question asks students to identify which statement is not true with respect to

management representations, the response labeled “correct” would not be true and those labeled

“incorrect” would be true .

a Correct The failure of management to furnish representations would result in either a

qualified opinion or a disclaimer of opinion.

b Incorrect Management representations do address disclosure of significant deficiencies in

internal control, regardless of materiality

c Incorrect Management representations are used by the auditor to corroborate information

received from the client and its employees

d Incorrect Management representations are dated the same date as the auditor’s reports (the

last day of fieldwork)

11.41 a Incorrect Management representations are dated as of the last day of fieldwork (in this

case, March 24, year 2), not the date of completion of the financial statements

b Incorrect Management representations are dated as of the last day of fieldwork (in this

case, March 24, year 2), not the date that fieldwork began

c Correct Management representations are dated as of the last day of fieldwork (in this

case, March 24, year 2)

d Incorrect Management representations are dated as of the last day of fieldwork (in this

case, March 24, year 2), not the date that the audit reports are completed.11.42 a Incorrect A charge to a notes receivable would relate to a transaction that has occurred in a

prior period, not current period

b Incorrect A charge to a notes receivable would relate to a transaction that has occurred in a

prior period, not current period

c Incorrect A charge would indicate that any obligation has been settled, not incurred

d Correct The entry may represent the establishment of a receivable from a party for

whom the client has guaranteed a debt The payment of the debt upon default of the party would be recognized in the accounts by a debit to notes receivable and

a credit to cash

11.43 a Correct Comparing interim financial statements with the financial statements being

audited would identify potential subsequent events

b Incorrect Second request confirmations would provide evidence regarding the valuation of

accounts receivable balances but would not provide evidence regarding subsequent events

c Incorrect Communicating material weaknesses in internal control would provide the client

with the opportunity to improve its internal control but would not provide evidence regarding subsequent events

d Incorrect Reviewing the cutoff bank statement would verify the valuation of cash but

would not provide evidence regarding subsequent events

11.44 a Incorrect This procedure would provide evidence about the valuation of these

transactions, but not subsequent events

b Correct This procedure may provide information about sales and repurchases of the

company’s stock

c Incorrect This procedure would be used to search for unrecorded accounts payable at

year-end, but not the occurrence of subsequent events

d Incorrect This procedure would provide evidence about the valuation of cash and potential

guarantees of debt, but not subsequent events

11.45 a Incorrect While the attorney letter will ask for corroboration of management’s information

regarding the probable outcome of litigation, claims, and assessments, management is the primary source of this information

b Correct The attorney letter requests the attorneys to corroborate information furnished

from management

c Incorrect Historical experiences are not included in an attorney letter

d Incorrect A description and evaluation of litigation, claims, and assessments is obtained

from the client; the attorney is asked to corroborate this information (see b above)

11.46 a Correct The attorneys’ response should be limited to matters in which they have given

substantive attention

b Incorrect The attorney should comment on matters of which they are aware that were not

disclosed by the entity

c Incorrect The attorney should not limit their response to matters in which the entity has

historical experience

d Incorrect The attorney should also comment upon unasserted claims as well as asserted

claims and pending or threatened litigation

SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS

11.47 Management Representations

a Auditors are required to obtain management representations in all audits conducted under

generally accepted auditing standards

b The purpose of obtaining management representations is to impress upon management its primary

responsibility for the financial statements In addition, management representations may establish

an auditor’s defense if a question of management integrity subsequently arises

c Management representations should be addressed to the auditor and dated as of the date of the

auditor’s reports (last day of fieldwork)

d Management representations should be signed by members of management whom the auditor

believes are responsible and knowledgeable about matters covered by the representations (usually the chief executive officer, chief financial officer, treasurer, or controller) Their refusal to sign the representations would constitute a scope limitation that would preclude the issuance of an

unqualified opinion

e Obtaining management representations does not relieve the auditor from their responsibility for

planning and performing the audit As a result, the auditor must still perform all usual procedures

to corroborate representations made by management

11.48Management Representations Omissions

Other matters that should be confirmed in management representations include:

1 Management acknowledgement of its responsibility for the fair presentation in the financial

statements in conformity with U.S generally accepted accounting principles (or other comprehensive basis of accounting)

2 Availability of all financial records and related data and completeness of the minutes of meetings

of stockholders, directors, and important committees

3 Management’s acknowledgement of its responsibility for the design and implementation of

programs and controls to detect fraud

4 Management’s disclosure of all significant deficiencies in internal control

5 Information concerning fraud involving management, employees who have significant roles in

internal control, or cases where the fraud could have a material effect on the financial statements

In addition to the above, which are required without limitation based on materiality, the following matters should be confirmed in Molar’s management representations:

 Material liabilities or gain or loss contingencies that are required to be accrued or disclosed

 The company has satisfactory title to all owned assets, and whether there are liens or

encumbrances on such assets or any pledging of assets

 Related party transactions or related amounts receivable or payable that may need to be disclosed

in the financial statements

 The company has complied with all aspects of contractual agreements that would have a material

effect on the financial statements in the event of noncompliance

 Events have occurred subsequent to the balance sheet date that would require adjustment to, or

disclosure in, the financial statements

 Provision, when material, has been made to reduce excess or obsolete inventories to their

estimated net realizable value

 Provision has been made for any material loss to be sustained in the fulfillment of, or from

inability to fulfill, any sales commitments

 Provision has been made for any material loss to be sustained as a result of purchase commitments

for inventory quantities in excess of normal requirements or at prices in excess of the prevailing market prices