Ch-5 Completing an Audit

5.0. Introduction

The completion stage of the audit is of crucial importance. It is during the completion
stage that the auditor reviews the evidence obtained during the audit together with the
final version of the financial statements with the objective of forming the auditor’s
opinion

5.1. Developing Accounting Estimates

Management is responsible for establishing a process for preparing accounting

estimates. Although the process may not be documented or formally applied, it
normally consists of

a. Identifying situations for which accounting estimates are required.

b. Identifying the relevant factors that may affect the accounting estimate.
c. Accumulating relevant, sufficient, and reliable data on which to base the
estimate.
d. Developing assumptions that represent management's judgment of the most
likely circumstances and events with respect to the relevant factors.
e. Determining the estimated amount based on the assumptions and other
relevant factors.
f. Determining that the accounting estimate is presented in conformity with
applicable accounting principles and that disclosure is adequate.

The risk of material misstatement of accounting estimates normally varies with the
complexity and subjectivity associated with the process, the availability and reliability
of relevant data, the number and significance of assumptions that are made, and the
degree of uncertainty associated with the assumptions.

Internal Control Related to Accounting Estimates

An entity's internal control may reduce the likelihood of material misstatements of
accounting estimates. Specific relevant aspects of internal control include the
following:

a. Management communication of the need for proper accounting estimates

b. Accumulation of relevant, sufficient, and reliable data on which to base an
accounting estimate
c. Preparation of the accounting estimate by qualified personnel
d. Adequate review and approval of the accounting estimates by appropriate
levels of authority, including

 Review of sources of relevant factors

 Review of development of assumptions
 Review of reasonableness of assumptions and resulting estimates
 Consideration of the need to use the work of specialists
 Consideration of changes in previously established methods to arrive at
accounting estimates

e. Comparison of prior accounting estimates with subsequent results to assess the

reliability of the process used to develop estimates
f. Consideration by management of whether the resulting accounting estimate is
consistent with the operational plans of the entity.

Evaluating Accounting Estimates

The auditor's objective when evaluating accounting estimates is to obtain sufficient

appropriate evidential matter to provide reasonable assurance that—

a. All accounting estimates that could be material to the financial statements

have been developed.
b. Those accounting estimates are reasonable in the circumstances.
c. The accounting estimates are presented in conformity with applicable
accounting principles2 and are properly disclosed.3 

Identifying Circumstances That Require Accounting Estimates

In evaluating whether management has identified all accounting estimates that could
be material to the financial statements, the auditor considers the circumstances of the
industry or industries in which the entity operates, its methods of conducting business,
new accounting pronouncements, and other external factors. The auditor should
consider performing the following procedures:

a. Consider assertions embodied in the financial statements to determine the need

for estimates. (See paragraph .16 for examples of accounting estimates
included in financial statements.)
b. Evaluate information obtained in performing other procedures, such as—

i. Information about changes made or planned in the entity's business,

including changes in operating strategy, and the industry in which the
entity operates that may indicate the need to make an accounting
estimate (AS 2110, Identifying and Assessing Risks of Material
Misstatement).
ii. Changes in the methods of accumulating information.
iii. Information concerning identified litigation, claims, and assessments
and other contingencies.
iv. Information from reading available minutes of meetings of stockholders,
directors, and appropriate committees.
v. Information contained in regulatory or examination reports, supervisory
correspondence, and similar materials from applicable regulatory
agencies

c. Inquire of management about the existence of circumstances that may indicate

the need to make an accounting estimate.

Evaluating Reasonableness

In evaluating the reasonableness of an estimate, the auditor normally concentrates on

key factors and assumptions that are—

a. Significant to the accounting estimate.

b. Sensitive to variations.
c. Deviations from historical patterns.
 d. Subjective and susceptible to misstatement and bias.

The auditor normally should consider the historical experience of the entity in making
past estimates as well as the auditor's experience in the industry. However, changes in
facts, circumstances, or entity's procedures may cause factors different from those
considered in the past to become significant to the accounting estimate.4

In evaluating reasonableness, the auditor should obtain an understanding of how

management developed the estimate. Based on that understanding, the auditor should
use one or a combination of the following approaches:

a. Review and test the process used by management to develop the estimate.
b. Develop an independent expectation of the estimate to corroborate the
reasonableness of management's estimate. 
c. Review subsequent events or transactions occurring prior to the date of the
auditor's report.

Note: When performing an integrated audit of financial statements and internal

control over financial reporting, the auditor may use any of the three approaches.
However, the work that the auditor performs as part of the audit of internal control
over financial reporting should necessarily inform the auditor's decisions about the
approach he or she takes to auditing an estimate because, as part of the audit of
internal control over financial reporting, the auditor would be required to obtain an
understanding of the process management used to develop the estimate and to test
controls over all relevant assertions related to the estimate.

Review and test management's process. In many situations, the auditor assesses the
reasonableness of an accounting estimate by performing procedures to test the process
used by management to make the estimate. The following are procedures the auditor
may consider performing when using this approach:

a. Identify whether there are controls over the preparation of accounting

estimates and supporting data that may be useful in the evaluation.
b. Identify the sources of data and factors that management used in forming the
assumptions, and consider whether such data and factors are relevant, reliable,
 and sufficient for the purpose based on information gathered in other audit
tests.
c. Consider whether there are additional key factors or alternative assumptions
about the factors.
d. Evaluate whether the assumptions are consistent with each other, the
supporting data, relevant historical data, and industry data.
e. Analyze historical data used in developing the assumptions to assess whether
the data is comparable and consistent with data of the period under audit, and
consider whether such data is sufficiently reliable for the purpose.
f. Consider whether changes in the business or industry may cause other factors
to become significant to the assumptions.
g. Review available documentation of the assumptions used in developing the
accounting estimates and inquire about any other plans, goals, and objectives
of the entity, as well as consider their relationship to the assumptions.
h. Consider using the work of a specialist regarding certain assumptions (AS
1210,Using the Work of a Specialist).
i. Test the calculations used by management to translate the assumptions and
key factors into the accounting estimate.

 Develop an expectation.    Based on the auditor's understanding of the facts and

circumstances, he may independently develop an expectation as to the estimate by
using other key factors or alternative assumptions about those factors.

Review subsequent events or transactions.    Events or transactions sometimes occur

subsequent to the date of the balance sheet, but prior to the date of the auditor's report,
that are important in identifying and evaluating the reasonableness of accounting
estimates or key factors or assumptions used in the preparation of the estimate. In
such circumstances, an evaluation of the estimate or of a key factor or assumption
may be minimized or unnecessary as the event or transaction can be used by the
auditor in evaluating their reasonableness.

AS 2810.24 through .27 discuss the auditor's responsibilities for assessing bias and
evaluating accounting estimates in relationship to the financial statements taken as a
whole.
Effective Date

This section is effective for audits of financial statements for periods beginning on or
after January 1, 1989. Early application of the provisions of this section is
permissible.

5.2. Audit Related Party Transactions

Ultimately, people typically prefer to do business with people they know, like and
trust. But related-party transactions can provide opportunities for individuals to act in
a way that creates confusion between the concerns of the entities and shareholders.
This is why auditors exert ways to classify and properly address related-party
transactions.

What is a related party?

Accounting Standards Codification (ASC) Topic 850 defines a related-party

transaction as one that takes place between:

 A parent entity and its subsidiaries,

 Subsidiaries of a common parent,
 An entity and trusts for the benefit of its employees, such as pension and
profit-sharing trusts that are managed by or under the trusteeship of the
entity’s management,
 An entity and its principal owners and managers (or members of their
immediate families), and
 Affiliated entities.

What’s the risk?

Related-party transactions sometimes involve contracts for goods or services that are
priced at less (or more) favorable terms than those in similar arm’s length transactions
between unrelated third parties. For example, a spinoff business might lease office
space from its parent company at below-market rates. Or a closely held manufacturer
might pay the owner’s son an above-market salary and various perks that aren’t
available to unrelated employees.

How do auditors address these transactions?

Given the potential for double dealing with related parties, auditors spend significant
time hunting for undisclosed related-party transactions. Examples of documents and
data sources that can help uncover these transactions are:

 A list of the company’s current related parties and associated transactions,

 Minutes from board of directors’ meetings, particularly when the board
discusses significant business transactions,
 Disclosures from board members and senior executives regarding their
ownership of other entities, participation on additional boards and previous
employment history,
 Bank statements, especially transactions involving intercompany wires,
automated clearing house (ACH) transfers, and check payments, and
 Press releases announcing significant business transactions with related
parties.

Audit procedures that target related-party transactions include 1) testing how related-
party transactions are identified and coded in the company’s enterprise resource
planning (ERP) system, 2) interviewing accounting personnel responsible for
reporting related-party transactions in the company’s financial statements, and 3)
analyzing presentation of related-party transactions in financial statements.

Accurate, complete reporting of these transactions requires robust internal controls. A

company’s vendor approval process should provide guidelines to help accounting
personnel determine whether a supplier qualifies as a related party and mark it
accordingly in the ERP system. Without the right mechanisms in place, a company
may inadvertently omit a disclosure about a related-party transaction.

Get it right
Undisclosed related-party transactions can raise a red flag to lenders and investors —
and may even require a business to restate its financial results. Our auditors are
committed to finding, disclosing and reporting these transactions in a transparent
manner that complies with U.S. Generally Accepted Accounting Principles (GAAP).
Contact Froehling Anderson for help.

5.3. Auditing opening balances

ISA 510 Initial Engagements - Opening Balances requires that when auditors take on
a new client, they must ensure that:

 opening balances do not contain material misstatements;

 prior period closing balances have been correctly brought forward or, where
appropriate, restated; and
 appropriate accounting policies have been consistently applied, or changes
adequately disclosed.
Considerations
 Were the previous financial statements audited?
 If the previous financial statements were audited, was the opinion modified?
 If the previous opinion was modified, has the matter been resolved since then?
 Were any adjustments made as a result of the audit? If so, has the client
adjusted their accounting ledgers as well as the financial statements?

If auditors are unable to satisfy themselves with regard to the preceding period, they
will have to consider modifying the current audit report.

Procedures

Where the prior period was audited by another auditor or unaudited, the auditors will
need to perform additional work in order to satisfy themselves regarding the opening
position. Such work would include:

 consulting the client's management

 reviewing records and accounting and control procedures in the preceding
period
 consulting with the previous auditor and reviewing (with their permission)
their working papers and relevant management letters
 substantive testing of any opening balances where the above procedures are
unsatisfactory.

Some evidence of the opening position will also usually be gained from the audit
work performed in the current period.

5.4. Subsequent events definition

A subsequent event is an event that occurs after a reporting period, but before the
financial statements for that period have been issued or are available to be issued.
Depending on the situation, such events may or may not require disclosure in an
organization's financial statements. The two types of subsequent events are:
Additional information. An event provides additional information about conditions in
existence as of the balance sheet date, including estimates used to prepare the
financial statements for that period.
New events. An event provides new information about conditions that did not exist as
of the balance sheet date.
Generally accepted accounting principles state that the financial statements should
include the effects of all subsequent events that provide additional information about
conditions in existence as of the balance sheet date. This rule requires that all entities
evaluate subsequent events through the date when financial statements are available to
be issued, while a public company should continue to do so through the date when the
financial statements are actually filed with the Securities and Exchange Commission.
Examples of situations calling for the adjustment of financial statements are:
Lawsuit. If events take place before the balance sheet date that trigger a lawsuit, and
lawsuit settlement is a subsequent event, consider adjusting the amount of any
contingent loss already recognized to match the amount of the actual settlement.
Bad debt. If a company issues invoices to a customer before the balance sheet date,
and the customer goes bankrupt as a subsequent event, consider adjusting the
allowance for doubtful accounts to match the amount of receivables that will likely
not be collected.
If there are subsequent events that provide new information about conditions that did
not exist as of the balance sheet date, and for which the information arose before the
financial statements were available to be issued or were issued, these events should
not be recognized in the financial statements. Examples of situations that do not
trigger an adjustment to the financial statements if they occur after the balance sheet
date but before financial statements are issued or are available to be issued are:
 A business combination
 Changes in the value of assets due to changes in exchange rates
 Destruction of company assets
 Entering into a significant guarantee or commitment
 Sale of equity
 Settlement of a lawsuit where the events causing the lawsuit arose after the
balance sheet date
A company should disclose the date through which there has been an evaluation of
subsequent events, as well as either the date when the financial statements were issued
or when they were available to be issued. There may be situations where the non-
reporting of a subsequent event would result in misleading financial statements. If so,
disclose the nature of the event and an estimate of its financial effect. If a business
reissues its financial statements, disclose the dates through which it has evaluated
subsequent events, both for the previously issued and revised financial statements.
The recognition of subsequent events in financial statements can be quite subjective in
many instances. Given the amount of time required to revise financial statements at
the last minute, it is worthwhile to strongly consider whether the circumstances of a
subsequent event can be construed as not requiring the revision of financial
statements.

There is a danger in inconsistently applying the subsequent event rules, so that similar
events do not always result in the same treatment of the financial statements.
Consequently, it is best to adopt internal rules regarding which events will always
lead to the revision of financial statements; these rules will likely require continual
updating, as the business encounters new subsequent events that had not previously
been incorporated into its rules.

Subsequent Events Disclosure Example

The following is an example of a typical disclosure of a subsequent event:

The following events and transactions occurred subsequent to December 31, 20XX:

The company concluded acquisition discussions with ABC Corporation, and paid
$10,000,000 in cash to the shareholders of ABC on February 28, 20XX to acquire
100% of the outstanding shares of ABC.

A jury found that the company was not liable in a lawsuit brought by Smith.

The company's largest customer, Jones & Company, declared bankruptcy on February
10, 20XX. Given this new information, the company increased its reported allowance
for doubtful accounts by $100,000, which is included in these financial statements.

5.5. Management representation letter

A management representation letter is a form letter written by a company's external
auditors, which is signed by senior company management. The letter attests to the
accuracy of the financial statements that the company has submitted to the auditors
for their analysis. The CEO and the most senior accounting person (such as the CFO)
are usually required to sign the letter. The letter is signed following the completion of
audit fieldwork, and before the financial statements are issued along with the auditor's
opinion.
In essence, the letter states that all of the information submitted is accurate, and that
all material information has been disclosed to the auditors. The auditors use this letter
as part of their audit evidence. The letter also shifts some blame to management, if it
turns out that some elements of the audited financial statements do not fairly represent
the financial results, financial position, or cash flows of the business. For this reason,
the statements that the auditor includes in the letter are quite broad ranging,
encompassing every possible area in which management's failings could lead to the
issuance of inaccurate or misleading financial statements. Following is a sample of
the representations that may be included in the management representation letter:

 Management is responsible for the proper presentation of the financial statements

 in accordance with the applicable accounting framework
 All financial records have been made available to the auditors
 All board of directors minutes are complete
 Management has made available all letters from regulatory agencies regarding
financial reporting noncompliance
 There are no unrecorded transactions
 The net effect of all uncorrected misstatements is immaterial
 The management team acknowledges its responsibility for the system of financial
controls
 All related party transactions have been disclosed
 All contingent liabilities have been disclosed
 All unasserted claims or assessments have been disclosed
 The company has disclosed all liens and other encumbrances on its assets
 All material transactions have been properly recorded
 Management is responsible for systems designed to detect and prevent fraud
 Management has no knowledge of fraud within the company
 The financial statements conform to the applicable accounting framework
Auditors typically do not allow management to make any changes to the content of
this letter before signing it, since this would effectively reduce the liability of
management.
An auditor typically will not issue an opinion on a company's financial statements
without first receiving a signed management representation letter.
The Public Company Accounting Oversight Board provides considerable detail
regarding the content of a management representation letter in its AU Section 333.

5.6. The specialists advice

The auditor's education and experience enable him or her to be knowledgeable about
business matters in general, but the auditor is not expected to have the expertise of a
person trained for or qualified to engage in the practice of another profession or
occupation. During the audit, however, an auditor may encounter complex or
subjective matters potentially material to the financial statements. Such matters may
require special skill or knowledge and in the auditor's judgment require using the
work of a specialist to obtain appropriate evidential matter.

Examples of the types of matters that the auditor may decide require him or her to
consider using the work of a specialist include, but are not limited to, the following:

a. Valuation (for example, special-purpose inventories, high-technology

materials or equipment, pharmaceutical products, complex financial
instruments, real estate, restricted securities, works of art, and environmental
contingencies)
b. Determination of physical characteristics relating to quantity on hand or
condition (for example, quantity or condition of minerals, mineral reserves, or
materials stored in stockpiles)
c. Determination of amounts derived by using specialized techniques or methods
(for example, actuarial determinations for employee benefits obligations and
disclosures, and determinations for insurance loss reserves fn 4 )
d. Interpretation of technical requirements, regulations, or agreements (for
example, the potential significance of contracts or other legal documents or
legal title to property)