404
CHAPTER ACCT 11
Completing the Audit
LEARNING OBJECTIVES
Review
Checkpoints
Exercises, Problems,
and Simulations
1.
Describe the approach used to examine major
revenue and expense accounts.
1, 2, 3, 4
2.
Identify procedures performed by auditors to
evaluate contingencies, including the use of an
attorney letter, during the completion of the
audit.
5, 6, 7
52, 53, 56, 66, 67
3.
Explain why auditors obtain management
representations and list the key components of
management representations.
8, 9, 10, 11
48, 49, 50, 51, 59
(partial), 65 (partial)
4.
Identify the two major categories of subsequent
events and describe the proper handling of these
events by auditors.
12, 13, 14, 15
55, 58 (partial), 59
(partial), 60, 61, 64
(partial), 65 (partial)
5.
Identify the final steps in the completion of an
audit.
16, 17, 18, 19, 20, 21
54, 65 (partial), 68
6.
Following the audit report release date, identify
auditors responsibilities for (1) facts that may
have existed at the date of the auditors reports
and (2) omitted audit procedures.
22, 23, 24
57, 58 (partial) 62, 63,
64 (partial), 65
(partial)
7.
Summarize important communications made by
auditors following completion of the audit and
audit report release date.
25, 26
69
Page 1 of 29
ACCT 404
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 audit completion date: (1) roll-forward work; (2) examination
of revenue and expense accounts; (3) attorney letters; (4) management representations; (5) goingconcern assessment; (6) adjusting journal entries; (7) audit documentation review; (8) subsequent
events.
3.
Between the audit completion date and audit report release date: subsequent events.
4.
Following the audit report release date: (1) subsequent discovery of facts; (2) omitted audit
procedures; (3) management letters; (4) communications with those charged with governance.
11.2
Revenue and Expense
Account
Balance Sheet Account
Transaction Cycle
Sales Revenue and Sales
Returns
Receivables
Revenue/Collection
Dividend and Interest
Revenue
Receivables, Investments
Finance/Investment
Gain or Loss on Asset
Disposals
Property, plant and equipment
Receivables
Investments
Acquisition/Expenditure
Finance/Investment
Cost of Goods Sold
Inventories
Production
Interest Expense
Liabilities
Acquisition/Expenditure
Finance/Investment
11.3
In addition to work with the related balance sheet accounts and transaction cycles, auditors (1) use
analytical procedures to examine the revenue and expense accounts and (2) scan 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).
Page 2 of 29
ACCT 404
11.5
The responsibilities of client management are to (1) respond to auditors inquiries regarding
litigation, claims, and assessments; (2) provide auditors 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 auditors 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.
c.
11.6
a.
The responsibilities of the attorney are to respond to auditors regarding the clients description of
litigation, claims, and assessments.
Attorney letters ordinarily contain the following information:
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.
11.7
A listing of pending or threatened litigation, claims, or assessments.
An estimate of the range of potential loss.
In addition to attorney letters, auditors 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 clients 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.
Page 3 of 29
ACCT 404
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 a defense if a question of
management integrity arises later.
The following representations must appear in all management representations:
1.
2.
Availability of all financial records and related data and completeness of the minutes of meetings
of stockholders, directors, and important committees.
3.
Managements 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.
11.9
Managements acknowledgement of its responsibility for the fair presentation of financial
statements in conformity with accounting principles generally accepted in the United States of
America.
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.
If the entity is subject to the requirements of AS 5, auditors 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).
Managements conclusion with respect to the effectiveness of its internal control over financial
reporting at year end.
Management did not use the auditors procedures performed during the audits of internal control over
financial reporting or the financial statements as part of their basis for our assessment of the
effectiveness of internal control over financial reporting.
No control deficiencies communicated to the audit committee (or those charged with governance) 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 field work and dated on or near the audit completion
date to ensure that the most current information has been considered and evaluated by auditors.
(Management representations must be dated on the audit completion date).
11.11
If the client refuses to furnish management representations, auditors may either qualify or disclaim an
opinion, as with other scope limitations. However, because of the importance of this communication,
auditors should be very skeptical if the client refuses to furnish management representations.
11.12
A subsequent event is an event occurring between the balance sheet date and the audit report release date.
Page 4 of 29
ACCT 404
11.13
Procedures performed during the subsequent period include:
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 responses to attorney letters from any legal counsel engaged by the client.
11.14
Reading the latest interim financial statements and comparing them with the financial statements
being reported upon.
Obtaining management representations.
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 clients 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).
11.15
Dual dating the auditors report provides a means of inserting important information in the financial
statements and footnote disclosures learned by auditors after the audit completion date. A significant
advantage of dual dating the report is that auditors liability for events after the audit completion date is
limited to the event specifically identified in the report date.
11.16
Adjusting entries and note disclosures are labeled proposed because it is ultimately the clients
responsibility to adjust the financial statements for these items.
11.17
An uncorrected misstatement is a misstatement that the auditor has identified and accumulated during the
audit that has not been corrected (or adjusted) by the client. Auditors are required to communicate all
detected during the audit to individuals charged with governance (such as the clients audit committee),
regardless of the materiality of these misstatements to the clients financial statements.
11.18
The rollover method considers only the current period income effect(s) of any misstatements. In contrast,
the iron curtain method considers the aggregate effect of the misstatements on the entitys balance sheet.
Staff Accounting Bulletin No. 108 requires auditors to evaluate misstatements using both methods and
propose an adjustment if either method indicates that the misstatement exceeds the level of performance
materiality.
Page 5 of 29
ACCT 404
11.19
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 firms quality standards.
11.20
An engagement quality review is a review of audit documentation by a partner (or equivalent with the
firm) 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.
11.21
Some of the benefits of audit documentation review are:
To provide the firm with an opportunity to evaluate the overall quality of the firms audit practice.
To provide an important component of the evaluation of audit staff members.
11.22
To ensure the audit is conducted in accordance with generally accepted auditing standards.
To allow the firm to adhere to the first standard of field work (that the work is adequately planned
and assistants, if any, are properly supervised).
A subsequent event is an event occurring between the balance sheet date and audit report release date.
Depending upon the type of subsequent event, auditors will either adjust the financial statements or
disclose the subsequent event in the financial statements
A subsequent discovery of facts occurs when auditors learn of events that existed at the balance sheet date
following the audit report release date. Auditors 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.
11.23
If the client consents to the disclosure, auditors should take actions to ensure that persons who are
continuing to rely on the financial statements and auditors reports are properly notified of the facts.
If the client refuses to make the appropriate disclosures, auditors 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.
Page 6 of 29
ACCT 404
11.24
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 auditors opinion and (2)
individuals are currently relying on the clients financial statements and reports.
2.
3.
11.25
If both of the above conditions exist, auditors should perform the omitted procedure or alternative
procedures. If both do not exist, no further action is necessary.
If performing the omitted or alternative procedures allow auditors to support the previously-expressed
opinion, no further action is necessary. However, if they do not, auditors should formally
withdraw the original reports, issue revised reports, and inform persons currently relying on the
financial statements.
Auditors should communicate the following information to individuals charged with governance:
Auditors responsibility under generally accepted auditing standards.
An overview of the planned scope and timing of the audit.
Auditors judgment about the quality of the clients accounting policies, accounting estimates, and
financial statement disclosures.
Any significant difficulties encountered during the audit.
Any uncorrected misstatements, other than those auditors believe to be trivial.
Any disagreements with management.
Material, corrected misstatements that were brought to the attention of management.
Representations requested from the clients management.
Any management consultations with other auditors.
Any significant issues arising from the audit that were discussed with management.
Other findings or issues that are significant and relevant to those charged with governance.
11.26
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
11.27
Incorrect
Correct
Interest income is related to the examination of notes receivable.
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.
11.28
a.
b.
Incorrect
Notes payable are not directly related to royalty revenue.
a.
Incorrect
b.
c.
Incorrect
Incorrect
d.
Correct
Management representations do not shift responsibility to auditors for the
financial statements.
Management representations should not substitute for other evidence sources.
Management makes assertions directly in the financial statements and not as part
of the management representations.
This responsibility is explicitly included in the management representations.
Page 7 of 29
ACCT 404
11.29
NOTE 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.
b.
c.
d.
a.
b.
Incorrect
Correct
Incorrect
Incorrect
a.
b.
Incorrect
Incorrect
Correct
Incorrect
a.
Correct
b.
c.
d.
11.34
Incorrect
d.
11.33
Incorrect
Incorrect
Correct
c.
11.32
a.
b.
c.
c.
d.
11.31
Incorrect
d.
11.30
Correct
Incorrect
Incorrect
Incorrect
Incorrect
Incorrect
a.
Incorrect
b.
c.
Incorrect
Correct
d.
Incorrect
Scanning expenses is unlikely to reveal any information about a contingency.
Attorney letters can provide information about contingencies.
Minutes of board of directors meetings can provide information about
contingencies.
Sales contracts can provide information about right of return that may need to be
disclosed as a contingency.
The issuance of stock occurred after December 31.
The injury related to the lawsuit was sustained after December 31.
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.
The storm occurred after December 31.
The report date is the audit completion date, not the balance sheet date.
The report date is the audit completion date and the dual date is the date related
to the specific event.
The report date is the audit completion date, not the balance sheet date.
The report date is the audit completion date, not the date of the subsequent
event.
See (c) below.
Because auditors have not yet released their reports, the responsibility for
subsequent events exists until the audit report release date. This response would
be correct if the subsequent events were discovered following the audit report
release date.
Auditors are responsible for ensuring that management properly disclose all
subsequent events occurring prior to the audit report release date.
See (c) above.
Subsequent discovery of facts refers to knowledge obtained after the audit report
release date.
See (a) above. These types of events are referred to as subsequent events.
See (a) above. These types of events are referred to as subsequent events.
See (a) above. These types of events do not require any special audit
consideration.
Management representations are required under generally accepted auditing
standards.
Attorney letters are required under generally accepted auditing standards.
Management letters, while helpful, are not required under generally accepted
auditing standards.
Engagement letters are required under generally accepted auditing standards.
Page 8 of 29
ACCT 404
11.35
NOTE 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.
b.
Incorrect
a.
Incorrect
b.
c.
Incorrect
Incorrect
d.
Correct
a.
b.
c.
Incorrect
Incorrect
Incorrect
d.
11.38
Incorrect
d.
11.37
Incorrect
c.
11.36
Correct
Correct
An engagement letter would be secured prior to the commencement of the audit
examination.
Tests of controls would be performed prior to the end of the year under audit.
A review for subsequent events would be performed after year end but prior to
the audit completion date.
Management representations would be obtained on the audit completion date.
Discovery of a subsequent event occurs after the audit report release date.
Dual dating the auditors report occurs following the audit completion date.
The management letter is prepared and presented to the client following the
conclusion of the audit examination.
The review of audit documentation occurs after the balance sheet date but before
the audit completion date.
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
b.
Correct
c.
Incorrect
d.
11.39
The clients 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 clients operations.
The clients accounting and production managers would provide information
about current practices for the management letter.
The accounting firms team would play a major role in drafting the management
letter based on their observations during the audit examination.
The accounting firms consulting and tax experts would participate in drafting
the management letter, as they are in position to identify possible efficiencies
and income tax savings..
Incorrect
a.
Incorrect
b.
Incorrect
c.
Incorrect
d.
Correct
Analytical procedures would be used in conjunction with the examination of
revenue and expense accounts.
Auditors would typically sample and investigate individual transactions in the
examination of the related balance sheet accounts, but not revenue and expense
accounts.
Auditors would consider evidence obtained in the examination of related
balance sheet accounts in the audit of revenue and expense accounts (see b
above).
Auditors would scan revenue and expense accounts for large and unusual debit
and credit entries.
This statement would typically be included in management representations and
not an attorney letter.
While this statement is related to communication with attorneys, it would not be
appropriate for the attorney to directly inform auditors of omitted unasserted
claims or assessments.
This statement would ordinarily be included in a management letter and not an
attorney letter.
The attorney letter would request that the attorney furnish this information to
auditors.
Page 9 of 29
ACCT 404
11.40
Incorrect
b.
Incorrect
c.
Correct
d.
11.41
a.
Incorrect
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.
Incorrect
d.
Incorrect
a.
Incorrect
b.
Incorrect
c.
Correct
d.
Incorrect
a.
Incorrect
b.
Incorrect
c.
d.
11.44
Incorrect
c.
11.43
Correct
b.
11.42
Prior to performing the omitted procedure or an alternative procedure, auditors
would determine that the omitted procedure is important in supporting the
opinion on the entitys financial statements.
Prior to notifying the board of directors and regulatory agencies who are
currently relying on the auditors reports, auditors would determine that the
omitted procedure is important in supporting the opinion on the entitys
financial statements.
This is the initial course of action that would be taken upon the discovery of an
omitted audit procedure.
A quality assurance review may reveal the omission of an audit procedure, but
would not be performed in response to an omitted procedure.
Incorrect
Correct
a.
Correct
b.
Incorrect
c.
Incorrect
d.
Incorrect
The failure of management to furnish representations would result in either a
qualified opinion or a disclaimer of opinion.
Management representations do address disclosure of significant deficiencies in
internal control, regardless of materiality.
Management representations are used by auditors to corroborate information
received from the client and its employees.
Management representations are dated the same date as the auditors reports (the
audit completion date).
Management representations are dated as of the audit completion date (in this
case, March 24, year 2), not the date of completion of the financial statements.
Management representations are dated as of the audit completion date (in this
case, March 24, year 2), not the date that field work began.
Management representations are dated as of the audit completion date (in this
case, March 24, year 2).
Management representations are dated as of the audit completion date (in this
case, March 24, year 2), not the date that the auditors reports are completed.
A charge to notes receivable would relate to a transaction that has occurred in a
prior period, not current period.
A charge to notes receivable would relate to a transaction that has occurred in a
prior period, not current period.
A charge would indicate that any obligation has been settled, not incurred.
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.
Comparing interim financial statements with the financial statements being
audited would identify potential subsequent events.
Second request confirmations would provide evidence regarding the valuation of
accounts receivable balances but would not provide evidence regarding
subsequent events.
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.
Reviewing the cutoff bank statement would verify the valuation of cash but
would not provide evidence regarding subsequent events.
Page 10 of 29
ACCT 404
11.45
Correct
c.
Incorrect
d.
Incorrect
a.
Incorrect
b.
Correct
c.
d.
Incorrect
Incorrect
a.
Correct
b.
Incorrect
c.
Incorrect
d.
11.47
Incorrect
b.
11.46
a.
Incorrect
This procedure would provide evidence about the valuation of these
transactions, but not subsequent events.
This procedure may provide information about sales and repurchases of the
entitys stock.
This procedure would be used to search for unrecorded accounts payable at year
end, but not the occurrence of subsequent events.
This procedure would provide evidence about the valuation of cash and potential
guarantees of debt, but not subsequent events.
While the attorney letter will ask for corroboration of managements information
regarding the probable outcome of litigation, claims, and assessments,
management is the primary source of this information.
The attorney letter requests the attorneys to corroborate information furnished
from management.
Historical experiences are not included in an attorney letter.
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).
The attorneys response should be limited to matters in which they have given
substantive attention.
The attorney should comment on matters of which they are aware that were not
disclosed by the entity.
The attorney should not limit their response to matters in which the entity has
historical experience.
The attorney should also comment upon unasserted claims as well as asserted
claims and pending or threatened litigation.
SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS
11.48
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
a defense for auditors if a question of management integrity subsequently arises.
c.
Management representations should be addressed to auditors and dated as of the date of the
auditors reports (audit completion date).
d.
Management representations should be signed by members of management whom auditors believe
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 auditors from their responsibility for
planning and performing the audit. As a result, auditors must still perform all usual procedures to
corroborate representations made by management.
Page 11 of 29
ACCT 404
11.49
Management 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 accounting principles generally accepted in the United
States of America (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.
Managements acknowledgement of its responsibility for the design and implementation
of programs and controls to detect fraud.
4.
5.
Managements disclosure of all significant deficiencies in internal control.
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 Molars management representations:
Material liabilities or gain or loss contingencies that are required to be accrued or disclosed.
The entity 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 entity 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.
Page 12 of 29
ACCT 404
11.50
Management Representations
a.
Appropriate.
b.
Inappropriate. While management representations address fraud involving management and
employees who have significant roles in internal control, they do not indicate that no frauds that
could have a material effect exist. Managements assessment of internal control over financial
reporting will not provide management with a basis for a statement of this nature.
c.
Appropriate.
d.
Inappropriate. The description and evaluation of contingencies would accompany the letter sent to
the clients attorney. While management representations indicate that management is unaware of
unasserted claims or assessments that are required to be disclosed in accordance with Statement of
Financial Accounting Standards No. 5, they would not list contingencies in which attorneys have
participated.
e.
Inappropriate. While management representations will indicate that all deficiencies in the design
or operation of internal control have been disclosed to auditors, they will not state that no such
deficiencies exist, even in cases where no deficiencies are noted.
f.
Inappropriate. Management letter comments are merely advisory to management, and no action is
required to be taken on these comments. Accordingly, reference to action on previous
management letter comments is not appropriate.
g.
Inappropriate. Managements assessment of internal control over financial reporting will not
provide such a high level of assurance to management; as a result, a reference of this nature in
management representations is not appropriate.
h.
Appropriate.
Page 13 of 29
ACCT 404
11.51
Management Representations
a.
Included in management representations regardless of materiality.
b.
Not included in management representations. (This would accompany an attorney letter sent from
the client to their attorneys.)
c.
Not included in management representations. (This would be included in a management letter
prepared by auditors to the client.)
d.
Included in management representations regardless of materiality.
e.
Included in management representations, if material.
f.
Included in management representations regardless of materiality.
g.
Included in management representations regardless of materiality.
h.
Not included in management representations. (This would be communicated to the clients audit
committee, or those charged with governance.)
i.
Included in management representations, if material.
j.
Not included in management representations. (Management representations indicate that
management believes the effects of uncorrected misstatements are immaterial to the financial
statements but management representations should not express an opinion on the financial
statements.)
Page 14 of 29
ACCT 404
11.52
Client Request for Attorney Letter
NOTE TO INSTRUCTOR: The categories of Major and Other deficiencies are the authors
judgment. Students should be able to identify the Major deficiencies, while the Other deficiencies may
be a bit more difficult to identify.
MAJOR DEFICIENCIES:
1.
A description of the progress of each case to date is omitted.
2.
An evaluation of the likelihood of an unfavorable outcome of each case is omitted.
3.
An estimate, if one can be made, of the amount or range of potential loss of each case is omitted.
4.
The various other pending or threatened litigation on which Young was consulted is not identified
and included.
5.
The unasserted claims and assessments probable of assertion that have a reasonable possibility of
an unfavorable outcome are not identified.
6.
Materiality (or the limits of materiality) is not addressed.
7.
The reference to a limitation on Youngs response due to confidentiality is inappropriate.
8.
Young is not requested to include matters that existed after December 31, 2010, up to the date of
Youngs response.
9.
There is no inquiry about any unpaid or unbilled charges, services, and disbursements.
OTHER DEFICIENCIES:
10.
The action that Consolidated intends to take concerning each suit (for example, to contest the
matter vigorously, to seek an out-of-court settlement, or to appeal an adverse decision) is omitted.
11.
Consolidateds understanding of Youngs responsibility to advise Consolidated concerning the
disclosure of unasserted possible claims or assessments is omitted.
12.
Young not is requested to identify the nature of and reasons for any limited response.
13.
The date by which Youngs response is needed is not indicated.
14.
The reference to Youngs response possibly being quoted or referred to in the financial statements
is inappropriate.
15.
Ambiguous terminology such as slight and some chance is included where remote and
possible are more appropriate.
Page 15 of 29
ACCT 404
11.53
Attorney Letters
a.
Inquireofmanagementregardinglitigation,claims,andassessments.
Obtain from management a description and evaluation of litigation, claims, and
assessments.
Examine documents in the clients possession concerning litigation, claims, and
assessments, including correspondence and invoices from lawyers.
Obtain assurance from management that it has disclosed all material unasserted claims
the lawyer has advised them are likely to be litigated.
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.
b. Jaworskis responsibilities with respect to litigation, claims, and assessments are to perform the
procedures noted in (a) above and initiate the request to the client for the attorney letter.
Fulbrightsresponsibilitieswithrespecttolitigation,claims,andassessmentsaretorespondto
auditorsinquiriesregardinglitigation,claims,andassessments;provideauditorswithalisting,
description,andevaluationoflitigation,claims,andassessments;andsendalettertotheattorney
thatincludesinformationrelatedtolitigation,claims,andassessments.
Vinsonsresponsibilitieswithrespecttolitigation,claims,andassessmentsaretorespondto
auditorsregardingFulbrightsdescriptionoflitigation,claims,andassessments.
c.
1.
Auditors initiate the request for the client to send the attorney letter.
2.
3.
d.
The attorney letter, along with a listing of litigation, claims, and assessments, is sent to
each attorney who has devoted attention to legal matters on behalf of the client.
The attorneys will respond directly to auditors on the information contained in the
attorney letter.
The following information is typically included in an attorney letter (prepared from the clients
perspective):
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.
Page 16 of 29
ACCT 404
An estimate of the range of potential loss.
Page 17 of 29
ACCT 404
11.54
Uncorrected Misstatements and Materiality
a.
The misstatement would have the following financial statement effects:
Overstatement of net income by $7,150 (assume taxes of $3,850)
Overstatement of assets by $11,000
Overstatement of liabilities by $3,850 (taxes payable)
Overstatement of equity by $7,150
b.
Turners comment is incorrect. While this misstatement is not material by itself, it might result in
material misstatements when considered along with previously identified (but not corrected)
misstatements.
c.
The rollover method considers only the current period income effect(s) of a misstatement when
evaluating its materiality; the iron curtain method considers the aggregate balance sheet effects of
the current misstatement along with previously-identified misstatements when evaluating
materiality.
d.
Under the rollover method, Rivers would conclude that the misstatement was not material, since
the amount of the misstatement ($7,150) was less than the materiality level ($25,000).
Under the iron curtain method, Rivers would consider both the current misstatement as well as the
previous misstatements. Summarizing the misstatements from 2005 2009 reveals an uncorrected
misstatement (net balance sheet effect) from prior audits of $18,450; including the current
misstatement of $7,150 would result in a cumulative effect of $25,600, which exceeds materiality
of $25,000.
As a result, Rivers should propose an adjustment to Chargers financial statements. Ordinarily,
Rivers would recommend an adjustment of the entire $25,600 of uncorrected misstatements
(assuming that these misstatements were actual misstatements and not projections of identified
misstatements). If a projection of identified misstatements, the minimum adjustment would be
$601, which would result in an adjusted cumulative effect of $24,999 ($25,600 - $601 = $24,999),
which is less than materiality.
11.55
Subsequent Events Internet Exercise
a.
Subsequent events are events occurring between the balance sheet date and the audit report release
date.
b.
Caterpillars fiscal year-end is December 31, 2007 and its report was filed with the SEC on
February 22, 2008.
c.
Because the event is dated February 8, 2008, it occurs between the balance sheet date and audit
report release date and appears to be properly classified as a subsequent event.
d.
This event would be a Type II event, since the event did not exist at the balance sheet date but
occurred prior to the audit report release date.
e.
Caterpillars auditors would likely verify that the event did, in fact, occur. Because no estimates of
the impact on Caterpillars financial statements can be made at this time, PricewaterhouseCoopers
cannot evaluate whether such estimates are reasonable.
Page 18 of 29
ACCT 404
11.56
Attorney Letters and Litigation Internet Exercise
NOTE TO INSTRUCTOR: Responses to parts (a) and (d) will depend upon the disclosure identified by the
student. One interesting method of debriefing this exercise is to ask one student to share his or her example
of litigation with the class and determine if other student(s) with similar type of litigation examples
identified similar audit procedures and approaches. With respect to (b) and (c), the following are
applicable to various types of litigation examples.
a.
See Note to Instructor above.
b.
The auditors primary concern with respect to the disclosure of pending litigation is that all items
are properly presented and disclosed in the clients financial statements.
c.
The responsibilities of these various parties are:
Company
Respond to auditors inquiries regarding pending litigation
Provide auditors with a list, description, and evaluation of pending
litigation
Send letter to attorneys that includes information related to litigation
Auditors
Inquire of company regarding existence of pending litigation
Perform various procedures regarding pending litigation
Initiate request to company for attorney letter
Attorney
d.
11.57
Respond to auditors regarding companys description of pending
litigation.
See Note to Instructor above.
Omitted Procedures and Subsequent Discovery of Facts Internet Exercise
a.
The auditors responsibility for subsequent discovery of facts is to disclose the facts and their
impact on the financial statements to persons relying on the financial statements if (1) the facts are
reliable and existed at the report date, (2) the facts affect the financial statements and auditors
reports, and (3) persons are continuing to rely on the financial statements and auditors reports.
The auditors responsibility for omitted procedures is to perform the omitted procedures or
alternative procedures if (1) the procedures are important in supporting the auditors opinion and
(2) individuals are currently relying on the clients financial statements and auditors reports.
b.
The students response to this question will depend upon which years reports are reviewed. Three
general responses that are provided by firms are (1) they disagree with the PCAOB review reports
assessment; (2) they believed that any subsequent discoveries or omitted procedures did not affect
their opinion on the clients financial statements; and, (3) they performed either the omitted
procedure or a similar procedure. One important point to raise as you review this part of the
exercise is that even major accounting firms can encounter issues related to omitted procedures
and subsequent discoveries of facts.
Page 19 of 29
ACCT 404
11.58
Subsequent Events
a.
A subsequent event is an event or transaction that occurs after the balance sheet date but prior to
the audit report release date (and the issuance of the entitys financial statements).
Michaels responsibility for subsequent events depends upon when he learns of these events. If he
learns of a subsequent event prior to the audit report release date, he is responsible for these events
until the audit report release date. If he learns of these events following the audit report release
date, his responsibility is limited to the audit completion date.
b.
Procedures that Michael can perform to assist him in identifying subsequent events include:
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.
c.
Reading the latest interim financial statements and comparing them with the financial
statements being reported upon.
Obtaining management representations.
The two types of subsequent events are:
1.
Michael could evaluate the disclosure of this event without additional considerations,
since he became aware of the transaction prior to the audit completion date.
Michael could evaluate the disclosure of this event, since his reports (and the financial
statements) have not been issued. However, since he became aware of the subsequent
event following the audit completion date, he would ordinarily dual date the auditors
report to limit his responsibility beyond the audit completion date to the disclosure
related to the subsequent event.
3.
e.
Type II subsequent events involve 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).
2.
d.
Type I subsequent events provide 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 included in the financial statements.
This situation would reflect a subsequent discovery of facts, since Michael became
aware of the transaction after the audit report release date. Michael should request that
Dallas Companys management disclose the facts and their impact on the financial
statements to persons relying on the financial statements if the following conditions exist:
(a) the facts are reliable and existed at the report date; (2) the facts affect the financial
statements and auditors reports; and, (c) persons are continuing to rely on the financial
statements and auditors reports.
Because the announced acquisition of San Antonio Company did not exist at the report date,
Michael has no responsibility with respect to this acquisition in the 2010 audit.
Page 20 of 29
ACCT 404
11.59
Audit Simulation: Subsequent Events and Contingent Liabilities
a.
1.
A subsequent event is an event or transaction that occurs after the balance sheet
date but prior to the issuance of the financial statements (audit report release date) (AU
560.01).
2.
The two types of subsequent events are (AU 560.03 AU 560.05):
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 included in the
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).
3.
Procedures performed to ascertain the occurrence of subsequent events include (AU
560.12):
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.
b.
1.
A contingent liability is an existing condition, situation, or set of circumstances
involving uncertainty as to a possible loss that will ultimately be resolved when one or
more future events occur or fail to occur (AU 337B.01).
2.
A contingent liability should be accrued only if information available prior to issuance of
the financial statements, indicates that it is probable that a liability has been incurred at
the date of the financial statements and the amount of the loss can be reasonably
estimated (AU 337B.08).
A contingent liability should be disclosed in a note when it is probable that a liability has
been incurred but the amount cannot be estimated. A contingent liability for which it is
only reasonably possible that a liability has been incurred should be disclosed in a note.
Where the probability that a liability has been incurred is remote, no disclosure is
required (337B.08).
Page 21 of 29
ACCT 404
c.
11.60
Subsequent events may provide new and important information about known or unknown loss
contingencies as of the balance sheet date. The subsequent event may very well modify the
circumstances surrounding the contingent loss thereby changing the reporting method from no
disclosure to note disclosure or accrual. For example, a contingent loss may have been recorded as
a note disclosure because, at the balance sheet date, the company had only a reasonable possibility
that a loss may be incurred. If a subsequent event occurs which (in the auditors judgment) makes
it probable that a liability has been incurred, the contingent liability will now have to be accrued in
the financial statements (assuming that an amount can be estimated).
Subsequent Events Procedures
a.
The purpose of a review for subsequent events is to determine whether there have been any
material transactions or events following year end that have a significant effect on the financial
statements and may require adjustment to or disclosure in the financial statements. While the
review for subsequent events normally ends as of the audit completion date (February 20),
auditors are responsible for any information of which they become aware until the audit report
release date (March 12).
b.
The following procedures would be performed to identify subsequent events:
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.
Page 22 of 29
ACCT 404
11.61
Subsequent EventsCases
1.
It is improbable that auditors would learn the source of the $25,000 unless it was revealed
in a discussion with the President or his personal accountant, or unless auditors prepared
the Presidents personal income tax return.
Disclosing the loan in the balance sheet as a loan from an officer would be sufficient. The
source of the funds would not be disclosed because it is the officers personal business
and has no effect upon Olars financial statements.
a.
The additional liability for the ore shipment would have been revealed to auditors
through scanning of January transactions. The regular examination of transactions and
related documents such as purchase contracts would have caused him to note the item for
subsequent follow-up to determine the final liability. In addition, the management
representations might have mentioned the potential liability.
The inventory and accounts payable balances would need to be adjusted by amount of the
additional charge, $9,064 [[$20,600 x (0.72/0.50)] - $20,600 = $9,064]. Because of this
adjustment, no further disclosure would be necessary.
a.
Auditors might learn of the agreement to purchase the treasurers stock ownership
through his inquiries of management and legal counsel, examination of the minutes of the
meetings of the board of directors and stockholders and subsequent reading of the
agreement. The physical absence of the treasurer might from Olars headquarters also
arouse the auditors curiosity.
b.
5.
a.
b.
4.
The details of the construction of the express highway would need to be disclosed in the
footnotes to the financial statements. This disclosure would be required because it affects
an asset (land) held by Olars.
b.
3.
This would have come to auditors attention through inquiries of client officers and key
personnel, review of the minutes of the meetings of the board of directors and
stockholders, or through local news media.
b.
2.
a.
The details of the agreement would be disclosed in the footnotes to the financial
statements because the use of company cash for the repurchase of stock and the change in
the amount of stock hold by stockholders might have a significant impact on subsequent
years financial statements. Usually, a management change, such as the treasurers
resignation, does not require disclosure in the financial statements. The details underlying
the separation (personal disagreements and divorce) need not be disclosed.
a.
Auditors would learn of the reduced sales and of the strike through inquiries of
management, review of financial statements for January, scanning transactions, and
general observations during the engagement.
b.
Disclosure should be made in the footnotes to the financial statements of these conditions
and the facts available at the date of the financial statements. This would be an example
of a Type II subsequent event, for which disclosure is required.
Page 23 of 29
ACCT 404
11.62
Subsequent Discovery of Facts
The manner in which Faultless treated the discovery of facts after the audit report release date is
inappropriate. Once the chief executive of Hopkirk refused to make proper disclosure, Faultless should
have notified the Board of Directors of the need to disclose the facts to persons who are known to be
relying on the financial statements. If the Board then agreed to such disclosure, Faultless and Hopkirk
would issue a revised set of financial statements and auditors reports or provided other notification as
appropriate. If the Board refused to make such disclosure, Faultless should (1) notify Hopkirk that the
auditors reports must not be associated with the financial statements, (2) notify the appropriate regulatory
agencies that the reports cannot be relied upon, and (3) notify users or the SEC that the reports cannot be
relied upon.
Significantly, Faultless probably increased its potential liability for three reasons. First, auditors appear to
have released confidential information. In this regard, auditors are warned to consult attorneys prior to
releasing information that may be governed by state statutes. Second, Hopkirk may continue to issue the
reports with the financial statements, increasing auditors potential liability to third parties. Third, by not
notifying the SEC and other regulatory agencies, Faultless may not only increase their potential liability to
third parties, but also risk potential censure by the SEC.
11.63
Omitted Audit Procedures
a.
1.
If it is discovered that an important audit procedure was omitted, auditors should consult
legal counsel and take the following actions:
Assess the importance of the omitted procedure to the present ability to support
the previously-expressed opinion.
Determine if any persons are currently relying or likely to rely on their reports.
If the omitted procedure impairs auditors present ability to support the
previously-expressed opinion, the omitted procedure should be applied or
alternative procedures applied that would provide a satisfactory basis for the
opinion.
If as a result of subsequent application of the omitted procedure or alternative
procedures, auditors become aware of facts that existed at the date of their
report, they should formally withdraw the original reports, issue revised reports,
and inform persons currently relying on the financial statements.
2.
If after reviewing the audit documentation auditors determined that procedures were
performed that compensate for the omitted procedure, the omitted procedure would not
have to be performed. Auditors should document their decision and their support for this
decision.
3.
If auditors become aware of material new information that should have been disclosed in
the financial statements, they should follow the guidelines for subsequent discovery of
facts, which require that they request the client to disclose necessary information to
persons known to be relying on the financial statements and auditors reports. If the client
refuses to do so, auditors 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.
Page 24 of 29
ACCT 404
b.
Case 1: You should document the decision that the specific procedures considered omitted by the
internal inspection reviewers were not considered necessary in the valuation of Wildcats
inventory. You should cite the specific performed procedures that you feel compensate
for the procedure the reviewers thought necessary.
Case 2: You should immediately notify the partners of Arthur Hurdman that the December 31
financial statements of Top Stove are not correct. They should consult legal counsel and
notify the client and ask the client to disclose to users that the financial statements are in
error. The financial statements should be corrected as soon as possible and reissued with
Arthur Hurdmans reports.
11.64
Subsequent Events, Subsequent Discovery of Facts, and Omitted Procedures
a.
The class action lawsuit and deterioration of Raiders customers financial condition are
subsequent events. Because Ralph learned of these events prior to the audit report release date,
Raiders financial statements and disclosures should have been modified to include information
related to these events (Raiders assertion about required disclosure of these events is incorrect).
However, Raiders financial statements did not disclose these events nor were Ralphs reports
modified in response to these events.
Ralph should treat this situation as he would a subsequent discovery of facts. Assuming (1) the
facts are reliable, (2) the facts affect Raiders financial statements and Ralphs reports, and (3)
persons continue to rely on the financial statements and Ralphs reports, Ralph should request that
Raider disclose information about these events and their impact on the financial statements to
persons known to be relying on the financial statements.
NOTE TO INSTRUCTOR: You may wish to note that Ralph may be subject to liability in this
case, because he was clearly aware of these events and should have insisted upon their disclosure
in Raiders financial statements or modification of his report.
b.
In this case, Ralph did not learn of these events until following the audit report release date. With
respect to the dividend, because the date of declaration was after the last day of field work (audit
report date), no action was necessary. With respect to the line of credit, because it was activated
prior to the audit report date (February 3), Ralph should treat this as a subsequent discovery of
facts. Assuming (1) the facts are reliable, (2) the facts affect Raiders financial statements and
Ralphs reports, and (3) persons continue to rely on the financial statements and Ralphs reports,
Ralph should request that Raider disclose information about these events and their impact on the
financial statements to persons known to be relying on the financial statements.
c.
The failure to evaluate impairment of the carrying value of property, plant and equipment is an
example of an omitted audit procedure. In this case, Ralph should consider whether (1) the omitted
procedures are important in supporting his opinion and (2) individuals are currently relying on
Raiders financial statements and Ralphs reports. If so, Ralph should perform the omitted
procedure or alternative procedures, withdrawing his original reports if the results of performing
these procedures suggest that Raiders financial statements and Ralphs reports are no longer
appropriate.
Page 25 of 29
ACCT 404
11.65
Audit Simulation: Various Completion Matters
a.
b.
AU 333.09 notes that management representations should be dated as of the date of the auditors
reports (audit completion date). As a result, Carmelo should request that Nugget reissue the
representations with a date of February 9, 2011.
c.
This is an example of a subsequent discovery of facts. Because this settlement does not have a
material effect on either Mannings financial statements or Colts ability to support his previouslyissued opinion on Mannings financial statements, no further action is necessary by Manning (AU
561.05).
d.
This is an example of a subsequent event. In this case, since the financial statements and Altas
reports have not been released, Saxe should disclose information related to the potential loss from
the flood in its financial statements. Alta should examine the fairness of this disclosure and either
extend the date of the auditors report to reflect this later audit completion date or dual date the
report (AU 560.05 AU 560.06).
e.
Under the provisions of SAS 107 (AU 312) Myron must accumulate the effects of these
misstatements on the financial statements with those identified in prior years. In addition, SAS 114
(AU 380.34) requires Myron to communicate any uncorrected misstatements, other than those
Myron believes to be trivial, to individuals charged with governance of Glomco.
f.
11.66
This is an example of a subsequent event; since this event relates to information already disclosed
in Andersons financial statements (accounts receivable from sales made to Jones), Alison should
insist that Andersons financial statements be adjusted to consider the most recent information
related to Jones financial condition. (AU 560.03 AU 560.04)
Because Jill believes that the omitted procedure affects her ability to support the opinion on
Blankenships financial statements and persons continue to rely on her report, she should
undertake to perform the omitted procedure or perform alternate procedures. (AU 390.05)
Attorney Letter Responses
a.
The four responses were based on AU 9337, as are these solutions.
1.
2.
According to AU 9337, this means remote likelihood of material loss.
3.
According to AU 9337, this means remote likelihood of material loss.
4.
b.
This response is too vague for adequate information. More evidence would be required to
support the claim that the plaintiffs will have serious problems establishing Omegas
liability.
Meritorious does not mean strong or adequate. The phrases reasonable chance,
adequate defense, less than the damages claimed all indicate potential issues. More
information is needed.
Plaintiffs counsel would probably assert the merits of the plaintiffs case, suggesting that the
auditors client (defendant) will certainly lose large damages. However, it is important to note that
auditors would not obtain representations from the plaintiffs regarding the outcome of litigation
against a client.
Page 26 of 29
ACCT 404
11.67
Accounting for a Contingency: Attorney Letter Information
a.
b.
11.68
Both of these amounts should be considered with some skepticism. While MALDEF may indeed
seek $250,000 from the city, this amount does not necessarily represent the amount of damages
that will be paid (and the amount at which the liability might be settled). The fact that the attorney
letter indicates that the damages could be between $30,000 and $175,000 provides some evidence
that a negative outcome may occur but does not provide any reliable information as to the amount
of that outcome.
The financial statements should disclose the verdict and mention the possibility of a monetary
settlement. If this litigation had commenced prior to December 31, 2010 (which is highly likely),
it would be treated as a Type I subsequent event and include the most current information as to the
status of the case. If the litigation commenced following December 31, 2010, it would be treated
as a Type II subsequent event and disclosed in the financial statements. However, it does not
appear that any basis exists for including dollar amounts in the disclosure.
Mini-Case: Going-Concern Reporting
NOTE TO INSTRUCTOR: For this assignment, questions 1 through 6 from this Mini-Case are
applicable.
1.
Examining the financial information in Exhibit 1, it appears that GMs financial distress began in
2005. It was during this year that GM suffered its first negative operating loss and first net loss.
Similarly, Exhibit 2 reveals that GMs stock price significantly declined during 2005.
2.
AU 341 identifies, the following factors indicative of going-concern uncertainties:
Other indications of financial difficulties (default on loan or similar agreements,
arrearages in dividends, denial of usual trade credit from suppliers, restructuring of debt,
noncompliance with statutory capital requirements, the need to seek new sources or
methods of financing, or the need to dispose of substantial assets).
Internal matters (work stoppages or other labor difficulties, substantial dependence on the
success of a particular project, uneconomic long-term commitments, or the need to
significantly revise operations).
3.
Negative trends (such as recurring operating losses, working capital deficiencies,
negative cash flow from operating activities, or adverse changes in key financial ratios).
External matters (legal proceedings; legislation; loss of a key franchise, license, or patent;
loss of a principal customer or supplier; or, uninsured or underinsured catastrophe).
This is a question that requires judgment on the part of the student. Clearly, while the losses in
2005 are of concern given GMs consistent profitability to that point, 2005 may have been viewed
as an abnormal year and the loss judged to be a one-time occurrence. While GM also experienced
a net loss in 2006, the amount of this loss was lower than that in 2005 (likely because of the spinoff of GMAC). In both years, GM showed negative cash flow from operations, raising further
questions as to GMs ability to continue as a going-concern.
Page 27 of 29
ACCT 404
In 2007, GMs net loss reached almost $39 billion; however, cash flow from operations was a
positive $7.7 billion in that year. Based on AU 341, the third consecutive year of recurring
operating losses (see (2) above) might be interpreted as some to have been indicative of goingconcern uncertainties. However, it is also reasonable to conclude that the positive cash flow from
operations in 2007 might mitigate Deloitte & Touches concerns to some extent.
4.
The following general economic factors in 2008 may have contributed to Deloitte & Touches
decision to issue an opinion modified for going-concern uncertainties:
The international credit crisis, which resulted in increased difficulty for GMs customers
in obtaining credit, reducing demand for all vehicles.
5.
High oil prices, which resulted in high gasoline prices that reduced consumer demand for
trucks and sports utility vehicles.
The general worsening of the U.S. economy (including extensive layoffs and increases in
unemployment), which reduced consumer demand for all vehicles.
While it is far too early to comment on GMs potential success, these events following the GM
bankruptcy may alleviate some of the concerns of Deloitte & Touche:
The terms of the restructuring plan, which provided the following potential benefits to GM:
(a) additional capital; (b) organization of the less viable GM brands under Motors Liquidation
Company; and, (c) reduced levels of debt, employees, dealers, and manufacturing plants
(Exhibit 3).
6.
Increased access to consumer credit and a more positive U.S. economy, which may increase
demand for vehicles.
The Cash for Clunkers program that temporarily increased consumer demand for vehicles.
The primary issue raised by a going-concern opinion is the continued existence of the entity
receiving that opinion. Many speculated that such an opinion would make customers wary of
purchasing automobiles from GM, because of the inability to obtain parts or warranty service on
the automobile if GM were to fail. With respect to investments in GM, the potential failure of an
organization would make investors similarly wary.
There is no correct response as to whether a going-concern opinion is a self-fulfilling prophecy.
The threat of continued existence is one that will never be resolved with certainty. However, the
fact that concerns have reached such a level that auditors modify their opinion suggests greater
concerns on the part of financial statement users and others having relationships with the
organization.
Page 28 of 29
ACCT 404
11.69
Kaplan CPA Exam Simulation: Audit Committee Communications
A significant deficiency in internal control over
financial reporting that is not a material weakness.
Required
Yes
An uncorrected misstatement that management deems
to be immaterial.
Yes
Specific field work procedures where internal auditors
were utilized.
No
Specific issues for which auditors consulted another
accountant.
No (however, managements consultation
with other accountants must be
communicated to the audit committee).
Auditors responsibility under generally accepted
auditing standards.
Yes
A list of all audit adjustments.
No (only significant adjustments are
communicated)
Disagreements with management that were resolved to
the auditors satisfaction.
Yes (all disagreements must be
communicated, regardless of whether they
were resolved)
Time delays and ill-timed vacations that made
completion of the audit difficult.
Yes (any difficulties in performing the audit
must be communicated)
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