1) Distinguish between a contingent liability and an actual liability and give three examples of each.
: A contingent liability is a potential future obligation to an outside party for an unknown amount resulting from activities that have already taken place. Some examples would be:
Pending litigation
Income tax disputes
Product warranties
Notes receivable discounted
Guarantees of obligations of others
Unused balances of outstanding letters of credit
An actual liability is a real future obligation to an outside party for a known amount from activities that have already taken place. Some examples would be:
Notes payable
Accounts payable
Accrued interest payable
Income taxes payable
Payroll withholding liabilities
Accrued salaries and wages
2) In the audit of the James Mobley Company, you are concerned about the possibility of contingent liabilities resulting from income tax disputes. Discuss the procedures you could use for an extensive investigation in this area.
: If you are concerned about the possibility of contingent liabilities for income tax disputes, there are various procedures you could use for an intensive investigation in that area. One good approach would be an analysis of income tax expense.
Unusual or nonrecurring amounts should be investigated further to determine if they represent situations of potential tax liability. Another helpful procedure for uncovering potential tax liabilities is to review the general correspondence file for communication with attorneys or internal revenue agents. This might give an indication that the potential for a liability exists even though no actual litigation has begun. Finally, an examination of internal revenue agent reports from prior years may provide the most obvious indication of disputed tax matters.
3) Explain why an auditor is interested in a client’s future commitments to purchase raw materials at affixed price.
: The auditor would be interested in a client's future commitments to purchase raw materials at a fixed price so that this information could be disclosed in the financial statements. The commitment may be of interest to an investor as it is compared to the future price movements of the material. A future commitment to purchase raw materials at a fixed price may result in the client paying more or less than the market price at a future time.
4) Explain why the analysis of legal expense is an essential part of every audit.
: The analysis of legal expense is an essential part of every audit engagement because it may give an indication of contingent liabilities which may become actual liabilities in the future and require disclosure in the current financial statements.
Since any single contingency could be material, it is important to verify all legal transactions, even if the amounts are small. After the analysis of legal expense is completed, the attorneys to whom payment was made should be considered for letters of confirmation for contingencies (attorney letters).
5) During the audit of the Merrill Manufacturing Company, Ralph Pyson, CPA, has become aware of four lawsuits against the client though discussions with the client, reading corporate minutes, and reviewing correspondence files. How should Pyson determine the materiality of the lawsuits and the proper disclosure in the financial statements?
: Pyson should determine the materiality of the lawsuits by requesting from Merrill's attorneys an assessment of the legal situations and the probable liabilities involved. In addition, Pyson may have his own attorney assess the situations. Proper disclosure in the financial statements will depend on the attorneys' evaluations of the probable liabilities involved. If the evaluations indicate highly probable, material amounts, disclosure will be necessary in the form of a footnote, assuming the amount of the probable material loss cannot be reasonably estimated. If the client refuses to make adequate disclosure of the contingencies, a qualified or adverse opinion may be necessary.
6) Distinguish between an asserted and unasserted claim. Explain why a client’s attorney may not reveal an unasserted claim.
: An asserted claim is an existing legal action that has been taken against the client, whereas an unasserted claim represents a potential legal action. The client's attorney may not reveal an unasserted claim for fear that the disclosure of this information may precipitate a lawsuit that would be damaging to the client, and that would otherwise not be filed.
7) Describe the action that an auditor should take if an attorney refuses to provide information that is within the attorney’s jurisdiction and may directly affect the fair presentation of the financial statements.
: If an attorney refuses to provide the auditor with information about material existing lawsuits or likely material unasserted claims, the audit opinion would have to be modified to reflect the lack of available evidence. This is required by SAS 12 (AU 337), and has the effect of requiring management to give its attorneys permission to provide contingent liability information to auditors and to encourage attorneys to cooperate with auditors in obtaining information about contingencies.
8) Distinguish between the two general types of subsequent events and explain how they differ. Give two examples of each type.
: The first type of subsequent event is one that has a direct effect on the financial statements and requires adjustment. Examples of this type of subsequent event are as follows:
Declaration of bankruptcy by a customer with an outstanding accounts receivable balance due to the deteriorating financial condition
Settlement of a litigation for an amount different from the amount recorded on the books
Disposal of equipment not being used in operations at a price below the current book value
Sale of investments at a price below recorded cost
Sale of raw material as scrap in the period subsequent to the balance sheet date
The second type of subsequent event is one that has no direct effect on the financial statements but for which disclosure is advisable. Examples include the following:
Decline in the market value of securities held for temporary investment or resale
Issuance of bonds or equity securities
Decline in the market value of inventory as a consequence of government action barring further sale of a product
Uninsured loss of inventories as a result of fire
9) In obtaining letters from attorneys, Bill Malano’s aim is to receive the letters as early as possible after the balance sheet date. This provides him with a signed letter from every attorney in time to properly investigate any exceptions. It also eliminates the problem of a lot unresolved loose ends near the end of the audit. Evaluate Malano’s approach.
: Malano's approach does not take into consideration the need to obtain letters from attorneys as near the end of field work as possible. If the letters are received near the balance sheet date, the period from the balance sheet to the end of the auditor's field work will not be included in the attorneys' letters. His procedure would not obtain the most current information regarding contingent liabilities, and would not provide adequate information for disclosure of pertinent subsequent events.
10)What major considerations should the auditor take into account in determining how extensive the review of subsequent events should be?
: The major considerations the auditor should take into account in determining how extensive the subsequent events review should be are:
The company's financial strength and stability of earnings
The effectiveness of the company's internal controls
The number and significance of the adjustments made by the auditor
The length of time between the balance sheet date and the completion of the audit
Changes in key personnel
Auditors of public companies should be aware that PCAOB Standard 2 requires them to also inquire about changes in internal control over financial reporting occurring subsequent to the end of the fiscal period that might significantly affect internal control over financial reporting.
11)Identify five audit procedures normally done as a part of the review for subsequent events
: Audit procedures normally performed as a part of the review for subsequent events are:
Cutoff and valuation tests of various balances and related transactions;
e.g., sales cutoff tests
Inquire of management
Correspond with attorneys
Review internal statements prepared subsequent to the balance sheet date
Review records prepared subsequent to the balance sheet date
Examine minutes of meetings of board of directors and stockholders subsequent to the balance sheet date
Obtain a letter of representation
12)Distinguish between subsequent events occurring between the balance sheet date and the date of the auditor’s report, and subsequent discovery of facts existing at the date of the auditor’s report. Give two examples of each and explain the appropriate action by the auditor in each instance.
: Subsequent events occurring between the balance sheet date and the date of the auditor's report are those transactions and events which might affect the financial statements being audited (either adjustment, disclosure, or both).
Examples of these types of events would be:
Declaration of bankruptcy by a customer with an outstanding accounts receivable balance due because of a deteriorating financial condition
Settlement of a litigation for an amount different from the amount recorded on the books
Disposal of equipment not being used in operations at a price below the current book value
Sale of investments at a price below recorded cost
Sale of raw material as scrap in the period subsequent to the balance sheet date
Decline in the market value of securities held for temporary investment or resale
Issuance of bonds or equity securities
Decline in the market value of inventory as a consequence of government action barring further sale of a product
Uninsured loss of inventories as a result of fire
If these events and transactions have a material effect on the financial statements, they may require adjustment of the current period financial statements or disclosure. Auditors of public companies should also be alert for subsequent changes in internal control over financial reporting.
The subsequent discovery of facts existing at the date of the auditor's report occurs when the auditor becomes aware that some information included in the financial statements was materially misleading after the audited financial statements have been issued. Some examples of such facts would be:
Subsequent discovery of the inclusion of fraudulent sales
Subsequent discovery of the failure to write-off obsolete inventory
Omission of an essential footnote
In such cases when the auditor discovers the statements to be misleading, he or she should request the client to issue a revised set of financial statements as soon as possible containing a new audit report and an explanation of the reasons for the revisions to the financial statements.
13)Miles Lawson, CPA, believes that the final summarization is the easiest part of the audit if careful planning is follow throughout the audit. He makes sure that each segment of the audit is completed, he is finished with the audit. He believes this may cause each part of the audit to take a little longer, but he makes up for it by not having to do the final summarization. Evaluate Lawson’s approach.
: The weakness in Lawson's approach is the danger of discovering an inadequacy in one audit area which could affect other areas of the audit. For example, if misstatements were discovered as part of the tests of controls for sales, the initial plans for the tests of details of balances for accounts receivable may have been insufficient and should have been revised. Similarly, the audit of fixed assets is related to the contracts and notes payable whenever fixed assets are used as collateral.
Another difficulty with Lawson's approach is that there is no combining of the misstatements in different audit areas to determine if the combined misstatements are material. If the combined misstatements are considered material, it may be necessary to expand the testing in certain areas or require adjusting entries to some balances.
14)Compare and contrast the accumulation of audit evidence and the evaluation of the adequacy of the disclosures in the financial statements. Give two examples in which adequate disclosure could depend heavily on the accumulation of evidence and two others in which audit evidence does not normally significantly affect the adequacy of the disclosure.
: The accumulation of audit evidence is crucial to the auditor in determining whether the financial statements are stated in accordance with generally accepted accounting principles, applied on a basis consistent with the preceding year. The evaluation of the adequacy of the disclosures in financial statements is made to determine that the account balances on the trial balance are properly aggregated and disclosed on the financial statements.
Examples where adequate disclosure could depend heavily upon the accumulation of evidence are:
The disclosure of declines in inventory values below cost
The segregation of current from noncurrent receivables
The segregation of trade accounts receivable from amounts due from affiliates
The disclosure of contingent liabilities that the auditor has not been informed of by the client
Examples where audit evidence does not normally significantly affect the adequacy of the disclosure are:
Deciding whether a disposal of equipment should be recorded as an extraordinary item
The disclosure of an acquisition as a pooling of interests or a purchase
The disclosure of contingencies that the auditor was informed of by the client
15)Distinguish between a client letter of representation and a management letter and state the primary purpose of each. List some items that might be included in each letter.
: A letter of representation is a written communication from the client to the auditor which formalizes statements that the client has made about matters pertinent to the audit. SAS 85 (AU 333) suggests four categories of items that should be included in the letter. Below are those four items with examples in each category follow (refer students to SAS 85―AU 333―for a comprehensive list):
1. Financial statements
Management's acknowledgment of its responsibility for the fair presentation in the financial statements of financial position, results of operations, and cash flows in conformity with generally accepted accounting principles