ISL458U-AUDITING
Chapter 7: Completing The Audit
Introduction
The audit does not end until the audit report is written. Even then, some facts that may not have been completed can be discovered after the balance sheet date and before the issuance of financial statements. Once the audit of the financial statement items is almost complete, some additional procedures are usually applied to “complete the audit”.
This chapter focuses on ‘completing the audit’ part of the last phase and consists of three main parts. In the first part uncertainties regarding the future such as contingent liabilities, and subsequent events are examined. In the second part, final evidence evaluation procedures are presented including the communication with the management of the client company about the audit. In the third part, procedures regarding Quality Control Review are explained.
Review of Contingent Liabilities, Related Party Transactions, and Subsequent Events
One of the most difficult tasks of the auditor is to gather evidence about uncertainties and complex transactions among related parties. In many cases, it is not possible to obtain sufficient and appropriate evidence about uncertainties before the last phase. One common example of uncertainties is contingent liabilities. This section presents audit procedures for contingent liabilities, related party transactions, and subsequent events.
Review of Contingent Liabilities
A contingent liability is defined as an existing condition, situation, or set of circumstances involving uncertainty about a possible loss that will ultimately be resolved when some future event occurs or fails to occur(Messier et. al.:2008). The primary difference between a current liability and contingent liability that current liability is the liability that you already owe. However, a contingent liability is a potential liability company owes depending on events occurring.
Auditors should perform procedures to obtain evidence about contingent liabilities. These procedures are conducted in order to see that financial reports of the client’s company present contingent liabilities if any, as defined in the related financial reporting framework. If a material contingent liability is not included in financial statements accordingly, this may deteriorate the fair presentation of these statements.
In order to identify contingent liabilities, auditors mostly use inquiry of management, observation, and examination of documents. Auditors discuss with management about accounting treatment approaches of contingent liabilities. Also, auditor is obtaining a legal letter from the company lawyer or the legal advisor. A Legal Letter is an audit inquiry sent to the client’s attorneys in order to obtain or corroborate information about litigation, claims, and assessments (Messier et. Al., 2008).
Review of Related Party Transactions
A related party transaction is described as a transfer of resources, services, or obligations between related parties, regardless of whether a price is charged in International Accounting Standard (IAS) 24 Related Party Disclosures. Normally, most companies operate with partners, people, or entities through subsidiaries, associates, or joint ventures. Such relationships affect the operating results and financial position of the reporting entity.
Auditors must examine related party relationships and transactions which may result in a material misstatement in financial reports. ISA 550 Related Parties suggests that transactions with these parties may give rise to a high risk of material misstatement.
ISA 550 especially requires professional skepticism when conducting an audit of related party relationships. An auditor should review:
• whether the identified related party relationships and transactions accounted for and disclosed accordingly and • whether the effects of the related party relationships and transactions cause misleading financial statements.
In order to identify related party relationships and transactions, the auditor should ask management a written representation about such transactions.
Review of Subsequent Events
Even if financial statements are generally prepared for a 1 year period, audit procedures and finalizing financial statements continue after the end of the year. Therefore auditors should be careful about events that occur between the balance sheet date and the date financial statements are issued. In most of the firms, the Balance Sheet date is the last day of the year, namely 31st December, in many cases the issuance date of financial statements is the date that management or the recognized authority asserts and makes the statements available to the third parties. Subsequent events transactions and other pertinent events that occurred after the balance sheet date that affect the fair presentation or disclosure of the statements being audited (Messier et. al., 2008). Events that occur between the balance sheet date and the issuance date of financial statements are called ‘subsequent events’.
In some cases, subsequent events may have a material effect on financial statements and the opinion of the auditor. ISA 560 Subsequent Events requires that all events up to the date of the auditor’s report should be identified and included in the financial reports accordingly. The objectives of the auditor are:
a. To obtain sufficient appropriate audit evidence about whether events occurring between the date of the financial statements and the date of the auditor’s report that require adjustment of, or disclosure in, the financial statements are
appropriately reflected in those financial statements under the applicable financial reporting framework; and b. To respond appropriately to facts that become known to the auditor after the date of the auditor’s report, that, had they been known to the auditor at that date, may have caused the auditor to amend the auditor’s report.
Subsequent events are categorized under two main headings:
1. Type I: Adjusting events 2. Type II: Non-adjusting events
Type I events are events occurring after the balance sheet date that give further evidence of conditions that existed at the balance sheet date. An important customer’s declaration of bankruptcy is an example of a Type I event and requires adjustments of financial statements. On the other hand Type II events are events that occur between the balance sheet date and issuance date. If a type II event is material, in some cases, an explanation in footnotes is required.
At the completion stage of the audit, the auditor should review events after the balance sheet date and make sure that adjustments have been made accordingly in financial statements. If an adjusting event is not included then the auditor asks management to adjust the event accordingly. Otherwise, the auditor may give a qualified or an adverse opinion depending on the materiality of the subsequent event.
In order to gather evidence about subsequent events or events after the balance sheet date auditor conducts procedures like;
• Inquiry of management, • Reading minutes of meetings, and • Inquiry of legal council.
The auditor requests a written representation that all subsequent events and for which the applicable financial reporting framework requires adjustment or disclosure have been adjusted or disclosed from management.
Final Evaluation and Communication with the Management
Auditors perform final evaluation procedures before preparing the audit report. For this purpose, the auditor performs final analytical procedures, reviews the sufficiency of evidence and working papers, and evaluates the company’s ability of going concern. At this stage the auditor also asks for a letter of representation from the management of the company.
After general evaluation, if the auditor decides there are material misstatements then asks the client’s management to make necessary adjustments in the financial statements. If a client’s management disagrees with the suggestions
then the auditor may give an opinion other than unqualified depending on the materiality of misstatements.
Final Analytical Procedures
Analytical procedures include the comparison of the company’s financial statements with prior period information, anticipated results such as budgets, and similar companies in the same sector. Analytical procedures include analysis of information among both financial and non-financial data.
Analytical procedures are used to examine unusual transactions or events and fluctuations in financial statement items in the every phase of the audit process. Analytical procedures are used for planning the audit as well as obtaining evidence about account balances and transactions. At the final evaluation phase, it is used for the overall review of the financial statements. An overall review of financial statements will include reading the financial statements and considering the adequacy of the evidence about unusual balances or relationships. It may be useful to detect material misstatements such as fraud or errors resulting with understatement or overstatement of income. As a result of this review, the auditor may decide to obtain more evidence about the audit of financial statements.
Review Sufficiency of Evidence And Working Papers
Before preparing the audit report, the auditor evaluates whether evidence gathered is sufficient and appropriate and whether working papers are prepared in accordance with relevant regulations etc. for the audit of financial statements. Working papers are the auditor’s record of the work performed and the conclusions reached on the audit (Messier et. al., 2008). At this stage, working papers should be reviewed by an experienced auditor out of the audit team. The results of tests also should be reviewed.
Working papers owned by the auditor and must be protected and kept confidential by the auditor. Auditors cannot disclose, use, and transfer information from worksheets to third parties unless asked by courts or other relevant institutions.
In Turkey, Independent Audit Regulation states that the audit institutions have to keep their commercial books, the audit reports issued, including those kept in electronic, magnetic, and similar environments, together with their attachments, and all documents related to the audit work and the quality control system for a period of ten years.
As part of a quality control review for financial statement audit, audit firms generally require the completion of a financial statement disclosure checklist in the form of questionnaires for every audit.
ISA 700 requires the auditor’s report to be dated no earlier than the date on which the auditor has obtained sufficient appropriate evidence on which to base the auditor’s opinion on the financial statements. In cases of an audit of financial statements, an engagement quality control review
assists the auditor in determining whether sufficient appropriate evidence has been obtained.
International Standard on Quality Control (ISQC) 1 requires firms to establish policies and procedures for the timely completion of the assembly of audit files. An appropriate time limit within which to complete the assembly of the final audit file is ordinarily not more than 60 days after the date of the auditor’s report.
Evaluation of Going Concern
Commonly financial statements are prepared under the going concern assumption. Under this assumption, a firm or a company is seen as a continuing business for the foreseeable future. This means that the company will be able to realize a positive return on its assets and discharge its liabilities in the normal course of business. However, this assumption is invalid when there is a possibility of the company’s liquidation or intend to cease trading.
International Accounting Standard (IAS) 1 ‘Presentation of Financial Statements’ states that:
an entity shall prepare financial statements on a going concern basis unless management either intends to liquidate the entity or to cease trading or has no realistic alternative but to do so. When an entity does not prepare financial statements on a going concern basis, it shall disclose that fact, together with the basis on which it prepared the financial statements and the reason why the entity is not regarded as a going concern.
International Standard on Auditing (ISA) 570 Going Concern, emphasizes that the auditor must examine the appropriateness of the going concern assumption.
The following events or conditions are the common example of signs of going concern risks:
1. Net liability, 2. Withdrawal of financial support by creditors, 3. Adverse key financial ratios, 4. Inability to pay liabilities, and 5. Loss of key management without replacement.
When the company’s ability as a going concern is risky then instead of historic costs auditors use liquidation values to adjust the balance sheet.While evaluating the validity of going concern assumption auditors mostly use analytical procedures and inquiry of management. If the final assessment of the auditor shows the company’s ability as a going concern is risky then the auditor should discuss plans of management to deal with bankruptcy. When necessary, the auditor asks management to adjust financial statements accordingly.
Management Representation Letter
Along the audit process, the auditor makes discussions with the management about many issues to gather evidence about financial statements. A written representation letter is requested from the management of
the client’s company in addition to discussions with the management.
International Standard on Auditing (ISA) 580 Written Representations regulates issues regarding written representations. According to ISA 580, Management representation letter has three main purposes:
1. To impress upon management’s responsibility for the assertions in the financial statements. 2. To remind management of potential misstatements or omissions in the financial statements. 3. To document the responses from management to inquiries about various aspects of the audit.
The auditor shall request management to provide a written representation that it has fulfilled its responsibility for the preparation of the financial statements under the applicable financial reporting framework, including, where relevant, their fair presentation, as set out in the terms of the audit engagement.
The auditor shall request management to provide a written representation that:
a. It has provided the auditor with all relevant information and access as agreed in the terms of the audit engagement; and b. All transactions have been recorded and are reflected in the financial statements.
Even if a management representation letter is a good source of evidence, it is not sufficient on its own. If a management modifies or does not provide the requested written representations, then the auditor should take appropriate actions and consider the effect on the audit report.
Communication With the Management
At the completion of the audit phase findings are shared with the management. The auditor discusses issues that remain unsolved if any, modifications and additions to the financial statements with the management. Material misstatements, errors, and frauds are also discussed with the management. The auditor must also communicate significant internal control deficiencies and material weaknesses in the design or operation of internal control to the management.
Quality Control Review
International Standard on Quality Control (ISQC) 1 deals with the audit firm’s responsibilities for its system of quality control for audits and reviews of financial statements, and other assurance and related services engagements. International Standard on Quality Control (ISQC) 1 requires audit firms to establish a system of quality control of audits conducted. This control should be undertaken by an engagement quality control reviewer.
Engagement quality control review is a process designed to provide an objective evaluation, on or before the date of
the auditor’s report, of the significant judgments the engagement team made and the conclusions it reached in formulating the auditor’s report.
A quality review of the financial statement audit aims an objective evaluation of the results of the audit process and the main conclusions reached for issuing the audit report. For this purpose reviewer examines:
A. whether the auditor complies with professional standards and regulatory requirement, and B. whether the opinion of the auditor about financial statements is applicable under circumstances.
The objectivity of the Engagement Quality Control Reviewer is required. For this purpose audit firms should establish policies and procedures designed to maintain the objectivity of the engagement quality control reviewer.
Accordingly, such policies and procedures provide that the engagement quality control reviewer:
• Where practicable, is not selected by the engagement partner; • Does not otherwise participate in the engagement during the period of review; • Does not make decisions for the engagement team; and • Is not subject to other considerations that would threaten the reviewer’s objectivity.
In particular, the auditor should review: whether the audit has been performed in accordance with the audit program; whether the results obtained have been adequately documented; whether all significant audit matters have been resolved or are reflected in audit conclusions; whether the objectives of the audit procedures have been achieved, and whether the conclusions expressed are consistent with the results of the work performed and support the audit opinion (Hayes et. Al.,2005).
The responsibilities of auditors and reviewers about quality control procedures are explained in International Standard on Auditing (ISA) 220 Quality Control for an Audit of Financial Statements. A quality control review is performed on or before the audit report date. However, documentation of the engagement quality control review may be completed after the date of the auditor’s report as part of the assembly of the final audit file.