ACCT 3109 – Auditing

Completing a Quality Audit

Chapter 14
Fall Semester, 2023/24
Dr. Sammy Fung

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Obtain Remaining Audit Evidence
● Detected misstatements
● The auditor summarizes the misstatements detected
during the audit to determine:
● Whether they are material
● Whether the client needs to record and correct them
● Misstatements fall into three categories:
● Known misstatements
● Projected misstatements
● Judgmental misstatements.
● Summary of Unadjusted Audit Differences (SUAD)

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Exhibit 14.1

Johnstone, Auditing: A Risk-Based Approach, 11th Edition. ©2019 Cengage. All Rights Reserved. May
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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Prior Period and Current Period Misstatements
● Misstatements from prior periods
● May have been uncorrected because they were judged
immaterial in the prior period
● May materially affect the current period’s financial results
● Dual approach to uncorrected misstatements
● Rollover method
● Iron curtain method
● Subjective differences between the auditor and the client

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Check Your Basic Knowledge (14-3)
14-3 The auditor discovers various errors in the client’s
financial statements during the audit. At the end of the
audit, the auditor analyzes these misstatements to
determine if the client needs to correct them. In which of
the following situations could management and the
auditor decide not to correct the misstatement?
a. If, by correcting the misstatements, net income would
increase rather than decrease.
b. If, by correcting the misstatements, net income would
decrease rather than increase.
c. If the misstatements, in the aggregate, are material.
d. If the misstatements, in the aggregate, are immaterial.

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Check Your Basic Knowledge (14-4)
14-4 Which of the following statements is false?
a. Management’s incentives may bias their willingness to book, or
correct, detected misstatements.
b. Known misstatements are those that arise from differences in
judgments of management concerning accounting estimates that the
auditor considers unreasonable, or the selection or application of
accounting policies that the auditor considers inappropriate.
c. Section 10A(b) of the Exchange Act requires auditors to take action
upon discovery of an illegal act even if it does not have a material
effect on the financial statements, including alerting management
and the audit committee.
d. The auditor evaluates the misstatements that have been posted to
the summary of unadjusted audit differences (SUAD) to determine
whether uncorrected misstatements are material—either
individually or in combination with other misstatements.

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Responsibilities Related to Loss Contingencies
● Management is responsible for designing and maintaining
policies and procedures to identify, evaluate, and account
for loss contingencies.
● Auditors are responsible for determining that the client
has properly identified, accounted for, and disclosed
material loss contingencies.

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Standard For Accruing and Disclosing Loss
Contingencies
● In Accounting Standards Codification (ASC) 450, the FASB
provides the standard for accruing and disclosing loss
contingencies that can be reasonably estimated.
● The categories of contingencies are organized around
probability of outcomes that reflect the contingent nature of
the loss.
● Probable - >=50% chance
● Reasonably possible
● Remote
● ASC 450 requires the following:
● The accrual and disclosure of contingent losses that are reasonably
estimated and probable.
● The client disclose a contingent loss if there is at least a reasonable
possibility that a loss may occur and either an accrual has not been
made or an exposure exists that is greater than the amount accrued.

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Examples of Loss Contingencies
● Litigation, claims, and assessments
● Guarantees of debts of others
● Obligations of banks under standby letters of credit
● Agreements to repurchase receivables that have been
sold
● Purchase and sale commitments

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Sources of Audit Evidence
● The auditor should obtain the following from management:
● A description and evaluation of contingencies that existed at the
balance sheet date or that arose prior to the end of the fieldwork
and for which matters were referred to legal counsel, including
correspondence and invoices from lawyers
● Assurance that the accounting and disclosure requirements
concerning contingent liabilities have been met
● Information about major contracts in which contingencies may be
present, such as the sale of receivables
● Documentation of communication with internal and external legal
counsel of the client
● Documentation of contingent liabilities contained in corporate
minutes, correspondence from governmental agencies, and bank
confirmations

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Letter of Audit Inquiry
● The auditor should ask the client to send a letter of audit inquiry to
its legal counsel asking counsel to confirm information about
asserted claims and those claims that are probable of assertion.
● The American Bar Association and the AICPA have agreed that the
letter of audit inquiry should include:
● Identification of the company, its subsidiaries, and the date of the audit
● Management’s list (or a request by management that the lawyer
prepare a list) that describes and evaluates the contingencies to which
the lawyer has devoted substantial attention
● A request that the lawyer furnish the auditor with:
1. A comment on the completeness of management’s list and evaluations
2. For each contingency:
a. A description of the nature of the matter, the progress to date, and the action the
company intends to take
b. An evaluation of the likelihood of an unfavorable outcome and an estimate of the
potential loss or range of loss
3. Any limitations on the lawyer’s response, such as not devoting substantial
attention to the item or that the amounts are not material

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Check Your Basic Knowledge—True/False
14-5 The auditor is responsible for designing and maintaining
policies and procedures to identify, evaluate, and account
for loss contingencies; management is responsible for
determining that the auditor has properly identified,
accounted for, and disclosed material loss contingencies.
(T/F)
14-6 One important primary source of evidence concerning
loss contingencies is the client’s management; a primary
source of corroborative evidence concerning
contingencies is the client’s legal counsel, which provides
the management representation letter. (T/F)

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Adequacy of Disclosures
● The auditor’s report covers the basic financial statements,
which include the balance sheet, income statement,
statement of cash flows, a statement of changes in
stockholders’ equity or retained earnings, and the related
notes.
● If the auditor determines that disclosures are not
reasonably adequate, the auditor must identify that fact
in the auditor’s report.
● Disclosures can be made on the face of the financial
statements (in the form of classifications or parenthetical
notations), or they can be made in the notes to the
statements.

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Adequacy of Disclosures—Reasonable Assurance
● When assessing the adequacy of disclosures, the auditor
should have reasonable assurance that:
● Disclosed events and transactions have occurred and pertain to the
organization.
● All disclosures that should have been included are included.
● The disclosures are understandable to users.
● The information is accurately disclosed and at appropriate amounts.
● To review and assess the adequacy of disclosures, the auditor
will complete the following types of activities: • Read the
client’s disclosures for each financial statement line item and
associated discussion in the footnotes • Obtain evidence to
determine whether the disclosures are adequate in light of
required GAAP, e.g., by completing a disclosure checklist
• Consider alternative or enhanced disclosures that may be
helpful to users

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Activities Used to Review and Assess the Adequacy
of Disclosures
● To review and assess the adequacy of disclosures, the
auditor will complete the following types of activities:
● Read the client’s disclosures for each financial statement line
item and associated discussion in the footnotes.
● Obtain evidence to determine whether the disclosures are
adequate in light of required GAAP, e.g., by completing a
disclosure checklist.
● Consider alternative or enhanced disclosures that may be
helpful to users.

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Evaluating the Accuracy of Management’s Disclosure
Assertion: The Role of Disclosure Checklists
● Engagement teams use audit firm disclosure checklists to
help ensure a quality audit so that auditors do not forget
important disclosures.
● A disclosure checklist serves as a cue to guiding audit planning
around management’s assertions in various disclosures.
● These disclosure checklists are often industry-specific.
● Disclosure checklists can also be specific to a certain set of financial
reporting standards.
● In addition to aiding audit quality, disclosure checklists are a
convenient documentation format for evidence that the
auditor adequately evaluated management’s assertions about
the adequacy of its disclosures.

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Exhibit 14.2 - Excerpts from EY’s International Gap
Disclosure Checklist (1 of 2)

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Exhibit 14.2 - Excerpts from EY’s International Gap
Disclosure Checklist (2 of 2)

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Check Your Basic Knowledge (14-11)
14-11 In completing the audit, the auditor should review the
adequacy of the disclosures in the financial statements.
When assessing the disclosures, the auditor should have
reasonable assurance about which of the following?
a. The disclosed events and transactions have occurred
and pertain to the entity.
b. All the disclosures that should have been included are
included.
c. The disclosures are understandable to users.
d. All of the above.

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Check Your Basic Knowledge (14-12)
14-12 Which of the following statements is false?
a. Disclosure checklists are a convenient documentation
format for evidence that the auditor adequately evaluated
management’s assertions about the adequacy of its
disclosures.
b. The auditor’s report, and assurance therein, covers
mandatory disclosures in the basic financial statements and
the related notes, along with voluntary disclosures in the
MD&A.
c. When assessing the adequacy of disclosures, the auditor
should have reasonable assurance that the disclosures are
understandable to users.
d. Disclosure checklists tend to be industry-specific.
e. All of the above are false.
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Noncompliance with Laws and Regulations
● Noncompliance involves “acts of omission or commission by
the entity, either intentional or unintentional, which are
contrary to the prevailing laws or regulations” (AU-C 250).
● Auditors are responsible for obtaining reasonable assurance
that the financial statements are free from material
misstatements, including material misstatements relating to a
client’s compliance with laws and regulations.
● Auditing standards recognize that there are inherent limitations in an
auditor’s ability to detect material misstatements relating to the
client’s compliance with laws and regulations. These limitations
include:
● Laws and regulations often relate to operational issues within the client
that do not necessarily relate to the financial statements.
● Management may act to conceal noncompliance, or may override
controls, or may intentionally misrepresent facts to the auditor.
● The legal implications of noncompliance are ultimately a matter for legal
authorities to resolve, and are not a matter the auditor can resolve.

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Reviewing for Potential Noncompliance with Laws
and Regulations
● In reviewing for potential noncompliance, the auditor
should:
1. Obtain an understanding of internal controls the client has
implemented to achieve proper compliance with laws and
regulations.
2. Obtain the knowledge necessary to understand applicable
laws and regulations relevant to the client’s business, both
nationally and internationally.
3. Search for indications of noncompliance, e.g., tips to
whistleblower hotlines, and/or unusual payments to vendors
in countries with high corruption indices.

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Check Your Basic Knowledge—True/False
14-13 Auditing standards recognize that there are inherent
limitations in an auditor’s ability to detect material
misstatements relating to an organization’s compliance
with laws and regulations. (T/F)
14-14 The legal implications of a client’s noncompliance with
laws and regulations are ultimately a matter for the
auditor to resolve before the auditor can issue the audit
opinion. (T/F)

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Review Analytical Procedures
● Objective
● The objective of review analytical procedures is to help the auditor form an
overall conclusion about whether the financial statements are consistent with
the auditor’s understanding of the entity.
● Performing review analytical procedures
● The auditor’s expectation when performing review analytical procedures will be
less precise than if the auditor were performing substantive analytical
procedures.
● Review analytical procedures indicate whether certain relationships make sense
in light of the knowledge obtained during the audit.
● Review analytical procedures should corroborate conclusions formed during the
audit.
● Auditors response
● If review analytical procedures identify a previously unrecognized risk of
material misstatement, the auditor must go back, revise the original risk
assessment, and conduct additional audit procedures to address the risk.
● The need for additional audit procedures is particularly relevant when
management is unable to provide an explanation for the previously
unrecognized risk identified through the analytical procedures.

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Exhibit 14.3 -
Identifying Risks
at PPG
Industries, Inc.
Using Analytical
Procedures

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Check Your Basic Knowledge (14-19)
14-19 Which of the following statements concerning review
analytical procedures is false?
a. Review analytical procedures help auditors assess the
overall presentation of the financial statements.
b. The auditor’s expectations in review analytical procedures
should be more precise than those for substantive
analytics.
c. Auditing standards require the use of review analytical
procedures to assist in identifying ending account
relationships that are unusual.
d. Ratio analysis, common-size analysis, and analysis of the
dollar and percentage changes in each income statement
item over the previous year are useful for performing
review analytical procedures.
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The Going-Concern Assumption
● Auditors issue an opinion based on a going-concern assumption.
● As part of this assumption, auditors are required to evaluate the
likelihood of each client continuing as a going concern for a reasonable
period of time.
● The auditor’s assessment of the going-concern assumption is based on
information obtained from typical audit procedures performed to test
management assertions.
● If there is substantial doubt about the ability of the client to remain
a going concern, the auditor identifies and assesses management’s
plans to overcome the problems.
● Two possible outcomes:
● If, after reviewing management’s plans, the auditor concludes that substantial
doubt about the entity’s ability to continue as a going concern has been
alleviated, the auditor considers the disclosure of the conditions or events that
initially caused the auditor to believe there was substantial doubt.
● Alternatively, if the auditor concludes that substantial doubt about the entity’s
ability to continue as a going concern for a reasonable period of time remains, the
auditor should modify the audit report to include an emphasis-of-matter
paragraph that reflects that conclusion.

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Exhibit 14.4 -
Going
Concern
Process

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Indicators of Potential Going-Concern Problems
● Auditors must carefully analyze all the factors that indicate a going-concern
problem and determine if management has a viable plan to address the
problems.
● Potential indicators of going-concern problems include:
● Negative trends, such as recurring losses, working-capital deficiencies, negative
cash flows from operating activities, and adverse key financial ratios
● Internal matters, such as loss of key personnel, employee strikes, outdated
facilities and products, and uneconomic long-term commitments
● External matters, such as new legislation, pending litigation, loss of a key
franchise or patent, loss of a principal customer or supplier, and uninsured or
underinsured casualty loss
● Other miscellaneous matters, such as default on a loan, inability to pay
dividends, restructuring of debt, violation of laws and regulations, and inability
to buy from suppliers on credit
● Significant changes in the competitive market and the competitiveness of the
client’s products

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Indicators of Potential Going-Concern Problems—
Bankruptcy Prediction Models
● Audit firms may use bankruptcy prediction models in
analyzing whether the going-concern assumption is valid
for a particular client.
● Altman Z-scores
● Five-ratio model for publicly owned manufacturing companies
● Four-ratio model for privately owned non-manufacturing
companies—are available for auditor use, with
● Newer models available representing variations of the above
models
● Although a low Z-score (or a similar score using a different
bankruptcy prediction model) does not indicate that the
company will fail, it does provide evidence that the going-
concern assumption may not be valid.
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Exhibit 14.5

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Mitigating Factors
● If the auditor concludes that the going-concern assumption
may not be valid for a client, the auditor should assess
management’s plans to overcome this problem.
● Identify those factors that are most likely to resolve the problem.
● Gather independent evidence to determine the likely success of such
plans.
● Evaluate the reasonableness of other assumptions made by
management, including management’s assumption about:
● Increasing prices or market share
● Cost savings related to a reduction in workforce
● Selling off assets
● After considering these factors, the auditor will assess
whether management can mitigate the going-concern
problem, and audit reporting decisions will follow based upon
that assessment and possible disclosures that may be
necessary.

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Check Your Basic Knowledge (14-23)
14-23 In evaluating whether the client is a going concern, which
of the following questions should the auditor ask?
a. Are there indicators of going-concern problems?
b. Is it likely that management can mitigate any identified
going-concern problems?
c. Are disclosures about the going-concern problems
adequate?
d. All of the above.

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Check Your Basic Knowledge (14-24)
14-24 The Altman Z-Score is a model used to help assess the
likelihood that a company will go bankrupt. Which of the
following ratios is included in the model?
a. Working capital to total assets.
b. Working capital to total sales.
c. Sales to total debt.
d. Sales to total accounts receivable.

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Subsequent Events
● Auditors have responsibility for some events occurring
after the client’s balance sheet date.
● Every audit includes procedures to review for subsequent
events and transactions that occur in the period between the
balance sheet date and the audit report date (Period A).
● The auditor has no responsibilities to continue obtaining
audit evidence after the audit report date: Period B and
Period C.
● However, the auditor may become aware of relevant
information during Period B and Period C and will have to
assess appropriate actions to take.

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Exhibit 14.6

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Review of Subsequent Events (Period A)
● Type I Subsequent Events
● Type I subsequent events provide evidence about conditions
that existed at the balance sheet date.
● The financial statement numbers should be adjusted to reflect
these events.
● Type II Subsequent Events
● Type II subsequent events indicate conditions that did not exist
at the balance sheet date, but that may require disclosure.
● The events that the auditor should consider for disclosure are
financial in nature and material.

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Dual Dating (Period B)
● When the auditor becomes aware of an event that occurs
after the audit report date, but before the report release
date, and the event is disclosed in the footnotes, the
auditor has two options for dating the audit report:
1. Use the date of this event as the date of the audit report.
2. Dual-date the report, using the dates of the original audit
report and the date of the event, to disclose the work done
only on that event after the original audit report date.

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Subsequently Discovered Facts That Become Known
to the Auditor after Report Release Date (Period C)
● Facts may come to the auditor’s attention after the report
release date that may have affected the financial
statements and auditor’s report, if the auditor had known
the facts at the report release date.
● Such facts may come to the auditor’s attention through
reading news reports, performing another service for the client
or other business contacts, or performing a subsequent audit.
● If the auditor decides that steps should be taken to
prevent further reliance on the financial statements and
audit report, the client is advised to make appropriate
and timely disclosure of these new facts.

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Examples of Subsequent Events (1 of 2)
● Type I
● A major customer files for bankruptcy during the subsequent
period because of a deteriorating financial condition; auditor
should use this information when evaluating the allowance for
doubtful accounts.
● The client settles a lawsuit for a different amount than was
accrued.
● A sale of inventory below carrying value provides evidence that
the net realizable value was less than cost at year end.
● Information becomes available that provides evidence about the
valuation of an estimate or reserve accrued at year end.

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Examples of Subsequent Events (2 of 2)
● Type II
● An uninsured casualty loss that occurred after the balance sheet date
causes a customer’s bankruptcy during the subsequent period. Because
the inability of the customer to pay did not exist as of the balance sheet
date, the allowance account should not be adjusted but the information
should be disclosed.
● A customer initiates a significant lawsuit relating to an incident that
occurred after the balance sheet date.
● Because of a natural disaster such as a fire, earthquake, or flood, a
company loses a major facility after the balance sheet date.
● The client makes a major decision during the subsequent period, such as
to merge, discontinue a line of business, or issue new securities.
● A material change occurs in the value of investment securities.

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Check Your Basic Knowledge—True/False
14-25 Type I subsequent events provide evidence about
conditions that existed at the balance sheet date, while
Type II subsequent events provide evidence about
conditions that did not exist at the balance sheet date,
but that may require disclosure. (T/F)
14-26 An example of a Type I subsequent event would be when
a significant lawsuit is initiated relating to an incident that
occurred after the balance sheet date. (T/F)

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Check Your Basic Knowledge (14-27)
14-27 Which of the following is an example of a Type II
subsequent event?
a. The client settles a lawsuit for a different amount than
was accrued at the balance sheet date.
b. A sale of inventory below carrying value provides
evidence that the net realizable value was less than
cost at year-end.
c. Information becomes available that provides evidence
about the valuation of an estimate or reserve that had
been accrued at year-end.
d. None of the above.

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Check Your Basic Knowledge (14-28)
14-28 After the report release date, the auditor may become
aware of facts that may have affected the financial
statements and auditor’s report, had the auditor known
the facts at the time of issuance. With regard to this
situation, which of the following statements is true?
a. Because such facts become known after the report release date, the auditor
cannot reasonably be held accountable for these issues; no action is required
on the part of the auditor.
b. If the auditor decides that steps should be taken to prevent further reliance
on the financial statements and audit report, the client is advised to make
appropriate and timely disclosure of these new facts.
c. If such facts would have been investigated had they been known at the
report date, the auditor should determine whether engagement personnel
are competent and qualified to perform audits; action is required on the part
of the auditor to assess whether engagement personnel should be retained
to work on the engagement in the subsequent year.
d. If the auditor decides that steps should be taken to prevent further reliance
on the financial statements and audit report, the auditor should notify the
audit committee immediately; no action beyond this is required on the part
of the auditor because of confidentiality concerns.

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Management Representation Letter
● Auditors should obtain a management representation letter at
the end of each audit.
● The letter is not a substitute for audit procedures performed
during the audit.
● Rather, the purposes of the letter include:
● Reminding management of its responsibility for the financial
statements.
● Confirming oral responses obtained by the auditor earlier in the
audit and the continuing appropriateness of those responses.
● Reducing the possibility of misunderstanding concerning the matters
that are the subject of the representations.
● Management’s refusal to sign the management representation
letter is a scope limitation sufficient to preclude the auditor
from issuing an unqualified opinion.

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Exhibit 14.7 - Management
Representation Letter
Example from AU-C 580
“Management
Representations”

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Management Letter
● Throughout an audit, auditors often notice opportunities for
recommendations to management.
● The auditor generally reports these observations in a
management letter.
● Such a letter is different from a management representation
letter.
● The management letter is not required; the auditor uses it to make
significant operational or control recommendations to the client.
● The letter helps to provide management comfort that the auditor has
done a quality job and that the auditor knows and understands the
client’s business.
● Many audit firms consider management’s inattention to addressing
comments in the letter to be an important risk factor in subsequent-
year audits.

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Exhibit 14.8 -
Example
Management Letter
to a College
Foundation

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Check Your Basic Knowledge—True/False
14-29 The management letter confirms management responses
obtained by the auditor earlier in the audit and the
continuing appropriateness of those responses. (T/F)
14-30 The management letter is not required, but auditors use
it to make significant operational or control
recommendations to the client. (T/F)

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Check Your Basic Knowledge (14-31)
14-31 In completing the audit, the auditor communicates with
management via the management letter. Which of the
following statements is false about management letters?
a. The management letter is used to make significant
operational or control recommendations to
management.
b. Many audit firms consider management’s inattention
to addressing comments in the letter to be an
important risk factor in subsequent-year audits.
c. The management letter is required for publicly traded
companies in the United States, but not privately held
companies.
d. All of the above are false.
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Engagement Quality Review
● As part of a quality audit for public companies, the audit firm has
policies and procedures for conducting an engagement quality
review of each audit before issuing the audit opinion.
● Auditors of privately held companies generally perform these reviews,
even though they are not explicitly required.
● An experienced reviewer who was not a part of the audit team, but who
has appropriate competence, independence, integrity, and objectivity,
should perform this independent review, referred to as an engagement
quality review or concurring partner review.
● The purpose of these reviews is to provide reasonable assurance
that the audit and audit documentation are complete and support
the audit opinion on the financial statements and, for integrated
audits, on the client’s internal controls.
● The engagement quality review is a risk-based review, where the
reviewer evaluates the significant judgments and conclusions made
by the engagement team.

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Engagement Quality Review—Some Procedures
● Discussing with the audit team any significant matters related to the financial
statements and internal controls, including the audit team’s identification of
material weaknesses and audit procedures to address significant risks.
● Evaluating judgments about materiality and the disposition of corrected and
uncorrected identified misstatements.
● Reviewing the engagement team’s evaluation of the firm’s independence in
relation to the engagement .
● Reviewing the related audit documentation to determine its sufficiency
● Reading the financial statements, management’s report on internal control, and
auditor’s report.
● Confirming with the lead audit partner that there are no significant unresolved
matters.
● Determining if appropriate consultations have taken place on difficult or
contentious matters.
● Evaluating whether the auditor documentation supports the conclusions reached
by the engagement team with respect to the matters reviewed.
● Assessing whether appropriate matters have been communicated to audit
committee members, management, and other appropriate parties.
● Evaluating whether appropriate levels of supervision and reviews of individual
audit tasks were completed adequately during the audit.

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Check Your Basic Knowledge—True/False
14-33 The terms engagement quality review and concurring
partner review are synonymous. (T/F)
14-34 An engagement quality review is required for publicly
traded companies, and is optional for privately held
company audits. (T/ F)

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Audit Committee Communications
● It is important that the auditor have a constructive and
detailed dialogue with the audit committee.
● This communication is important because the audit committee
serves as an independent subcommittee of the board of
directors.
● The audit committee can also assist the auditor should a
disagreement occur between the auditor and management.
● The audit committee must be assured that the auditor is free
of any restrictions and has not been inappropriately influenced
by management during the course of the audit.

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Typical Communications Between the Auditor and
the Audit Committee
● Auditor’s responsibilities
● Overview and planned scope of the audit
● Independence
● Significant accounting policies
● Management judgments and accounting estimates
● Significant audit adjustments
● Judgments about the quality of the company’s accounting
principles
● Other information in annual reports
● Disagreements with management
● Major issues discussed with management before retention
● Internal control over financial reporting

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Check Your Basic Knowledge—True/False
14-37 Objective criteria for evaluating the quality of the client’s
accounting policies is not available; assessing the quality,
not just the acceptability of the significant accounting
policies, is a matter of professional judgment. (T/F)
14-38 One of the issues that the auditor is required to
communicate to the audit committee is the competence,
training, and industry specialization of each of the
highest-ranking members of the engagement team (the
partner, manager, and audit senior). (T/F)

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