AUDIT EVIDENCE

AUDIT EVIDENCE
Audit evidence is all the information used by the auditor in arriving at the conclusions on
which the audit opinion is based.
Sufficient refers to the quantity/amount of evidence that is required within a
reasonable time period and at a reasonable cost.
The amount sufficient is based on auditors judgement. Just the
accounting records are not sufficient support the auditor must test the
a/cing data to develop persuasive evidence to support the opinion.
Sufficiency relates closely to extent of testing.
The auditor will have to consider both costs and benefits of obtaining
evidence high cost alone cannot be a proper reason to omit at test.
The decision as to sufficiency will be based on the determination of the
acceptable level of DR.
Appropriate refers to the quality of evidence involved in terms of relevance and
reliability appropriate evidence is persuasive instead of convincing/conclusive.
Appropriateness relates closely to the nature of testing. Timing is a matter of
recognizing that y/end tests provide stronger evidence than interim.
The reliability of evidential matter refers to its appropriateness not to the amount
of evidence obtained.
The validity of audit evidence lies in auditors judgement.
Sufficient and appropriate documentation should include evidence that the audit
documentation has been reviewed. A review of audit documentation is a critical
part of the overall audit process. It is the means by which every audit judgement
made is reviewed and confirmed by a more experienced auditor to ensure that
the audit evidence supports the opinion rendered.
The auditor should document the linkage of the audit procedures performed with
the assessed level of RMM at the relevant assertion level.
The auditor is obligated to examine the entitys material J/Es and the material
adjustments made during the preparation of F/S.
When substantive tests of ending balances are performed at an interim date, the
auditor must extend the conclusions to the remainder of the period, by applying
AP, by relying on I/C, or otherwise.
In evaluating the effect of uncorrected misstatements, the auditor may need to
reassess the appropriateness of performance materiality.

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AUDIT RISK
Misstatement is the difference btw the amount, classification, presentation or
disclosure of a reported F/S item which is reqed to be in acc with AFRF.

Likely misstatements result from projected misstatements and

judgmental misstatements.
Projected misstatement the auditors best estimate of misstatements
based on the extrapolation from a sample to the population.
Judgmental misstatements are differences arising from the judgments
of Mgt that the auditor considers unreasonable; or the selection of a/cing
policies deemed inappropriate e.g. unreasonable a/cing estimates and
selection of inappropriate a/cing policies.
Factual misstatements misstatements for which there is no doubt.
These include: inaccuracy in processing data, misapplication of a/cing
principles & misclassification.
The auditor should accumulate identified misstatements, except for
those that are clearly trivial i.e. inconsequential. The auditor should
request Mgt. to correct such mistakes.
The auditor must document the ff regarding evaluation of misstatements:
1. The threshold for determining what is viewed as clearly trivial
2. All accumulated misstatements during the audit and whether they
have been corrected.
3. The auditors conclusion as to whether any uncorrected
misstatements are material (individually or in aggregate) and the
basis for that conclusion.

Risk of material misstatement (RMM) includes both control risk and inherent
risk. This is the risk of the likelihood that the F/S may be materially misstated
prior to the audit.
RMM exists at two levels overall F/S level and assertion level.
Overall F/S level refers to risks that are pervasive to the F/S and that
potentially affect many assertions.
RMM at assertion level for classes/a/c balances/disclosures the auditor
assesses RMM at this level for the purpose of determining the nature,
timing and extent of further audit procedures to obtain sufficient
appropriate audit evidence. It consists of two components - inherent risk
and control risk.
RMM = IR x CR
The auditor must make a preliminary assessment of RMM.
The preliminary assessment of RMM is usually based on prior experience
with the client or the audits of predecessors.
The final assessment of RMM wont take place until the auditor gains an
understanding of the client and its environment, including its I/C structure.

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 If this is diff from preliminary assessment, the audit program will have to
be modified to increase or decrease the amount of substantive testing to
be performed.
Inherent risk is a risk of a material misstatement due to the nature of an
element of F/S, assuming absence of any I/C policies and procedures. e.g. cash
has inherently high risk.
Control risk is the risk that a material misstatement will not be prevented or
detected and corrected on a timely basis due to lack of effective internal controls.
This reflects managements responsibility to design and maintain I/C.
Detection risk is the risk that a material misstatement will not be detected by
the auditor (not detected by substantive audit procedures). Detection risk is used
to determine the amount and types of substantive testing performed by the
auditor with the goal of reducing detection risk to an acceptable level. The higher
the RMM (IR/CR), the lower the auditor will wish to reduce detection risk since
only this risk is within the auditors control. The variables of planned audit
procedures that can be adjusted to change detection risk are:
Nature the auditor has to decide what specific substantive procedures to
perform including how much emphasis to place on TODs (which are more
labor intensive and expensive but which provide a stronger basis for
conclusions for F/S assertions v- substantive AP). The procedures to be
applied on a particular engagement are a matter of the auditors
professional judgement & assessment of RMM.
Timing whether to perform important substantive testing at the interim
date (b4 y/end) or at final y/end (after the books are closed). The auditor
would consider the difficulty in controlling incremental audit risk i.e. the
risk that MM will not be detected due to early testing at interim. This
difficulty would be impacted by the effectiveness of I/C, the presence of
rapidly changing b/s conditions/circumstances and the availability of
relevant info. Also the performance of substantive AP to address the roll-
forward activity between the interim date and the y/end date would
specifically consider whether the amounts of the y/end balances are
reasonably predictable with respect to amount, sgf and composition.
Extent of substantive testing how large the sample sizes should be
performed on a test basis.
DR = TD x AP, where TD means tests of details and AP means analytical
procedures
DR is inversely related to the assurance provided by substantive tests.
The lower the DR the higher the assurance needed from from TD & AP.

Audit risk the probability that the auditor issues an unqualified opinion on F/S
that contains a material misstatement. By definition, it is a probability.
Audit risk = inherent risk x control risk x detection risk/ RMM x DR
This audit risk mode is not applicable to overall F/S.

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 Audit risk and materiality can be said to underlie every aspect of the
auditors fieldwork and reporting responsibilities.
The presence of audit risk is indicated in the auditors report by reference
to reasonable assurance meaning that audit risk cannot be reduced to
zero % owing to the inherent limitations of the audit. Note that reasonable
assurance means a high level of assurance and a low level of audit risk.
The component risks do not necessarily have to be quantified; for e.g.
they could be assessed qualitatively as high, medium or low.
Each component is considered from left to right in order: AR then IR then
CR and finally the implications for the appropriate level of DR are
considered.
All 3 components of audit risk can be assessed in either quantitative or
non-quantitative terms.

AUDIT PROCEDURES
1. RISK ASSESSMENT PROCEDURES
2. TESTS OF CONTROL
3. SUBSTANTIVE PROCEDURES
SUBSTANTIVE PROCEDURES
Substantive procedures are procedures performed to detect material
misstatements at the relevant assertion level. These audit procedures are directly
related to the F/S elements and disclosures. These include RIIO re-
performance, inspection of documents and tangible assets, inquiry and
observation as well as
Confirmation obtaining a representation directly from a knowledgeable
3rd party. e.g.sending requests to customers to verify A/R balances.
Recalculation checking the mathematical accuracy of documents. Key
word here is accuracy.
AP helps in scanning to review a/cing data to identify unusual items to
be tested further. CAATs may be especially useful in identifying sgf or
unusual items. Key word here is scanning.
2 broad categories of substantive procedures: these should be responsive to the
planned level of DR;
1. Tests of details are relatively precise, labor-intensive procedures that
suggest whether a clients recorded amount is right or not.
Tests of ending balances verifying the clients recorded amounts
by directly testing the composition making up the ending balance.
Usually used when transactions during the year are many.
Tests of transactions verifying the clients recorded amounts by
testing those relative few debits and credits that caused the a/c

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 balance to change from bal b/d to bal c/d. Usually used when
transactions during the year are few.

2. Substantive AP are tests of reasonableness which involve analyzing

trends and interrelationships.
Analytical procedures (AP) are evaluations of financial info thru analysis of
plausible r/ships among both financial and non-financial data.
According to AICPA standards, analytical procedures are:
Required during planning as a risk assessment procedure
May be used as substantive evidence (not reqed)
Required during final review when forming an overall conclusion about
the F/S.
4 factors that affect the usefulness/efficiency & effectiveness of AP
Nature of assertion more effective in testing for omissions of
transactions than TOD that focus on recorded amounts completeness
assertion, since there may be no supporting documents for transactions
that were not recorded in the first place!
Plausibility and Predictability of relationship I/S more predictable
than B/S becoz B/S relates to a single moment in time. Relationships
involving b/sheet a/cs such as A/R, A/P are not as predictable as r/ships
involving income statement a/cs because I/S accounts involve
transactions occurring over a period of time, rather than a point in time.
Therefore, interest expense based on IR and principal balances, would
yield highest level of evidence becoz the r/ship is highly predictable. Also
non-discretionary a/cs that are not subject to change based on mgt
decision also have higher predictability. E.g. payroll exps Warranty and
advertising exps are relatively discretionary exps and so tend to yield
lower audit evidence. This predictability can be used to indicate existence
of material misstatement. For e.g. if the payroll exp predicted for this year
based on last year is materially difference then RMM.
Availability & reliability of underlying data used generally data is
more reliable when obtained from external sources, subject to audit testing
(either currently/ past), developed under conditions of effective I/C.
Ranking is as follows: direct personal knowledge obtained thru
examination by the auditor, external sources, effective I/C, documentary
evidence more reliable than verfbal responses.
Precision of the expectation DR increases as level of aggregation of
the data increases. For e.g., the auditor may focus on sales by month
broken down by product line instead of simply comparing current annual
sales to the current year.
The objective of tests of details (TOD) performed as substantive test is to detect
material misstatement in the F/S.
Determination of auditability of F/S depends on the adequacy of a/cing records.

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 In some cases, the auditor may find it impossible to design effective substantive
procedures that by themselves provide sufficient audit evidence because there is
no documentation of transactions due to IT. In that case, the auditor may have to
use TOC. If these TOC prove to be ineffective in addition to the auditors
substantive procedures deemed insufficient, the auditor would have not have
obtained sufficient, appropriate audit evidence and so the circumstances would
constitute a scope limitation.
Analytical procedures involve:
Developing expectations for an entity in a given year based on data for
that entity over time.
AP usually involve comparisons of recorded amounts, or ratios developed
from recorded amounts, to expectations developed by the auditor, not
mgt assertions.
These procedures assume that plausible r/ships among data may
reasonably be expected to exist and continue in the absence of known
conditions to the contrary. For this reason, data can be used to predict
future balances against which recorded balances may be compared.
Use of a std cost system wud facilitate AP.
Comparing the current year and prior years F/S is done both in planning
and final review stages.
Comparison of current year revenue to budgeted revenue is very useful in
evaluating the results of operations.
Ratio analysis is used in developing r/ships among b/s a/cs when
performing a review.
AP aid in the identification of unusual transactions and events. The
recording of debits and credits to an unusual combination of revenue and
expense a/cs would cause these a/cs to behave differently than expected.
So AP shud be designed to disclose differences from expectations.
Unexpected differences relative to auditors expectations may indicate the
possibility of a material misstatement.
According to GAAS, the working papers must show that the accounting
records agree/reconcile with the F/S.
Does not include projecting deviation rate by comparing the results of a
statistical sample with the actual population xtics. (test of control).
According to GAAS, when CR is assessed at maximum level, the auditor
need not document the basis for the conclusion.

TESTS OF CONTROL
Are procedures performed to obtain information about the operating
effectiveness of controls in preventing or detecting and correcting material
misstatements at the relevant assertion level.
These are performed when:

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 Reliance can be placed on I/C
Substantive procedures alone do not provide sufficient appropriate
audit evidence
It is cost-efficient.

RISK ASSESSMENT PROCEDURES (AIIO)

Are procedures performed to obtain an understanding of the entity and its
environment, including I/C, to assess the RMM, whether due to fraud or
error.
Risk assessment procedures include: AIIO - AP, Inquiries of mgt and
internal auditors, Inspection of documents and records and Observation of
the application of specific controls.
These are not further audit procedures.

ASSERTIONS
Assertions are implicit or explicit statements of fact by Mgt. that are associated
with the entitys F/S. Some of these assertions include:
Understanding and classification - transactions & events have been
recorded in the proper a/cs and info is presented & described clearly.
Presentation and disclosure all transactions have been presented
correctly and disclosure made of any RP transactions.
Existence or occurrence (vouching) all transactions have actually
taken place. Here the auditor moves from the books to the source
documents. E.g. vouching the acquisition of assets with cancelled checks;
independent comparison of perpetual inventory records with goods on
hand addresses the existence of manufacturing transactions which
produce inventory.
Rights and obligations confirms right or ownership to assets or to
collect receivables or pay off liabilities. E.g., verifying that securities in the
safe deposit box are registered in the entitys name.
Completeness (tracing) & cutoff deals with whether all transactions
are recorded/included. Eg tracing a bill of lading to the sales invoice. Or,
comparing assets on record with physical check. It means no omission of
transactions that should have been recorded. The std control for
completeness is controlling pre-numbered forms by checking the
numerical sequence of source documents and invoices. The numbering
helps assure that transactions do not get lost and thus that all transactions
are properly recorded.
Valuation, allocation and accuracy means that the $ amounts
attributed to the elements of the cos F/S are appropriate and in

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 accordance with GAAP or AFRF. i.e., whether a/cs are valued correctly
e.g. current prices of of recorded investments, A/R are likely to be
collected by checking credit granting policies.

As per AICPA professional stds, there are 3 broad categories of assertions:

B/S assertions 4 of the above existence, completeness, rights and
obligations and valuation. Wording used a/c balances at period end
I/S assertions 5 of the above accuracy, occurrence, completeness,
cut-off and classification. Wording used transactions and events. Cutoff
assertion states that transactions and events have been recorded in the
correct a/cing period, not in the period b4 or after. B4 violates the
occurrence assertion and after violates the completeness assertion.
Though cutoff by virtue becomes redundant once completeness and
occurrence assertions are verified, it is an important auditing concept.
Presentation and disclosure assertions (related to the footnotes) 4 of the
above occurrence & rights and obligations, completeness,
understanding and classification, valuation and accuracy.

AUDIT PROCEDURES FOR ASSERTIONS

A/C BALANCES 4 ASSERTIONS (RACE)
1. Rights and obligations related to any restrictions
Inquire - about compensating balances with banks; Inquire about
use of specific assets as collateral for debts; Review debt
agreements for collateral; The mgt representations letter should
document these inquiries regarding important matters.
Examine authorization of transactions.

2. Allocation and Valuation related to the appropriateness of dollar

measurements.
Recalculate a/c balances e.g. depn exp and prepaid insurance
Trace to subsequent cash receipts or disbursements to the
applicable bank statements
AP review the aged T/B for A/R to evaluate the allowance for
uncollectibles.
Examine published priced quotations for FV measurements.
3. Completeness related to omissions of amounts that should have been
recorded:
Cut off tests trace from supporting source documents back to the
a/cing records looking for omissions. For e.g. trace from shipping
documents to COGS or to the sales journal, or perform a search
for unrecorded liabs.

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 AP these are applicable to every audit area, but be specific;
calculate a particular ratio or compare something specific to
another specific thing.
4. Existence related to the validity of recorded items
Confirmation esp regarding overstatements
Observation esp for inventory or investment securities
Agree/vouch to underlying documents agree items from the
a/cing record to the supporting source documents

INDIVIDUAL AUDIT AREAS - INTRO

1. For every audit area, the auditor should scan the journals and ledgers for
any unusual items.
2. Agree F/S elements or T/B to underlying records (i.e. general ledger)
3. Directing inquiries to members of mgt or other client personnel and
document inquiries and responses in the mgt representations letter.
4. Applying AP for every audit area consider historical trends and events
within the industry.

AUDIT AREA CASH (RACE/PERCV)

Request Cutoff bank statement this is a short period bank statement obtained
directly from the bank (normally for a 10-day period) useful in verifying the
deposits in transit and partial evidence on a bank reconciliation. This request
must come from mgt to the entitys bank to provide info directly to the auditors.
Deposits in transit check for existence/occurrence assertion and
overstatement.
o/s chqs check for completeness and understatement.
Proof of cash compares the bal b/d per bank + deposits o/s chqs v- bal b/d
per books + receipts disbursements as per book.
Kiting an overstatement of the true cash bal c/d caused by recording the receipt
in this year, while failing to record the disbursement till next year. Kiting would be
evidenced by a low average balance compared to a high level of deposits
because, although deposits are being made, checks are immediately written to
remove the funds, resulting in a low average balance.
The schedule of interbank transfers is used to verify that t/fers btw the entitys
bank a/cs are recorded properly (and to detect kiting, which overstates cash bal).
Bank confirmations help to corroborate info regarding deposits and loans. Cash
in bank and collateral for loans are confirmed on the bank confirmation. Confirm
directly with the bank 2 separate bank related matters cash balances with
emphasis on existence assertion and liabilities with emphasis on completeness
assertion. This form must be completed by an indv who is knowledgable about
the financial relationships and transactions tht the bank has with the client.

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 Helps to verify the existence and ownership of bank a/cs
Also provides evidence about the completeness and terms of NP with
bank.
Petty cash may count on hand the amount otherwise AP is usu sufficient.
Restrictions on cash balances the auditor makes an appropriate inquiry of mgt,
and mgts response is usually documented in the mgt representations letter.
Audit of SCF agree amounts included in the SCF to amounts reported in other
F/S. e.g. depn exp to I/S.

AUDIT AREA A/C RECABLES (RACE/PERCV)

Rights & obligations
Inquire about recables pledged as collateral
Read the debt agreements for any discussion of collateral
Allocation & Valuation
Review the aged T/B and test its accuracy
Inquire about individually large, delinquent items
Estimate uncollectible a/cs based on prior years working papers tempered
by current economic conditions.
Review receiving documents after y/end for sales returns.
Review adjusting journal entries e.g. write offs for appropriate
authorization.
Completeness
Perform cutoff test of sales to verify that sales transactions are recorded in
the proper period. Cutoff assertion states that transactions and events
have been recorded in the correct a/cing period, not in the period b4 or
after. B4 violates the existence assertion and after violates the
completeness assertion. Though cutoff by virtue becomes redundant
once completeness and existence assertions are verified, it is an
important auditing procedure. These procedus primarily consist of
examining selected sales invoices and shipping docs a few days before
and after year-end for agreement to verify that the transactions were
recorded in the proper period.
Existence
Verify subsidiary ledger agrees with general ledger control a/c
Confirm individually material a/cs and selected others confirmations
provided the strongest evidence of the existence of the recable.
Investigate exceptions (disputed balances) from confirmations
Complete the alternate procedures for nonresponses to positive
confirmations.
Lapping is an attempt to cover up a theft of receipts, where a clerk might apply
a different customers payment to a prior customers a/c (whose payment was

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 stolen) to conceal the theft. It is a misappropriation of assets that is associated
with an improper segregation of duties.
CONFIRMATION (UNDER A/R)
The auditors objective is to design and perform external confirmations to obtain
relevant and reliable audit evidence. Confirmations are most useful in addressing
the existence/occurrence assertion.
External confirmation direct written response from 3rd party (confirming party)
Positive confirmation request whether the confirming party agrees/disagrees
with the clients amount. A non-response is viewed as a loose end that must be
addressed when:
Individual a/cs are large
Explicit evidence
Requires 2nd or 3rd requests as follow-up for non-responses
If no response is obtained then the auditor must perform alternative
procedures such as for receivables - see whether cash was received
subsequent to the date of confirmation request. For payables, verify
subsequent cash disbursements as evidence of payment on a/c.
Negative confirmation request where a response is only requested in the event
of a disagreement. A non-response is viewed as evidence of agreement. These
usually require a larger sample size than would positive confirmations. The
auditor may justify using negative confirmations when:
Population consists of large no of small homogenous items
Assessed level of RMM is low; and relevant controls are operating
effectively
Recipients are expected to pay attention to the request. One must keep in
mind that a non-response could be taken as agreement when the recipient
did not even open the envelope.
Having a small no of a/cs in dispute - a low rate of exceptions is expected.
Implicit evidence
In order to ensure timely response, the auditor may include a statement
such as if you do not report any diffs within 15 days, it will be assumed
that this statement is correct.
Blank - The blank form of A/R confirmations is where the recipient needs to fill in
the amount. special form of positive confirmation.
Large balance
Active a/c
Delinquency
High assessed level of RMM
Expectation that the customer will not pay attention to negative
confirmation.
provides a greater degree of assurance

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 might also result in a lower response rates because additional effort is
required.
Procedures when customer doesnt respond to positive or blank confirmation
Send second confirmation
Ask client to contact customer and request response.
If still no response is received the auditor should perform alternate
procedures. Here, subsequent cash receipts are traced to the cash
receipts journal and to the bank statement to confirm whether the balance
was valid and subsequently collected. Another alternate procedure which
is more of a last resort is to vouch (inspect) the underlying documents e.g.
purchase order, sales invoice and shipping documents to verify the sales
transactions included in A/R.

The auditor should use external confirmation procedures for A/R, except when
one or more of the following is applicable:
The overall a/c balance is immaterial
External confirmation procedures for A/R would be ineffective
The auditors assessed level of RMM at the relevant assertion level is low,
and other planned substantive testing address the assessed risk. In many
situations, both are needed to bring RMM to an acceptably low level.
If the auditor identifies that Mgt is under pressure to meet earnings expectations,
the auditor may use external confirmations to confirm not just o/s amounts but
also to confirm details of sales agreements: date, right of return and delivery
terms and inquiries of non-financial personnel in the entity regarding changes in
sales agreements and delivery terms.
Confirmations of A/R provide strong evidence for the existence assertion and
rights and obligations assertion. To an extent, some evidence for the valuation
(accuracy) assertion but not completeness assertion because customers may not
be inclined to report understatement errors in their a/cs. I.e. if the amount stated
is less than the actual amount they owe.
An auditor could include along with confirmations client prepared statements of
a/c that show the details of the a/c balances, thereby making it easier for the
customer to respond to a confirmation request.
There is a presumption that the auditor will confirm selected recables when they
are material.
A sgfly lower A/R t/over would result from lower credit sales or higher A/R
balances. If fictitious credit sales were recorded, the related recables would
remain unpaid, causing higher recable balances and thus lower A/R t/o ratio.

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AUDIT AREA INVENTORY
Rights and obligations
Inquire of mgt about any inventory held on consignment or pledged as
collateral.
Inspect the entitys debt agreements for any discussion of collateral such
as inventory.
Allocation and Valuation
Perform price tests to evaluate the appropriateness of the inventorys
cost/unit e.g. agree unit costs to a recent suppliers invoice.
Test the extensions qty x cost/unit and foot the total. Testing the entitys
computation of std overhead rates.
Perform lower of cost and market analysis - might calculate inventory
t/over ratio to identify slow moving inventory.

Completeness
Test sales cut-off regarding COGS, decreases to inventory.
Test purchases cut-off regarding purchases of inventory.
Test cut off procedures for shipping and receiving - To detect omissions
performing cut-off procedures for shipping and receiving enables the
auditor to detect late transactions that may have not been recorded in the
proper period and so may be missing from the current audit year.
The completeness assertion pertains to transactions that have NOT been
recorded or are missing so scanning purchase or inventory records is
ineffective.
Trace a sample of inventory tags to a clients computerized listing of
inventory items to determine whether the inventory items represented by
tags were included on the listing. Since it is source document to a/cing
records, this test addresses the completeness assertion by dealing with
the risk of omission.
Existence
Participate in the clients count of inventory
Basic steps to perform in physical count of inventory
Review and evaluate the entitys written counting procedures
Perform test counts of selected inventory tags to verify the accuracy of the
entitys counts. i.e. select a sample of items on the entitys inventory listing
and agree them to the auditors test counts.
Determine that all inventory tags are properly a/ced for
Be alert for and inquire about any obsolete or damaged items eg seeing
damaged or very dusty cartons.

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 If inventory is to be observed at an interim date, perpetual inventory
records must be maintained. Such records will provide the book balances
against which the physical count can be compared.
For inventory is to be observed at or after y/end, records must be available
to allow the physical count to be compared to a current book balance.
When inventory is held in a public warehouse, the auditor would ordinarily obtain
direct confirmation from the custodian.
Presentation and disclosure assertion an auditor would inspect loan documents
to verify adequate classification and disclosure of inventory.
Validity pertains to existence that inventory is real and exists. Agreeing items in
the inventory listing (which is like a subsidiary ledger for the adjusted general
ledger balance for inventory) to the underlying inventory tags(source document)
and the auditors recorded count sheets (source document) provides support that
the inventory in the listing actually exists. The reverse supports completeness.
Failure to record sales returns would result in actual inventory qties being higher
than clients perpetual records.
When a client has many inventory locations, auditors ordinarily need not be
present at each location and need not count all items in the inventory.
All auditor test counts need not be documented in the working papers.

AUDIT AREA PPE/FIXED ASSETS

Focus here is on transactions rather than ending balance. The auditor will normally
verify the appropriateness of the y/end balance of FA by performing substantive tests of
transactions on the change from bal b/d to bal c/d.
Rights and obligations
Inquire about any FA pledged as collateral for debts.
Inspect the entitys debt agreements for any discussion of collateral, such
as FA.
Document such inquiries and mgts response in the mgt representations
letter.
Allocation and Valuation
Review of calculations for depreciation expense.
Inquire of mgt as to whether any assets have become impaired.
Completeness
Review repairs and maintenance exp a/cs to see if any transactions
should have been capitalized instead of expensed.
Review any lease agreements to determine if lease capitalization might be
required.
Existence
Verify that detailed listing supports general ledger a/c.
Examine underlying documents to evaluate any additions.

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 Trace proceeds from any disposals (retirements) to cash receipts journal
and to bank statement.
Unrecorded disposals auditor must first inspect property ledger, insurance and
tax records to identify assets that are most likely retired (based on age). The
auditor may then attempt to locate such items in the plant. If the items are
missing from the plant, it means they were most likely disposed of but not
recorded. Go from RECORDS TO FLOOR. Also an examination of all major
additions that occurred during the year would highlight unrecorded disposals as
an addition may replace a retired property item.
Unrecorded additions touring the plant before inspecting ledger and other
records will enable the auditor to determine that the assets found are indeed
recorded. Go from FLOOR TO RECORDS.
Mortgage acqn costs could be verified in the cancelled checks, closing
statement and interest expense. Cancelled checks would provide verification of
mortgage acquisition costs. The closing statement would provide a detailed
listing of the costs of acquiring the real property, including possible mortgage
acquisition costs. Not likely to be stated in a deed.
The auditor is most likely to seek info from the plant manager regarding
existence of obsolete machinery since the manager comes into day-to-day
contact with the machinery

AUDIT AREA - INVESTMENT IN SECURITIES (RACE/PERCV)

A Derivative is a financial instrument or other contract whose value is derived from its
relationship with something else known as the underlying. The underlying can be
another financial instrument, a physical commodity, currency, etc.
Rights and obligations
Inspect underlying agreements
Trace to acqn supporting documents
Confirm sgf terms with counterparties and holders
Review bank confirmations for evidence of use as collateral
Allocation and Valuation
Confirm sgf terms with counterparties and holders
Compare to MVs for financial instruments with observable mkt data for
trading and AFS securities
For HTM securities the auditor might inspect the documentation of the
purchase price, test the amortization of premium and discount.
Review F/S of major investee (if based on equity method)
Completeness
Reconcile dividends reced to publicly available info
Confirm holdings with 3rd party custodians

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 Obtain confirmations from counterparties regarding absence of side
agreements.
Existence
Confirm with 3rd party custodians as publicly traded stock is commonly
held by a custodian on behalf of the investor.
Reconcile to interest and dividends received
Physically observe securities in the clients custody
Impairments how to determine whether it is other than temporary
How much and how long the FV is below the CV
Whether the financial condition of the issuer has deteriorated
Whether a rating agency has downgraded the security
Whether the dividends have been reduced or eliminated (or interest
payments not made).
Whether the entity recorded losses on the security after the period-end.
Hedge is a defensive strategy designed to protect against the risk of adverse
price or IR movements to achieve state of balance.
Proof of existence to verify the rights and obligations assertion:
Confirm ownership directly with independent custodians such as
brokerage firms. Note that confirmation cannot be obtained from investee
cos themselves, since they will usually list the custodian as the owner of
all shares held by custodian on behalf of their clients.
The auditor will perform a count of securities that are held by the client. In
many cases, these securities are kept in a safe deposit box at the bank,
and the auditor will accompany the client to the bank to open the box and
perform the count. Requiring that a client representative acknowledge the
receipt of securities will eliminate any question concerning the CPAs
responsibility for any subsequent misplacement or misappropriation of the
securities.
If the auditor is unable to count the securities at the B/S date, the auditor
will most likely request the client to have the bank seal the safe deposit
box until the auditor can count the securities at a subsequent date.
In testing long-term investments, an auditor ordinarily would use AP to ascertain
the reasonableness of the completeness of recorded investment income. The
auditor uses AP to develop an expectation of investment income, which is then
compared to recorded investment income and sgf diffs are investigated further.
Dividend record books produced by investment advisory services provide
summaries of dividends paid for various securities, and an auditor is able
to compare the reasonableness of a clients recorded dividend income
from investments with this information.
Derivatives and some other investment securities are valued at FV the auditor
should:
Evaluate whether methods used to determine FV are consistent with reqs
of AFRF.

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 The auditor should obtain an understanding of the methods used by
brokers or dealers. Determine their appropriateness.
The auditor should obtain sufficient appropriate audit evidence about the
FV based on that model.
To evaluate an investment in securities that is based on the investees financial
results
the auditor would normally read the audited F/S of the investee. If F/S is
not audited or otherwise not acceptable, the auditor should apply audit
procedures to the F/S or arrange for another auditor to do so.
Evaluate the potential lack of comparability if periods covered by F/S of
investee and R/Entity are different.
To evaluate investment in securities valued at cost
Inspect the documentation of the purchase price
Confirm the existence of the security with 3rd party custodians
Test the amortization of premium or discount.

AUDIT AREA CURRENT LIABILITIES

When auditing AP, the mgt assertion of completeness is the most important, since the
auditors primary concern is understatement of liabilities rather than overstatement.
Rights and obligations
Inquire of mgt about any transactions with related parties that result in
obligations.
Allocation and Valuation - use AP on accruals
Re-compute dividends payable the auditor might estimate the dividends
payable in view of the declared dividends/share (as per minutes of BOD) x
the number of shares o/s at y/end.
Re-compute wages and salaries the auditor might estimate the wages
and salaries payable based on the no of days to be accrued relative to the
payroll for a normal day period.
Interest payable estimate accrued interest for the time period based on
the IR and payment dates specified in debt agreements.
Note payable a NP that was renewed after the B/S date would be
examined by the auditor to ensure that it was properly presented at the b/s
date and related disclosures were adequate.
Completeness - Search for unrecorded liabilities
Review cash disbursements after y/end and examine underlying
documents to identify liabilities of the period under audit.
Examine unpaid invoices (open purchase order file) and receiving
documents at the time of the test to verify that all merchandise received
has been recorded.

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 Inquire of mgt as to the completeness of liabilities (document that in the
mgt representations letter).
Confirmation to vendors with whom the entity has previously done b/s,
not just the ones in AP file. Confirmation efforts are directed towards zero
or low balance a/cs and performed mostly after the B/S date. If it is
performed b4 then it will have to re-performed after.
Existence
Compare the general ledger control a/c to the supporting detailed listing of
payables
Vouch selected items in the A/P subsidiary ledger to vendors invoices,
purchase orders and receiving reports.

AUDIT AREA LONG-TERM LIABILITIES

The audit of long-term liability is normally ltd to few transactions during a typical year
except for interest payments. As a result, AP normally focuses on Interest exp to the
related debt. Here focus is proper classification on the B/S i.e. disclosure and
presentation is a very imp assertion.
Rights and obligations is the debt the obligation of the entity?
Review loan documents for any restrictive debt covenants to be disclosed.
Review the loan documents or inquire of mgt to identify the current portion
of long-term debt to be reclassified as liability.
Allocation and Valuation is debt is recorded in the appropriate amount?
Trace cash receipts for increases in debt and cash disbursements for
decreases from the a/cing records to the bank statement for any debt
activities.
Examine underlying loan documents for issuance of new debt and
scheduled payment
Recalculate the amortzn of any discount or premium involved.
Perform AP by comparing interest exp to related debt for reasonableness.
Completeness is all debt recorded?
Verify due dates for payments in the loan agreements
Trace cash disbursements from the a/cing records to the bank statement
Examine cancelled notes if paid in full.
Perform AP on interest expense provides evidence.
Existence does the debt recorded actually exist?
Obtain copies of new loan agreement for the audit documentation (i.e. to
be included in the audit working papers).
Verify authorization of new debt in minutes of meetings of those charged
with governance.
Trace the proceeds received from the a/cing records to the bank
statement.

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 The auditor can best verify a clients bond sinking fund transactions and y/end
balance by confirmation with the bond trustee.
Understated bond payable will result in a lower a/c balance and thereby create a
situation in which the interest expense appears excessive.

AUDIT AREA STOCKHOLDERS EQUITY

Objectives:
Adequacy of I/C
Transactions properly authorized and comply with regulations
Transactions recorded in conformity with GAAP
Adequately disclosed in F/S.
Rights and obligations
Review BOD minutes for authorization and check that consistent with the
articles of incorporation.
Review the entitys compliance with contracts for employee stock plans
Inquire of mgt about any restrictions applicable to R/E does the entity
have a right to the reported R/E for paying dividends. Note this also
addresses presentation and disclosure assertion (see below).
Allocation and Valuation
Review the cash receipts journal and the cash disbursements journal for
any changes related to the stock a/cs.
Compare the subsidiary ledger related to the stock a/cs to the general
ledger balance.
Verify the par value on the stock certificate or the stated value in the BOD
meeting minutes.
Completeness
Read the BOD minutes for authorization.
Verify that all certificate nos are a/ced for.
Existence
If the entity has an external registrar, confirm the o/s shares of stock. A
registrar is normally responsible for executing such transactions. If the
company has a transfer agent obtain a confirmation to verify the existence
of new transactions and the accurate recording of existing transactions.
Stock transfer agent is responsible for controlling the no of shares
issued, for issuing new shares, and for cancelling shares.
Registrar maintains stockholder records. His primary responsibility is to
prevent any over-issuance of stock, and thereby verify that stock is issued
properly.

Presentation and disclosure main focus is to verify if there are any restrictions
on R/E. Restrictions on R/E impact the amount of R/E available for dividends

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 and thus, require disclosure either on the face of the statement or notes. The
auditor will need to inspect loan agreements of minutes of meetings with BOD.
Note reviewing BOD minutes is the most preferred method of verifying
stockholders equity transactions. The minutes would document changes such as
the issuance of new stock, the purchase of treasury shares, or merger thru an
exchange of stock.
Stock options an auditor would trace the authorization for stock options to a
vote of the BOD to provide evidence supporting the existence of the stock
options.
Cancelled stock certificates should be defaced to prevent reissuance and
attached to their corresponding stubs where the corporation has no external
registrar or transfer agent.
Regarding R/E the auditor should check for authorization of cash and stock
dividends. The legality of a dividend depends in part on whether it has been
properly authorized (state law differ on specific requirements). Thus, the auditor
must determine that proper authorization exists, as both cash and stock
dividends affect R/E.

AUDIT AREA PAYROLL

Like other I/S items, payroll relates to transactions and events during the period rather
than ending balances and lists 5 main assertions - OACCC
Accuracy related to valuation
Recalculate selected entries on the payroll register. Payroll register is the
primary a/cing record that documents each employees compensation for
each payroll period.
Occurrence related to existence
Trace selected transactions from payroll register to the general ledger and
to the payroll bank a/c.
Examine personnel records on a test basis, to determine the level of
compensation and support for all deductions exist for all employees. The
personnel files will be maintained by the personnel dept. Officers
compensation should be documented in the BOD minutes.
Completeness
Review time reports and time cards to verify support for production
records.
Apply AP and recalculation to verify payroll-related accruals at y/end are
reasonable.
Cutoff related to completeness and also occurrence. When the auditor has
established that recorded transactions are properly recorded and no omissions
have taken place, by default, it is established that the transactions have been
recorded in the correct a/cing period.
Classification more like presentation and disclosure.

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 Detailed testing is usually performed only when the auditors AP suggest that
there is a RMM relating to the expense a/c. When control risk is assessed as low,
substantive procedures are typically limited to AP and recalculation of payroll
register.
The review of payroll tax reconciliations is performed to identify potential liabilities
for unpaid payroll taxes.
In auditing payroll, an auditor would be likely to compare payroll costs with entity
stds or budgets. This would enable auditor to detect unusual fluctuations or
RMM. The presence of sgf unexplained variances btw std and actual labor costs
might cause an auditor to suspect an employee payroll fraud scheme.
If overpayments are discovered in performing tests of details, the auditor would
likely extend substantive tests of payroll in order to ascertain whether such
overpayments materially impact the F/S.

AUDIT AREAS - OTHER POINTS TO NOTE

1. Channel stuffing is a marketing practice that suppliers sometimes use to boost
sales by inducing distributors to buy substantially more inventory than they can
promptly resell; accordingly, increased sales returns in the future are likely. This
results in additional audit procedures.
2. A bill and hold transaction results in the recording of a sale prior to delivery of the
goods accordingly, sales may be inappropriately recorded.
3. Suspense debits that mgt believes will benefit future operations must be audited
carefully to determine whether they have value and should be classified as an
asset. The conservative approach taken in audits is likely to cause the auditor to
have somewhat more concern about suspense purported to be assets rather
than those classified for current liabs.
4. The receipt of fewer a/c recables confirmation requests than expected may be
indicative of fictitious a/cs and thus, cause for an auditor to believe that material
misstatements may exist in the F/S.
5. Existence of short audit trails of computer-generated transactions is a recognized
limitation in the availability of data in some computerized systems.
6. Tracing bills of lading to sales invoices provides evidence that shipments to
customers were invoiced. Source documents to records = completeness.
7. When there are many diffs in the a/c balance level for A/R and they are not
misstatements, the auditor may choose to focus on specific transactions
represented by indv invoices for audit sampling purposes. That may make it
easier for customers to respond accurately.
8. To ensure that a fax is valid, the auditor would need to telephone the sender.
9. Confirmation of A/R is not a GAAS.
10. To evaluate the results of the confirmation process you do NOT total the
misstatements identified and to compare that total to the a/cs tolerable error
amounts.

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 11. A/R are NOT ordinarily confirmed on a std form developed by AICPA and the
Financial Executives Institute.
12. Ratio effect:
Omission of inventory or materials in transit = DR. inventory and CR.
COGS, therefore inventory ratio decreases as numerator decs and
denominator incs. COGS goes down means that Profit goes up therefore
ROE increases.
Omission of payment of cash dividends = DR. Dividends pd CR. Cash
Dividends reduce R/E and equity therefore reduces denominator in ROE
and so increases ROE.

AUDIT DOCUMENTATION
The work performed by the staff is recorded in the audit documentation. The
supervisor would review the audit documentation to ensure that the evidence
collected adequately supports the audit judgements reached.
3 purposes of audit documentation:
1. Provides principal support for the OPINION RENDERED in the auditors
report, not the F/S themselves.
2. Documents the auditors compliance with GAAS.
3. Assists in controlling the audit engagement. It also aids the auditor in the
conduct and supervision of the audit.
The quantity and content of an auditors documentation would be affected by the
following:
Nature of the engagement
Nature of the auditor s report
Nature of the F/S, schedules or other info
Nature and condition of the clients records
Assessed level of CR
Needs in the particular circumstances for supervision and review of the
work.
Audit documentation is the property of the auditor, however, a CPA approaching
retirement cannot sell those working papers without obtaining permission of client
management.
Report release date the date the auditor grants the entity permission to use the
auditors report; that date must be documented.
Under AICPA stds, (audits of non-issuers) the audit documentation should be
retained for at least 5 years from the report release date.
Under PCAOB stds, (audits of public cos) the auditor documentation should be
retained for at least 7 years from the report release date.
Under AICPA stds the auditor should complete the assembly of the final audit
file no later than 60 days after the report release date.

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 Under PCAOB stds the auditor should complete the same no later than 45
days after the report release date.
Types of files related to audit working papers:
The Permanent file contains information that affect multiple periods
pertaining to matters having ongoing audit sgf. E.g. I/C flowchart, AOA,
debt agreements, the corporate charter, lease agreements, pension plan
contract, analyses of capital stock and other OE a/cs, historical financial
info such as ratio analysis with ongoing usefulness.
The Current file includes items relevant to the current year audit and
would include: audit plan/program, memoranda, minutes of board
meetings, confirmations, letters, bank statement, attorney letters, working
trial balance, lead schedules. Lead schedules aggregate the major
components to be reported in F/S and include information such as a/c nos,
prior year account balances and current year unadjusted information.
Bulk file where documentation that is too voluminous can be stored e.g.
magnetic tapes, extensive computer printouts.
Correspondence file letter and emails form clients are organized.
Report file stores prior years audit reports and mgt letters.
The audit documentation must include the following:
Among other matters, the audit documentation should indicate who
reviewed specific audit working papers.
Among other matters, the audit documentation should indicate whether
the entitys a/cing records agree with (or reconcile to) the amounts
reported in the entitys F/S.
The use of microcomputers affects the way audit documentation is completed
and displayed use of spreadsheets may not contain readily observable details
of calculations.
It is appropriate to use calculator tapes with names or explanations on the tapes,
rather than writing separate lists into the audit documentation.
After the documentation completion date to audit retention date
The auditor must not delete audit documentation
The auditor may add to the documentation but must document any
materials added; by whom, when, the reasons for the change, and
the effect on the auditors conclusions.
B4 completion date, the auditor may delete superseded
documentation exception: info that reflects disparate point of view
should be retained.

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ACCOUNTING ESTIMATES
The auditors basic responsibility when auditing a/cing estimates is to evaluate
the reasonableness (and the adequacy of related disclosures) of any sgf a/cing
estimates relative to GAAP or other AFRF. Remember because of their
nature, such estimates are always subject to some bias even when the
estimation process involves the use of relevant and reliable data and competent
personnel.
In evaluating the reasonableness of an a/cing estimate, an auditor concentrates
on key factors and assumptions that are:
Sgf to the a/cing estimate
Sensitive to variations
Deviations from historical patterns
Subjective and susceptible to misstatement and bias.
Estimation uncertainty is the susceptibility of an a/cing estimate and related
disclosures to an inherent lack of precision in its measurement. RMM increases
when estimation uncertainty is high.
Factors affecting estimation uncertainty are:
Nature of the a/cing estimate
Extent to which there is an accepted method or model to be used
The subjectivity of any assumptions or the degree of judgement involved.
The audit procedures to assess a/cing estimates is:
Inquire of mgt to understand how the estimate was developed
Review and test mgt processes performing tests of the valuation model,
including sgf assumptions, and the underlying data.
Develop an independent expectation for comparison to the mgts estimate
Review subsequent events and transactions to evaluate the
reasonableness of the FV measurement.

For further substantive procedures reqed for sgf risks, the auditor should
evaluate:
How mgt addressed estimation uncertainty in making the estimate
Whether mgts sgf assumptions are reasonable;
Whether mgt has the intent and ability to carry out specific actions, as
relevant.
The auditor should document the following regarding a/cing estimates:
The basis for the auditors conclusions about the reasonableness of a/cing
estimates resulting in sgf risks and their disclosure;
Any indications of possible mgt bias.
In order to determine whether mgt has identified all a/cing estimates that could
be material to the F/S, the auditor must review the lawyers letter for information
regarding litigation. Litigation losses is an area that commonly requires estimates

24
 and one in which estimates could be material to the F/S. It is also an area that
falls outside of the normal F/rep process and thus, is more likely to be missed.
Because of the higher RMM, the auditor is required to evauate the
reasonableness of prior years sgf a/cing estimates. What the auditor is looking
or is evidence of pervasive bias. For e.g., did all of the prior year estimates err in
increasing net Y? This subsequent evaluation is known as retrospective review.

FAIR VALUE ESTIMATES

FV is the amount at which the asset could be bought/sold in a current transaction
btw willing parties, other than in a forced or liquidation sale.
The auditor must obtain sufficient appropriate audit evidence to provide
reasonable assurance that FV measurements and disclosures comply with
GAAP. The auditor should also determine that the methods used to determine
FV are consistently and appropriately applied.
2 main sources of inputs are used: observable inputs and unobservable inputs
Observable inputs are assumptions that market participants would use in
pricing an asset or a liability based on market data from sources
independent of the R/E.
Unobservable inputs are an entitys own judgments about what
assumptions market participants would use. Note estimation uncertainty
increases when the FV estimates are based on unobservable inputs
instead of observable inputs.
The auditor will consider whether or not the nature of sgf assumptions used in FV
measurements, the degree of subjectivity involved in the development of the
assumptions, and the relative materiality of the items being measured at FV need
to be communicated to those charged with governance. Remember F/S are
mgts responsibility, whereas those charged with governance should
provide appropriate oversight.
When there are no observable market prices, the auditor must consider whether:
Mgts valuation method is appropriate in the circumstances and relative to
the industry and environment of the entity and has applied criteria
provided by GAAP.
The auditor may engage a specialist to evaluate the reasonableness of
the FV measurements. The decision to engage a specialist is a matter of
professional judgement and the auditor does not have to consult mgt
regarding that. The auditor may choose not use a specialist if they have
the necessary skill and knowledge to audit FV.
The best evidence of FV certain assets and liabilities are the published
price quotations in an active market.

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LAWYERS LETTER
Auditors purpose in obtaining a lawyers letter is to corroborate mgts
responses to the auditors inquiries about litigation-related issues. The primary
source of information about legal-related uncertainties is mgt.
If there is a limitation in the lawyers response to the letter of inquiry or a refusal
then the auditor would consider this a scope limitation sufficient to prevent an
unqualified opinion and likely resulting in a disclaimer of opinion. However, a
lawyer may appropriately limit the response to matters to which the lawyer has
given substantive attention in the form of legal consultation or representation. It
would not be grounds for an adverse opinion, as an adverse opinion results from
a GAAP departure.
An auditor may not be required to obtain a letter from the entitys legal counsel if
the entity has no litigation, claims or assessments having F/rep relevance and so
did not engage legal counsel. In such a case, the mgt representations letter
would include a statement that the entity had no legal counsel to address
current/potential litigation issues.
There are two types of letters involved in the communication with the entitys
lawyers :
Letter of inquiry mgts letter to the lawyer asking the lawyer to provide
litigation-related information directly to the auditor; this normally includes
the entitys listing of pending legal matters that the lawyer is handling
classified separately as asserted and unasserted claims.
Lawyers letter the lawyers letter directly to the auditor.
Asserted claims also called pending or threatened litigation is a claim that
has already been filed (pending) or when the other party has announced an
intention to sue (threatened). There are 4 matters that must be addressed in the
lawyers letter regarding asserted claims:
1. The nature of the litigation
2. The progress of the case to date
3. How mgt is responding or intends to respond to the litigation
4. An evaluation of the likelihood of an unfavorable outcome and an
estimate, if one can be made, of the amount or range of potential loss.
Unasserted claims are where the entity has exposure to litigation but no one
has yet filed a law suit or announced an intention to sue. There are 3 matters that
must be addressed in the lawyers letter regarding unasserted claims:
1. The nature of the litigation
2. How mgt intends to respond if the claim is asserted
3. An evaluation of the likelihood of an unfavorable outcome and an
estimate, if one can be made, of the amount or range of potential loss.
An unasserted claim must be disclosed according to GAAP if it is probable that
the claim will be asserted; and it is at least reasonably possible that a material
unfavorable outcome will occur.

26
 Where there are omissions regarding asserted claims in the letter of inquiry, the
lawyers letter should inform the auditor directly of such an omission.
Where there are omissions regarding unasserted claims the lawyer will not
inform auditor directly but should encourage mgt to discuss the matter with the
auditor. Note: that this issue is specifically addressed in the mgt
representations letter.
A lawyers response to an auditors inquiry may be limited to matters that are
considered individually or collectively material to the clients F/S. The client and
the auditor should reach an understanding about materiality and communicate
this to the lawyer so that he/she can limit his/her response accordingly.
Audit procedures:
In auditing contingent liabilities, an auditor would read board meeting
minutes to identify issues that have F/rep implications.
Read the file of correspondence from taxing authorities regarding the
existence of any assessments imposed.
The auditor would not be allowed access to legal documents in the clients
lawyers possession. The auditor should examine the legal documents in
the clients possession.
Discuss with mgt the policies and procedures it has adopted for evaluating
and a/cing for litigation, claims and assessments.
Obtain assurance from mgt that it has disclosed all unasserted claims that
the lawyer has advised are probable of assertion and must be disclosed.
Obtain from mgt a description and evaluation of litigation, claims and
assessments existing at the b/s date.
If a clients lawyer resigned shortly after the receipt of lawyers letter which
indicated no sgf disagreements with the clients assessment of contingent
liabilities, the auditor should inquire why the attorney resigned. The auditors
concern is whether any undisclosed unasserted claims have arisen. A lawyer
may be required to resign if his advice concerning reporting for litigation, claims
and assessments is disregarded by the client. Accordingly, the resignation
shortly after issuance of an attorneys letter may indicate a problem.
Responsibility for evaluating a GC problem belongs to the auditor.

MANAGEMENT REPRESENTATION LETTER

The purpose of obtaining required mgt representations letter is to document in
writing the essence of (senior) mgts verbal responses to the auditors
important verbal inquiries thru out the fieldwork.
One purpose is to reduce the possibility of a misunderstanding concerning
mgts responsibility for the F/S and to document the representations made by
mgt during the course of the audit.
This letter complements but does not substitute substantive testing.

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 The members of mgt who are responsible for signing the mgt representations
letter are both CEO and CFO.
It should have the same date the auditors report and cover all periods
included in the audit report whether the current mgt was present or not. Note
the period includes up to the date of audit report not y/end.
If the mgt is unwilling to sign the mgt representations letter then this would be
considered a scope limitation; probably resulting in disclaimer or withdrawal.
A mgt representation letter typically includes the ff:
A reqed item in the mgt representation letter is that the Mgt must
acknowledge its responsibility for the design and implementation of
programs and controls to prevent and detect fraud.
Routinely includes a statement pointing out that senior mgt has no
knowledge of any fraud or suspected fraud involving mgt, which
includes the CFO.
Mgt states that all financial records have been made available.
Materiality is not a consideration.
Mgt states that all minutes have been available. Materiality is not a
consideration.
Mgts compliance with contractual agreements that may affect F/S e.g.
actual or potential litigation claims and assessments. Usually mgt
states that there have been no communications from regulatory
agencies concerning non-compliance with , or deficiencies in, f/rep
practices.
Mgt states that the company has satisfactory title to all owned assets,
and there no liens or encumbrances on such assets nor any asset has
been pledged as collateral.
Disclosure of compensating balances and other arrangements
involving restrictions on cash balances.
There are 2 basic categories of issues usually addressed by the mgt
representations letter
Financial statements
Information provided
Materiality limits would not apply when obtaining written management
representations involving mgt fraud. Because of their nature and related
implications for the control environment, any fraud committed by mgt is
considered to be extremely serious and no materiality limits would apply.
Materiality limits would not apply to the reporting of fraud involving employees
with significant roles in I/C.
Materiality limits would apply to amounts concerning related party
transactions.
Mgts refusal to allow the auditor to review the predecessors work may not
necessarily result in report modification.

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RELATED PARTY
A Related party is one party that controls or can significantly influence the mgt or
operating policies of another party.
Primary focus: to obtain sufficient appropriate audit evidence about whether RP
r/ships and transactions are properly a/ced for and evaluate the adequacy of
disclosure about the RP transactions as required by GAAP.
The auditor should consider any sgf RP transactions outside the entitys normal
course of b/s as sgf risks. E.gs complex equity transactions/acquisitions,
offshore entity transactions, sales with unusually large discounts, circular
arrangements such as repurchase agreements.
Audit procedures to identify existence of RP:
Inquire of mgt as to the existence of RP the auditor will need a lists of RP
from mgt as a starting point.
Review prior years documentation
Review any applicable SEC filings for a public co
Inquire of a predecessor auditors if applicable
Review stockholder listings of closely held companies to identify major
stockholders.
Audit procedures to identify existence of entitys transactions with RP
Review minutes of BOD meetings for activities with RP
Inquire of mgt
Review bank confirmations and other records or documents;
Examine underlying documents for unusual or large transactions with
terms or conditions that are inconsistent with prevailing mkt conditions.
E.g. abnormal interest rates or without stated maturity dates (no
scheduled terms for repayment of funds). Reviewing confirmations of loan
rec/loan pay, guarantees etc..
Audit responsibilities when RP are identified:
Obtain an understanding of the b/s purpose of the RP transaction to
determine the purpose, nature and extent of the RP transactions and their
effects on the F/S. The auditor can inspect contracts with RP, review of
employee whistle blowing reports, background research using internet
Determine if the RP transaction was authorized by BOD (those charged
with governance)
Evaluate the adequacy of the disclosures of the RP transactions.
The auditor should include in the audit documentation the names of the identified
RP and the nature of the RP r/ships and transactions.
The auditor will document the inquiry and mgts response in the mgt
representations letter.
Audit procedures when RP not previously disclosed by mgt now identified:
Communicate info to members of engagement team
Ask mgt to identify all transactions with the newly identified RP

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 Inquire why the entitys controls did not identify RP r/ship
Perform substantive audit procedures
Reconsider the risk that there may be other RP transactions undisclosed.
Evaluate whether mgts failure to disclose the matter might have been
intentional.
Arms length transaction is a transaction conducted on such terms and conditions
between a willing buyer and a willing seller who are unrelated and are acting
independently of each other and pursuing their own best interests. Historical cost
principle is based on the notion that the exchange price negotiated in an arms-
length transaction, which results in an accurate measure of the value
exchanged.

SUBSEQUENT EVENTS
Subsequent events are events or transactions that occur after the b/s date up to the
date of the auditors report which have a material effect on the F/S and therefore,
require either F/S adjustment or disclosure.
Subsequently known facts are facts that become known to the auditor after the
date of the auditors report that , had they been known to the auditor at that date,
may have caused the auditor to revise the report.
A subsequent event requires disclosure only when material events or
circumstances arise after the b/s date.
A subsequent event requires both disclosure and adjustment when material
events or circumstances clarify/provide better info about) circumstances already
in effect as of the b/s date.
Audit procedures to identify subsequent events:
Inquiry of mgt
Review of BOD minutes
Review of lawyers letters in response to inquiry
Scan the a/cing records subsequent to y/end for unusual activities.
Compare most recent interim F/S with the F/S being audited.
Audit procedures when subsequently discovered facts become known to the
auditor (either b4/after the report release date):
Discuss matter with mgt and those charged with governance
Determine whether F/S require revision and how mgt will deal with the
matter.
Audit procedures - If mgt revises the F/S before the report release date then
the auditor should perform appropriate audit procedures on the revision. If mgt
does not revise the F/S and the auditor believes that revision is necessary, the
auditor should appropriately modify the opinion.
Audit procedures if mgt revised the F/S due to subsequently discovered facts that
became known to the auditor after the report release date:

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 The auditor should perform appropriate audit procedures on the revision
The auditor should assess whether mgts actions are appropriate and
timely to inform users about previously issued (erroneous) F/S.
If the resulting option differs from that previously expressed, add an other-
matter paragraph to the auditors report to comment on that change of
opinion.
Auditors responsibilities if Mgt did not revise the F/S and the auditor believes
that revision is necessary:
The auditor should notify mgt and those charged with governance that the
F/S should not be made available to 3rd parties before making necessary
revisions and a new audit report has been provided.
If F/S have been made available to 3rd party then auditor should
determine if mgt has taken timely and appropriate steps to ensure that
users have been informed not to rely on those F/S.
If not taken steps then auditor should notify each member of the BOD of
such refusal and that he/she will take steps to prevent future reliance upon
the audit report.
The auditor would then notify the clients and regulatory agencies that the
report should no longer be associated with the F/S.
Audit procedures that the predecessor auditor performs when reissuing an
audit report
Read the subsequent F/S and compare to those previously audited
Make inquiries of mgt and obtain written representations from mgt
about issues affecting the previous representations obtained from mgt.
Obtain a representations letter from the successor auditor about
known relevant matters.
Dual dating of the auditors report the auditor uses one date for the overall audit
report, but specifies a later date to address a particular subsequent event. The
later date is limited to the specific subsequent event, and does not imply
responsibility for other matters beyond the basic date of the report.
If an auditor has decided to use the original report date when reissuing an audit
report, the auditor is not responsible for reviewing the entitys records,
transactions and events after that original report date.
However, when an auditor dates the entire auditors report at a later date, the
auditor is responsible for considering the F/S effects of all subsequent
events up to that date.
When a material subsequent event requires only disclosure, the auditors report
may either be dual dated or use a single later date applicable to when the
subsequent event was addressed.
Audit Procedure omitted subsequent to issuing a report on audited F/S, when
the auditor discovers that an audit procedure was omitted, the following actions
must be taken:

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 Immediately assess the importance of omitted procedures to the
auditors ability to support the previously expressed opinion.
Next - perform alternative procedures to determine whether the F/S are
fairly stated and whether the previously expressed opinion is appropriate.
i.e. determine whether there are actual misstatements.
If it turns out that there is a material misstatement then the auditor may
have to discuss the matter with governance and also withdraw the report
from known users.
Subsequent performance of an audit procedure previously omitted giving
same results should be documented in the working papers by the auditor.
The auditor need not perform an omitted procedure if the results of
alternative procedures that were performed compensate for the omission.
When a subsequent event occurs requiring adjustment of the F/S but no
disclosure is made, the report will still be dated when sufficient appropriate audit
evidence had been obtained, ie. End of field work date.
The auditors responsibility for the audited F/S ends with the issuance of the
report, unless info existed at the report date and may affect the report come to
the auditors attention.

GOING CONCERN
Reasonable period of time is a period of time not to exceed one year beyond the date of
the F/S being audited.
Indicators that might suggest GC issues:
Negative trends (recurring losses, working capital deficiencies, adverse
key financial ratios, negative CFs from OA)
Internal matters (labor problems, dependence on a single project or
customer)
External matters ( litigation, general decline in the economy or industry)
Other indicators (defaults on debt, violations of debt covenants, denial of
usual trade credit from suppliers

The auditor normally does not need to design audit procedures to specifically
search for GC issues. Routine audit procedures that should identify GC issues:
AP
Review for subsequent events
Review loan agreements for compliance with restrictive debt covenants
Read BOD minutes
Inquire of mgt about legal liability issues and obtain lawyers letters.
When the auditor has substantial doubt about the entitys ability to continue as a
GC, the auditors reporting responsibilities extend to one year after the b/s
date. Auditors evidence-gathering responsibilities regarding GC:

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 Inquire about mgts strategy to overcome the entitys financial difficulties
Evaluate the feasibility of the key elements of mgts plans with emphasis
on mitigating factors.
Obtain written representations from mgt about 2 matters:
1. Mgts plans designed to mitigate the adverse effects of such
conditions and the likelihood that those plans can be executed;
2. Mgts belief that the F/S disclose all relevant matters about the GC
issue of which mgt is aware.
Mitigating factors are those aspects of mgts strategy that might be expected to
improve the entitys cash flows i.e. generate cash inflows or reduce cash
outflows. An auditor would consider mitigating factors such as plans to dispose of
assets, plans to borrow money or restructure debt, plans to reduce or delay
expenditures like R&D, plans to increase ownership equity.

Auditors reporting responsibilities regarding GC:

Consider the adequacy of disclosure about these issues relative to GAAP
or other AFRF
If the F/S, including disclosure, are consistent with the reqs of the AFRF,
the auditor should add an emphasis-of-matter paragraph after the
unmodified opinion paragraph to draw the readers attention to these GC
issues. The phrase used would be: substantial doubt about the entitys
ability to continue as a GC.
Required communication with governance regarding GC:
Nature of conditions identified
The possible effect on F/S and disclosures; and
The effect on auditors report.
Documentation reqs relating to GC issues
The conditions that caused the auditor to believe that there is substantial
doubt about the entitys ability to continue as a GC.
The elements of mgts plans considered particularly important
The procedures the auditor performed to evaluate those sgf elements fo
mgts plans, and the evidence obtained.
The auditors conclusion as to whether substantial doubt about the entitys
ability to continue as a GC for a reasonable period of time remains or is
alleviated by mgts strategy.
The consideration and effect of that conclusion on the auditors report.

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