chapter 14 activities required in completing a quality audit
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CHAPTER 14 ACTIVITIES REQUIRED IN COMPLETING A QUALITY AUDIT. Learning Objectives. Review, summarize, and resolve detected misstatements and identified control deficiencies Review and assess the appropriateness of the client ’ s accounting for and disclosure of loss contingencies - PowerPoint PPT PresentationTRANSCRIPT
A U D I T I N GA RISK-BASED APPROACH TO
CONDUCTING A QUALITY AUDIT
9th Edition
Karla M. Johnstone | Audrey A. Gramling | Larry E. Rittenberg
Copyright © 2014 South-Western/Cengage Learning
CHAPTER 14ACTIVITIES REQUIRED IN COMPLETING A
QUALITY AUDIT
Copyright © 2014 South-Western/Cengage Learning 14-2
Learning Objectives
1. Review, summarize, and resolve detected misstatements and identified control deficiencies
2. Review and assess the appropriateness of the client’s accounting for and disclosure of loss contingencies
3. Review and assess the appropriateness of the client’s significant accounting estimates
4. Review the adequacy of disclosures5. Review and assess the implications of noncompliance
with laws and regulations
Copyright © 2014 South-Western/Cengage Learning 14-3
Learning Objectives
6. Review the appropriateness of the going-concern assumption using relevant professional guidance
7. Perform final analytical review procedures8. Review management representations in
certifications required under the Sarbanes-Oxley Act (for public clients) and describe the contents of a management representation letter
9. Review subsequent events that occur after the balance sheet date and assess proper treatment
Copyright © 2014 South-Western/Cengage Learning 14-4
Learning Objectives
10. Determine how to address situations in which omitted audit procedures come to the auditor’s attention after the audit report has been issued
11. Assess the adequacy of supervision and perform an engagement quality review
12. Identify issues to communicate to the audit committee
13. Identify issues to communicate to management via a management letter
Copyright © 2014 South-Western/Cengage Learning 14-5
Learning Objectives
14. Describe the process by which audit firms make client acceptance and continuance decisions
15. Identify the requirements concerning mandatory partner rotation and mandatory audit firm rotation for publicly traded audit clients
16. Apply the frameworks for professional decision making and ethical decision making to issues involved in completing the audit
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THE AUDIT OPINION FORMULATION PROCESS
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PROFESSIONAL JUDGMENT IN CONTEXT - A Case of Poor Review Quality and Improper Professional Conduct
• The Practice Office Assurance Director for BDO’s Philadelphia office assigned an audit manager to the audit of Hemispherix Biopharma Incorporated • BDO’s internal quality control review team selected
Hemispherix for inspection • Led to the director forcing the manager to sign the audit
papers in spite of the papers not being reviewed
• PCAOB detected the fraud and barred the director from performing audits of public companies for at least one year
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PROFESSIONAL JUDGMENT IN CONTEXT - A Case of Poor Review Quality and Improper Professional Conduct
• During the conduct of the audit engagement, reviews of work performed by lower-level staff are necessary to be sure that audit steps have been competently completed. Toward the end of the audit, what other types of reviews should be conducted? (LO 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11)• Why are engagement quality reviews important? (LO
11)
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PROFESSIONAL JUDGMENT IN CONTEXT - A Case of Poor Review Quality and Improper Professional Conduct
• Why were the director’s actions harmful to the BDO and the Hemispherx audit? (LO 11, 16)• What was the ethical dilemma faced by the
manager? (LO 16)• What alternative courses of action could the director
have taken when he discovered that the engagement had not been reviewed and that it was about to be inspected during the engagement quality review? (LO 10, 11, 16)
Copyright © 2014 South-Western/Cengage Learning
Review, summarize, and resolve detected misstatements and identified control
deficiencies
Learning objective 1
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Reviewing, Summarizing, and Resolving Detected Misstatements
• Misstatement may be:• Difference between the amount reported in the
financial statements and what should be reported under Generally Accepted Accounting Principles (GAAP)• Omission of an amount that should be disclosed in
accordance with GAAP
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Categories of misstatements
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Resolving Detected Misstatements
• Audit firms use a schedule to:• Accumulate known and projected misstatements• Carryover effects of prior-year uncorrected
misstatements• Immaterial misstatements are waived (left
uncorrected)
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EXHIBIT 14.1 - Summary of Possible Adjustments
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Resolving Detected Misstatements
• Materiality of a misstatement is based on:• Quantitative amount of the misstatement• Nature of misstatement to determine the qualitative
features that would make it material
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Auditing in Practice - The PCAOB Position on Management Bias in Correcting Detected
Misstatements
• Decide whether refusal to correct a detected misstatement is indicative of intentional bias• Management bias should lead auditors to reevaluate:• Risk assessments• Risk of fraud
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Additional Considerations for an Integrated Audit
• Assessing whether financial statement misstatements were a result of:• Significant deficiencies in internal control• Material weaknesses in internal control
• Evaluating severity of each individual control deficiency to determine whether it is a material weakness• Accumulating deficiencies less severe than material
weaknesses, on a summary work sheet
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REVIEW AND ASSESS THE APPROPRIATENESS OF THE CLIENT’S ACCOUNTING FOR AND
DISCLOSURE OF LOSS CONTINGENCIES
Learning objective 2
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Reviewing Contingencies
• Categories of potential losses • Probable• Reasonably possible• Remote
• Management is responsible for designing and maintaining policies and procedures to identify, evaluate, and account for contingencies• Auditor is responsible for determining that client has
identified, accounted for , and disclosed contingencies
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Auditing in Practice - Contingent Liabilities at British Petroleum (BP)
• In July 2010, BP released its second quarter earnings report discussing:• Risks associated with ongoing events and cleanup
effort in the Gulf of Mexico due to an oil spill associated with BP
• BP’s auditors should have obtained assurance that the contingency in connection with oil spill was accurately reported and disclosed
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Sources of Audit Evidence related to Contingencies
• Description and evaluation of contingencies• Assurance that accounting
and disclosure requirements have been met• Information about major
contracts in which contingencies may be present
• Documentation of communication the legal counsel of the client• Documentation of
contingent liabilities contained in:• Corporate minutes and
bank confirmations• Correspondence from
governmental agencies
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Letter of Audit Inquiry
• Letter that the auditor asks the client to send to its legal counsel to gather corroborative evidence concerning litigation, claims, and assessments• Legal counsel should be instructed by the client to
respond directly to the auditors• Scope limitation - If a lawyer refuses to furnish the
requested information
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REVIEW AND ASSESS THE APPROPRIATENESS OF THE CLIENT’S SIGNIFICANT ACCOUNTING
ESTIMATES
Learning objective 3
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judgmental estimates included in Financial statement balances
• Fair value of many assets• Net realizable values of inventory and receivables• Property and casualty insurance loss reserves• Revenues from contracts accounted for by
percentage-of-completion method• Warranty expenses and associated liabilities• Depreciation and amortization methods• Impairment of depreciable assets and goodwill
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judgmental estimates included in Financial statement balances
• Useful lives and residual values of productive facilities, natural resources, and intangibles• Valuation and classification of:• Financial instruments• Pensions• Other postretirement benefits
• Compensation in stock option plans
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Reviewing Significant Estimates
• Auditors should be alert to period-end adjusting journal entries• They are responsible for providing assurance that:• Estimates are reasonable• Estimates are presented in conformity with GAAP• Disclosure about estimates is adequate
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Reviewing Significant Estimates
• Management estimates are based on:• Subjective factors• Objective factors
• Events or transactions useful in identifying and evaluating reasonableness of estimates occur:• After balance sheet date• Before audit report date
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Reviewing Significant Estimates
• Auditor should focus on factors and assumptions that are:• Significant to accounting estimate• Sensitive to variations• Deviations from historical patterns• Subjective and susceptible to misstatement and bias• Inconsistent with current economic trends
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Auditing in Practice - PCAOB Fines Ernst & Young for an Issue Involving Accounting Estimates
• Medicis’ management convinced their audit partners that their revenue recognition policy was acceptable • Even though it violated GAAP
• National-level consultation experts suggested that partners involved in the Medicis audit were incorrect• After investigation PCAOB imposed a penalty on:• Ernst & Young • Individual partners on Medicis engagement
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Review the adequacy of disclosures
Learning objective 4
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Reviewing the Adequacy of Disclosures
• Auditor’s report must indicate if disclosures are not reasonably adequate• Disclosures can be made:• On face of financial statements • In form of classifications or parenthetical notations
• In notes to statements
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Auditing in Practice - Related Party Disclosures at OAO Gazprom
• Company’s International Financial Reporting Standards (IFRS) based disclosures led to difficulty for PwC due to: • Complex nature of related-party transactions • High-level interrelationships between executives in
companies operating in the Federation
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Reasonable assurance that auditors should have When assessing adequacy of disclosures
• Disclosed events and transactions have occurred and pertain to the entity• All disclosures that should have been included• Disclosures are understandable to users• Information is disclosed accurately and at
appropriate amounts
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Review and assess the implications of noncompliance with laws and regulations
Learning objective 5
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AUDITORS’ RESPONSIBILITIES REGARDING CLIENTS’ NONCOMPLIANCE WITH LAWS AND REGULATIONS
• Noncompliance: Acts of omission or commission, either intentional or unintentional, contrary to prevailing laws or regulations• Limitations in an auditor’s ability to detect material
misstatements• Information systems relating to financial reporting may
not capture noncompliance
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AUDITORS’ RESPONSIBILITIES REGARDING CLIENTS’ NONCOMPLIANCE WITH LAWS AND REGULATIONS
• Management may: • Act to conceal noncompliance• Override controls• Intentionally misrepresent facts to the auditor
• Legal implications of noncompliance are ultimately a matter for legal authorities to resolve
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Auditing in Practice - Triton Energy and Noncompliance with Laws and Regulations
• When violations like these occur the auditor should notify audit committee about:• The violations • Their circumstance• The effect on the financial statements
• Consider whether risk assessments made prior to knowledge of violations are still appropriate
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main provisions of FCPA for Companies with securities listed on U.S. markets
• Anti-bribery provision - No company may make a payment to a foreign official for obtaining or retaining business• Financial records should accurately reflect transactions • Adequate system of internal accounting controls
should be designed and maintained• Certain payments to foreign officials are acceptable• Grease payments - Made to an official to expedite
performance of his duties
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Review the appropriateness of the going-concern assumption using relevant professional
guidance
Learning objective 6
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Evaluating the Going-Concern Assumption
• Responsibility of management - Assessing company’s going concern status for a reasonable period of time• Reasonable period of time: A period of time not to
exceed one year beyond the date of the financial statements being audited
• Responsibility of auditor - Evaluating appropriateness of that assessment• Use of bankruptcy prediction models to analyze
whether a particular client might have a going-concern problem
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EXHIBIT 14.3 - Going-Concern Process
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Evaluating the Going-Concern Assumption
If substantial doubt about entity’s ability to continue as a
going concern is alleviated
Consider disclosure of conditions that initially
caused auditor to believe there was substantial
doubt
Consider possible effects of such conditions or
events, and any mitigating factors, including
management’s plans
If substantial doubt about entity’s ability to continue as a going concern for a reasonable
period of time remains
Include an emphasis-of-matter paragraph in
auditor’s report to reflect that conclusion
Audit report will include phrase - Substantial doubt
about entity’s ability to continue as a going
concern
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Reasons auditors might resist issuing a going-concern audit opinion
• It can be a self-fulfilling prophecy that the company will go bankrupt• It is difficult to know beforehand whether a
financially distressed client will:• Cease operations • Pull itself away from that outcome
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Indicators of Potential Going-Concern Problems
• Negative trends• Internal matters• External matters• Significant changes in:• Competitive market • Competitiveness of client’s products
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Indicators of Potential Going-Concern Problems
• Altman Z-scores: Series of ratios that have predictive power in indicating the likelihood of bankruptcy• Five-ratio model - For publicly owned manufacturing
companies• Four-ratio model - For public or privately owned
manufacturing and service companies
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EXHIBIT 14.4 - Altman Z-Score Models
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Mitigating Factors for a going-concern problem
• Identify and assess management’s plans to overcome this problem • Identify factors most likely to resolve the problem
and gather independent evidence to determine success of such plans• Consider, and independently test, adequacy of
support for major assumptions
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Mitigating Factors for a going-concern problem
• Evaluating reasonableness of other assumptions made by the management• Increasing prices or market share is analyzed in
relation to current industry developments• Cost savings related to a reduction in work force is
recomputed and evaluated • Selling off assets is evaluated in relation to current
market prices
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Perform final analytical review procedures
Learning objective 7
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Four-step process for using analytical procedures
Develop an expectation
Define when difference between auditor’s expectation and client’s balance would be considered significant
Compute the difference between auditor’s expectation and client’s balance
Follow up on significant differences
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Techniques used for analytical procedures
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Review management representations in certifications required under the Sarbanes-Oxley Act (for public clients)
and describe the contents of a management representation letter
Learning objective 8
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Certifications Required under Sarbanes-Oxley Act of 2002 (SOX) for Public Companies
• Signing officers of publicly traded companies required to certify that financial statements are fairly presented in accordance with GAAP• Management representation letter: Letter to the
auditors that the client’s chief executive and chief financial officers are required to sign • Specifies management’s responsibility for the financial
statements • Confirms oral responses given to the auditor during
the audit
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management representation letter
• Purpose is to help promote audit quality by:• Reminding management of its responsibility for
financial statements• Confirming oral responses obtained by auditor• Reducing the possibility of misunderstanding
• Management’s refusal to sign the letter:• Implies their untruthfulness in verbal representations• Considered a scope limitation
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Review subsequent events that occur after the balance sheet date and assess proper treatment
Learning objective 9
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Reviewing Subsequent Events and Subsequently Discovered Facts
• Events occurring after balance sheet date that require special audit attention• Those that provide evidence of conditions that existed
at the date of financial statements• Those that provide evidence of conditions that arose
after the date of financial statements
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EXHIBIT 14.8 - Subsequent Periods
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Review of Subsequent Events
• Subsequent events: Occur between the date of the financial statements and date of the auditor’s report• Subsequent events review: Review of events in the
period between the balance sheet date and the audit report date to determine their effect on the financial statements
• Type I subsequent events: Existed at the balance sheet date (adjustment to financial statements)• Type II subsequent events: Did not exist at balance
sheet date (disclosure)
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Auditing in Practice - Deloitte, Ligand, and the PCAOB: A Case where Subsequent Events were Important
• Audit plan required procedure related to product returns• After year end• Before completion of audit
• Audit plan was not:• Executed by Deloitte personnel• Adequately reviewed by Fazio
• Deloitte resigned from Ligand engagement in 2004• Ligand restated its 2002, 2003, and some of its 2004
financial statements
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Audit Procedures Concerning the Review of Subsequent Events
• Cutoff tests• Reviewing subsequent collections of receivables• Searching for unrecorded liabilities• Reading minutes of meetings • Reading and comparing interim financial statements
to audited financial statements• Inquire of management concerning:• Significant changes noted in the interim statements
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Audit Procedures Concerning the Review of Subsequent Events
• Existence of significant contingent liabilities or commitments at balance sheet date or date of inquiry• Significant changes in working capital, long-term debt,
or owners’ equity• Status of items for which tentative conclusions were
drawn earlier in audit• Any unusual adjustments made to accounting records
after balance sheet date
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Dual Dating
• Awareness of an event occurring after audit report date but before report release date• Report release date: Grant of permission to the entity
to use the auditor’s report in connection with financial statements
• Options for dating the audit report:• Using date of this event as date of audit report• Dual-date the report
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Subsequently Discovered Facts That Become Known to Auditor after Report Release Date
• If facts had been know at the report date, then auditor should determine:• Reliability of new information• Whether development or event had occurred by
report date• Whether users are likely to still be relying on financial
statements• Whether audit report would have been affected had
facts been known at report date
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Appropriate action for Subsequently Discovered Facts
• Key action - Notify users very soon so they do not continue to rely on incorrect information • If possible quickly revise and distribute financial
statements and audit report• Reasons for revision described in a footnote and
referred to in auditor’s report• Revision and explanation can be made in subsequent-
period audited financial statements if distribution is imminent
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Subsequently Discovered Facts That Become Known to Auditor after Report Release Date
• If extended amount of time is needed to develop revised financial statements, notify users that: • Previously distributed financial statements and auditor’s
report should no longer be relied on• Revised statements and report will be issued as soon as
possible
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Subsequently Discovered Facts That Become Known to Auditor after Report Release Date
• For clients who do not cooperate, notify:• Client and regulatory agency having jurisdiction over it
that audit report should no longer be associated with client’s financial statements• Users that audit report should no longer be relied on
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DETERMINE HOW TO ADDRESS SITUATIONS IN WHICH OMITTED AUDIT PROCEDURES COME TO THE AUDITOR’S ATTENTION AFTER THE AUDIT REPORT HAS BEEN ISSUED
Learning objective 10
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Consideration of Omitted Procedures Discovered after the Report Date
• Omitted procedure: After the audit report has been issued, auditor may discover that an important audit procedure was not performed• If previously issued audit report cannot be supported
in light of omitted procedures• Alternative procedures should be promptly performed
and documented
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Assess the adequacy of supervision and perform an engagement quality review
Learning objective 11
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Performing an Engagement Quality Review
• Engagement quality review (Concurring partner review): Review at the end of each audit conducted by an experienced auditor having appropriate competence, independence, integrity, and objectivity• To help make sure that audit and audit documentation
are complete and support audit opinion
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Performing an Engagement Quality Review
• Procedures that reviewer should perform as part of the review process• Discussing with audit team significant matters related
to financial statements and internal controls• Evaluating judgments about materiality and disposition
of corrected and uncorrected identified misstatements• Reviewing evaluation of firm’s independence in
relation to engagement
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Performing an Engagement Quality Review
• Reviewing related audit documentation to determine its sufficiency• Reading financial statements, management’s report on
internal control, and auditor’s report• Confirming with lead audit partner that there are no
significant unresolved matters• Determining if appropriate consultations have taken
place on difficult or contentious matters
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Performing an Engagement Quality Review
• Evaluating whether:• Auditor documentation supports conclusions reached by
engagement team • Appropriate matters have been communicated to audit
committee members, management, and other appropriate parties• Appropriate levels of supervision and reviews of
individual audit tasks were completed
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Identify issues to communicate to the audit committee
Learning objective 12
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Reasons for External Auditors to Communicate with the Audit Committee
• Audit committee serves as an independent subcommittee of board of directors• Audit committee can assist auditor during a
disagreement between the auditor and management• Audit committee must be assured that auditor:• Is free of any restrictions • Has not been inappropriately influenced by the
management
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typical communications between the auditor and the audit committee
• Auditor’s responsibility under generally accepted auditing standards• Overview and planned scope of audit• Independence• Significant accounting policies• Management judgments and accounting estimates• Significant audit adjustments• Judgments about quality of company’s accounting
principles
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typical communications between the auditor and the audit committee
• Other information in annual reports• Disagreements with management• Major issues discussed with management before
retention• Internal control over financial reporting
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Auditing in Practice - Guidance on Assessing the Quality, Not Just the Acceptability, of Significant Accounting
Policies
• Consistency of organization’s accounting principles and their application• Clarity and completeness of financial statements and
related disclosures• Presence of items that have an impact on the
representational faithfulness, verifiability, and neutrality of the accounting information included in the financial statements• Use of accounting practices by the company that are
not specifically addressed in the accounting literature
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Identify issues to communicate to management via a management letter
Learning objective 13
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Communicating with Management via the Management Letter
• Management letter: From the auditor to the client identifying any problems and suggested solutions to improve management’s efficiency or effectiveness• Used to make significant operational or control
recommendations to client
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Issues Relating to Audit Firm Portfolio Management, Audit Partner Rotation, and Audit Firm Rotation
• Audit firm portfolio management - Deciding whether to:• Continue providing audit services to client • Begin providing services to a new client
• Consider mandatory partner rotation and mandatory audit firm rotation requirements for publicly traded audit clients
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Describe the process by which audit firms make client acceptance and continuance decisions
Learning objective 14
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Client Acceptance and Continuance Decisions
• Decisions taken by audit firms and individual engagement partners immediately before agreeing to conduct an audit or after completing audit • Called client acceptance and continuance decisions• Client acceptance decision: When a new client is
evaluated by the audit firm and individual engagement partner prior to being accepted into the audit firm’s portfolio of clients
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EXHIBIT 14.9 - Audit Firm Portfolio Management
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Client Acceptance and Continuance Decisions
• Client continuance decision: When existing clients are evaluated by the audit firm and individual engagement partner at the completion of the audit to determine whether the audit firm should continue to provide services again in the next period
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Client Acceptance and Continuance-Related Risks
• Client entity characteristics• Independence risk factors• Third party /due diligence risk factors• Quantitative risk factors• Qualitative risk factors• Entity organizational or governance risks• Financial reporting risks
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Reasons for not providing audit services to a client
• Client does not fit the profile that the firm requires to achieve its growth strategy• Client not in an industry that the firm wants to
emphasize• Client’s growth not feasible for firm anymore• Client being potentially problematic
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Auditing in Practice - Why Might an Audit Firm Refuse to Continue Providing Services to a Client?
• Developments that undermine the ability of the audit firm to rely on the representations of management• Recently identified falsity of records • Deliberate interference by the management in the
audit process• Unlawful retention of audit files
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Identify the requirements concerning mandatory partner rotation and mandatory audit firm rotation for publicly
traded audit clients
Learning objective 15
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Partner Rotation and Audit Firm Rotation
• Familiarity threat occurs when auditor has a longstanding relationship with an important person associated with the client• Having a longstanding relationship with client could:• Aid audit quality • Knowledge that partner and members of engagement
team gain through time• Impair auditor’s willingness or ability to perform an
unbiased assessment of audit evidence
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Auditing in Practice - KPMG andGeneral Electric Company
• The United Brotherhood of Carpenters Pension Fund, a shareholder, filed a letter and proposal to General Electric • Requesting to consider implementing an audit firm
rotation policy every seven years• Proposal was ignored by company, and was not put
to vote• Shows that General Electric and KPMG are not
supportive of the mandatory audit firm rotation
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Partner Rotation and Audit Firm Rotation
• Differences exist internationally in terms of:• Requirement of rotation• Length of time:• Auditor or audit firm may serve before rotation• Of a cooling off period• Cooling off period: Number of years after which individual
auditor or audit firm may resume its prior role with audit client
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EXHIBIT 14.10 - U.S. and International Guidance on Mandatory Audit Partner Rotation and Mandatory
Audit Firm Rotation