Completion and review

Introduction

After the auditor has completed their substantive testing there are still many procedures that need to be performed before they can sign the auditor’s report. These include:

2 Subsequent events

ISA 560 Subsequent Events, para 4, requires the auditor to:

Obtain sufficient appropriate audit evidence about whether events occurring between the date of the financial statements and the date of the auditor’s report, that require adjustment or disclosure are appropriately reflected in accordance with the applicable financial reporting framework.

Respond appropriately to facts that become known to the auditor after the date of the auditor’s report.

IAS 10 Events After the Reporting Period identifies two types of event after the reporting period:

Adjusting

Non-adjusting.

Illustration 1 – Adjusting and non-adjusting events

Adjusting events

These are events that provide additional evidence relating to conditions existing at the reporting date. Such events provide new information about the items included in the financial statements and hence the financial statements should be adjusted to reflect the new information.

Examples of adjusting events include:

Allowances for damaged inventory and doubtful receivables.

Amounts received or receivable in respect of insurance claims which were being negotiated at the reporting date.

The determination of the purchase or sale price of non-current assets purchased or sold before the year-end.

Agreement of a tax liability.

Discovery of errors/fraud revealing that the financial statements are incorrect.

Non-adjusting events

These are events concerning conditions which arose after the reporting date. If material, disclosure is required in the notes to the financial statements indicating what effect the events may have. Such events, therefore, will not have any effect on items in the statements of financial position or statement of profit or loss for the period.

Examples of non-adjusting events include:

Issue of new share or loan capital.

Major changes in the composition of the group (for example, mergers, acquisitions or reconstructions).

Losses of non-current assets or inventory as a result of fires or floods.

Strikes, government action such as nationalisation.

Purchases/sales of significant non-current assets.

(IAS 10 Events After the Reporting Period)

Auditor responsibilities

Between the date of the financial statements and the date of the auditor’s report

The auditor should perform procedures to identify events that might require adjustment or disclosure in the financial statements.

[ISA 560, 6]

If material adjusting events are not adjusted for, or material non-adjusting events are not disclosed, the auditor will ask management to make the necessary amendments to the financial statements.

If the identified adjustments or disclosures necessary are not made then the auditor should consider the impact on the auditor’s report and whether a modification is necessary.

Subsequent events procedures

Enquiring of the directors if they are aware of any events, adjusting or non-adjusting, that have not yet been included or disclosed in the financial statements.

Enquiring into management procedures/systems for the identification of events after the reporting period.

Reading minutes of members’ and directors’ meetings.

Reviewing accounting records including budgets, forecasts, cash flows, management accounts and interim information.

[ISA 560, 7]

Obtaining a written representation from management confirming that they have informed the auditor of all subsequent events and accounted for them appropriately in the financial statements. [ISA 560, 9]

Inspection of correspondence with legal advisors.

Reviewing the progress of known risk areas and contingencies.

Considering relevant information which has come to the auditor’s attention, from sources outside the entity, including public knowledge, competitors, suppliers and customers.

Inspecting after date receipts from receivables.

Inspecting the cash book after the year-end for payments/receipts that were not accrued for at the year-end.

Inspecting the sales price of inventories after the year-end.

Between the date of the auditor’s report and the date the financial statements are issued

The auditor is under no obligation to perform audit procedures after the auditor’s report has been issued, however, if they become aware of a fact which would cause them to issue a modified report, they must take action. [ISA 560, 10]

This will normally be in the form of asking the client to amend the financial statements, auditing the amendments and reissuing the auditor’s report.

If management do not amend the financial statements and the auditor’s report has not yet been issued to the client, the auditor can still modify the opinion. [ISA 560, 13a]

If the auditor’s report has been provided to the client, the auditor shall notify management and those charged with governance not to issue the financial statements before the amendments are made.

If the client issues the financial statements despite being requested not to by the auditor, the auditor shall take action to prevent reliance on the auditor’s report. [ISA 560, 13b]

After the financial statements are issued

The auditor is under no obligation to perform audit procedures after the financial statements have been issued, however, if they become aware of a fact which would have caused them to modify their report, they must take action.

The auditor should discuss the matter with management and consider if the financial statements require amendment.

[ISA 560, 14]

Management must also take the necessary actions to ensure anyone who is in receipt of the previously issued financial statements is informed. [ISA 560, 15b]

The auditor should perform audit procedures on the amendments to ensure they have been put through correctly. [ISA 560, 15a]

Issue a new auditor’s report including an emphasis of matter or other matter paragraph to draw attention to the fact that the financial statements and auditor’s report have been reissued. [ISA 560, 16]

If management refuses to recall and amend the financial statements, the auditor shall take action to prevent reliance on the auditor’s report.

[ISA 560, 17]

Test your understanding 1

Murray case study: Subsequent events review for the year-ended 31 December 20X4

On 2 January 20X5, Golf is Us, a major customer of Murray Co, was placed into administration owing $211,000.

On 3 January 20X5, the sales director left the company. The sales director is suing Murray Co for constructive dismissal. If successful, the claim amounts to $280,000.

On 5 February 20X5 there was a fire at the premises of the third party warehouse provider, which destroyed all inventory held there. Approximately one half of Murray Co’s inventory was stored in these premises. The total value of inventory stored at the premises was $1,054,000.

The financial statements include a $40,000 provision for an unfair dismissal case brought by an ex-employee of Murray Co. On

7 February 20X5 a letter was received from the claimant’s solicitors stating that they would be willing to settle out-of-court for $25,000. It is likely the company will agree to this.

Financial statement extracts	31 Dec 20X4	31 Dec 20X3
	$000	$000
Revenue	21,960	19,580
Total assets	9,697	7,288
Profit before tax	1,048	248

Required:

For each of the events above discuss whether the financial statements require amendment in order to avoid a modified audit opinion.

3 Going concern

The going concern concept

Going concern is the assumption that the entity will continue in business for the foreseeable future.

The period that management (and therefore the auditor) is required to consider is the period required by the applicable financial reporting framework or by law or regulation if longer. [ISA 570, 13]

Generally the period is a minimum of twelve months from the year-end. In some jurisdictions the period is a minimum of twelve months from the date the financial statements are approved (e.g. the UK).

Consideration of the foreseeable future involves making a judgment about future events, which are inherently uncertain. [ISA 570, 5]

Uncertainty increases with time and judgments can only be made on the basis of information available at any point. Subsequent events can overturn that judgment.

The going concern concept – significance

Whether or not a company can be classed as a going concern affects how its financial statements are prepared.

Financial statements are prepared on the basis that the reporting entity is a going concern.

An entity shall prepare financial statements on a going concern basis, unless

– management either intends to liquidate the entity or to cease trading, or

– has no realistic alternative but to do so.

(ISA 570, 2)

Where the assumption is made that the company will cease trading, the financial statements are prepared using the break-up or liquidation basis under which:

– The basis of preparation and the reason why the entity is not regarded as a going concern are disclosed.

– Assets are recorded at likely sale values.

– Inventory and receivables may need to be written down as inventory may be sold for a lower price or may be scrapped, and receivables may not pay if they know the company is ceasing to trade.

– Additional liabilities may arise (redundancy costs for staff, the costs of closing down facilities, etc.).

Responsibilities for going concern

Director’s responsibilities in respect of going concern

It is the directors’ responsibility to assess the company’s ability to continue as a going concern when they are preparing the financial statements.

[ISA 570, 4]

In order to do this the directors should prepare forecasts to help assess whether they are likely to be able to continue trading for the next 12 months as a minimum.

If they are aware of any material uncertainties which may affect this assessment, the directors should disclose these in the financial statements.

When the directors are performing their assessment they should take into account a number of relevant factors such as:

– Current and expected profitability

– Debt repayment

– Sources (and potential sources) of financing.

Auditor’s responsibilities in respect of going concern

ISA 570 Going Concern [para 9] states that the auditor shall:

Obtain sufficient appropriate evidence regarding the appropriateness of management’s use of the going concern basis of accounting in the preparation of the financial statements.

Conclude on whether a material uncertainty exists about the entity’s ability to continue as a going concern.

Report in accordance with ISA 570.

Indicators of going concern problems

Typical indicators and explanations of going concern problems include the following:

Net current liabilities (or net liabilities overall): indicates an inability to meet debts as they fall due.

Borrowing facilities not agreed or close to expiry of current agreement: lack of access to cash may make it difficult for a company to manage its operating cycle.

Defaulted loan agreements: loans normally become repayable on default, the company may find it difficult to repay loan.

Unplanned sales of non-current assets: indicates an inability to generate cash from other means and as non-current assets generate income, will cause a decline in income and therefore profits.

Missing tax payments: results in fines and penalties, companies normally prioritise tax payments indicating a lack of working capital.

Failure to pay the staff: indicates a significant lack of working capital.

Negative cash flow: indicates overtrading.

Inability to obtain credit from suppliers: suggests failure to pay suppliers on time and working capital problems.

Major technology changes: inability or insufficient funds to keep up with changes in technology will result in loss of custom and obsolescence of inventory.

Legal claims: successful legal claims may result in significant cash payments that can only be settled with liquidation.

Loss of key staff: may result in an inability to trade.

Over-reliance on a small number of products, staff, suppliers or customers: loss may result in inability to trade.

Customers ceasing to trade or having cash flow difficulties: likely to become an irrecoverable debt and therefore payment won’t be received.

Emergence of a successful competitor: will impact revenue if customers switch.

Uninsured/under-insured catastrophes: the company may not have enough cash to survive.

Changes in laws and regulations: the cost of compliance may be more than the company can afford.

Audit procedures to assess management’s evaluation of going concern

Evaluate management’s assessment of going concern. [ISA 570, 12]

Assess the same period that management have used in their assessment and if this is less than 12 months, ask management to extend their assessment. [ISA 570, 13]

Consider whether management’s assessment includes all relevant information. [ISA 570, 14]

Audit procedures to perform where there is doubt over going concern

Analyse and discuss cash flow, profit and other relevant forecasts with management. This should include assessment of the reasonableness of the assumptions used to prepare the forecasts.

Analyse and discuss the entity’s latest available interim financial statements.

Review the terms of debentures and loan agreements and determining whether any have been breached.

Read minutes of the meetings of shareholders, the board of directors and important committees for reference to financing difficulties.

Enquire of the entity’s lawyer regarding the existence of litigation and claims and the reasonableness of management’s assessments of their outcome and the estimate of their financial implications.

Confirm the existence, legality and enforceability of arrangements to provide or maintain financial support with related and third parties and assess the financial ability of such parties to provide additional funds.

Review events after the year-end to identify those that either mitigate or otherwise affect the entity’s ability to continue as a going concern.

Review correspondence with customers for evidence of any disputes that might impact recoverability of debts and affect future sales.

Review correspondence with suppliers for evidence of issues regarding payments that might impact the company’s ability to obtain supplies or credit.

Review correspondence with the bank for indication that a bank loan or overdraft may be recalled.

Obtain written representations from management regarding its plans for the future and how it plans to address the going concern issues.

Exam tip

Audit procedures should focus on cash flows rather than profits. A company can continue to trade as long as it can pay its debts when they fall due. Therefore suggest procedures to obtain evidence about the amount of cash that is likely to be received and the amount of cash that it likely to be paid out and consider whether there is any indication of cash flow difficulties.

Disclosures

Disclosures relating to going concern are required to be made by the directors in the following circumstances:

Where there is any material uncertainty over the future of a company, the directors should include disclosure in the financial statements.

A material uncertainty exists when the magnitude of its potential impact and likelihood of occurrence is such that disclosure of the nature and implications of the uncertainty is necessary for the fair presentation of the financial statements and for the financial statements not to be misleading. [ISA 570, 18]

The disclosure should explain:

– the principal events or conditions that cast significant doubt on the entity’s ability to continue as a going concern and management’s plans to deal with them

– the company may be unable to realise its assets and discharge its liabilities in the normal course of business.

[ISA 570, 19]

Where the directors have been unable to assess going concern in the usual way (e.g. for less than one year beyond the date on which they sign the financial statements), this fact should be disclosed.

Where the financial statements are prepared on a basis other than the going concern basis, the basis used should be disclosed.

Reporting implications

The auditor should modify the audit opinion if the directors have not made adequate disclosure of any material uncertainty related to going concern or if the directors have not prepared the financial statements on the appropriate basis.

The auditor should modify the auditor’s report without modifying the audit opinion if the directors have appropriately disclosed going concern uncertainties or prepared the financial statements on the break-up basis.

Reporting implications in relation to going concern are covered in more detail in the Reporting .

Examination of a cash flow forecast

One way of assessing the client’s ability to continue as a going concern is to examine the reasonableness of the assumptions used to prepare the cash flow forecast.

The following procedures are typical of those that would be performed in the examination of a cash flow forecast. They are generic procedures.

Procedures in the examination of a cash forecast would include:

Agree the opening balance of the cash forecast to the cash book, to ensure accuracy.

Consider how reasonable company forecasts have been in the past by comparing past forecasts with actual outcomes. If forecasts have been reasonable in the past, this would make it more likely that the current forecast is reliable.

Determine the assumptions that have been made in the preparation of the cash flow forecast. For example, if the company is operating in a poor economic climate, you would not expect cash flows from sales and realisation of receivables to increase, but either to decrease or remain stable. If costs are rising you would expect payments to increase in the cash flow forecast.

Agree the timing of receipts from realisation of receivables and payments to suppliers with credit periods and previous trade receivables and payables payment periods.

Examine the company’s detailed budgets for the forecast period and discuss any specific plans with the directors.

Examine the assessment of the non-current assets required to meet production needs. Agree cash outflows for non-current assets to supplier quotations.

For acquisitions of buildings, agree the timing and amount of cash outflows to the expected completion date and consideration in the sale and purchase agreement.

Consider the adequacy of the increased working capital and the working capital cash flows included in the forecast.

If relevant, inspect post year management accounts to compare the actual performance against the forecast figures.

Recalculate the cash flow forecast balances to verify arithmetical accuracy.

Inspect board minutes for any other relevant issues which should be included within the forecast.

Test your understanding 2

Murray case study: Going concern review for the year-ended 31 December 20X4

On 2 January 20X5, Golf is Us, a major customer of Murray Co, was placed into administration owing $211,000.

On 3 January 20X5, the sales director left the company and has yet to be replaced. The sales director is suing Murray Co for constructive dismissal.

On 5 January 20X5 there was a fire at the premises of the third party warehouse provider, which destroyed all inventory held there. Approximately one half of Murray Co’s inventory was stored in these premises.

The assembly line for ergometers (rowing machines) was refurbished during the year at a cost of $1m. The additional $1.5m loan facility provided to Murray Co during the year is secured, in part, on the refurbished assembly line. The assembly line broke down during January and six weeks later is still not working.

The company is seeking new funding through an initial public offering of shares in the company (i.e. listing on the stock exchange). In the event that the initial public offering does not proceed, this will require Murray Co’s existing banking arrangements to be renegotiated and additional funding to be raised from either existing or new investors.

The financial statements of Murray Co show an overdraft at 31 December 20X4 of $ 180,000 (20X3: $120,000). The overdraft limit is $250,000. The cash flow forecast shows negative monthly cash flows for the next twelve months. As a result of cash shortages in February 20X5, a number of suppliers were paid late.

Required:

Using the information provided, explain the potential indicators that Murray Co is not a going concern.

4 Overall review of the financial statements

Before forming an opinion on the financial statements and deciding on the wording of the auditor’s report, the auditor should conduct an overall review.

The auditor should perform the following procedures:

Review the financial statements to ensure:

– Compliance with accounting standards and local legislation disclosure requirements. This is sometimes performed using a disclosure checklist.

– Accounting policies are sufficiently disclosed and to ensure that they

are in accordance with the accounting treatment adopted in the financial statements.

– They adequately reflect the information and explanations previously obtained and conclusions reached during the course of the audit.

Perform analytical procedures to corroborate conclusions formed during the audit and assist when forming an overall conclusion as to whether the financial statements are consistent with the auditor’s understanding of the entity. [ISA 520, 6]

Review the aggregate of the uncorrected misstatements to assess whether a material misstatement arises. If so, discuss the potential adjustment with management.

The purpose of review procedures

Review forms part of the engagement performance quality control procedures covered in the Planning .

As part of the overall review, the auditor should assess whether:

The audit work was performed in accordance with professional standards.

Significant matters have been raised for further consideration and appropriate consultations have taken place.

There is a need to revise the nature, timing and extent of the work performed.

The audit evidence gathered by the team is sufficient and appropriate to support the audit opinion and report.

[ISA 220, A17]

Initial assessments made at the start of the audit are still valid in light of the information gathered during the audit.

The audit plan was properly flexed to meet any new circumstances.

5 Evaluation of misstatements

The auditor must consider the effect of misstatements on both the audit procedures performed and ultimately, if uncorrected, on the financial statements as a whole. Guidance on how this is performed is given in ISA 450 Evaluation of

Misstatements Identified During the Audit.

In order to achieve this the auditor must:

Accumulate a record of all identified misstatements, unless they are clearly trivial. [ISA 450, 5]

Consider if the existence of such misstatements indicates that others may exist, which, when aggregated with other misstatements, could be considered material. [ISA 450, 6a]

If so, consider if the audit plan and strategy need to be revised. [ISA 450, 6]

Report all accumulated misstatements to an appropriate level of management on a timely basis and request that all misstatements are [ISA 450, 8]

If management refuses to correct some or all of the misstatements the auditor should consider their reasons for refusal and take these into account when considering if the financial statements are free from material misstatement. [ISA 450, 9]

Evaluation of uncorrected misstatements

If management have failed to correct all of the misstatements reported to them, the auditor should:

Reassess materiality to determine whether it is still appropriate in the circumstances as the level of risk may be deemed higher as a result of management’s refusal. [ISA 450, 10]

Determine whether the uncorrected misstatements, either individually or in aggregate, are material to the financial statements as a whole, considering both the size and nature of the misstatements and the effect of misstatements related to prior periods (e.g. on corresponding figures, comparatives and opening balances). If an individual misstatement is considered material it cannot be offset by other misstatements.

[ISA 450, 11]

Report the uncorrected misstatements to those charged with governance and explain the effect this will have on the audit opinion. [ISA 450, 12]

Request a written representation from those charged with governance that they believe the effects of uncorrected misstatements are immaterial. [ISA 450, 14]

Evaluation of misstatements

You are at the completion stage of the audit of Murray Co. The profit before tax for the year is $1,048,000 and total assets are $9,697,000. The following matters have not been corrected by management and have been left for your attention:

An irrecoverable debt of $211,000 has not been written off.

An adjustment to a provision relating to the unfair dismissal of an ex-employee of $15,000 has not been made.

Website development costs of $50,000 were incorrectly capitalised.

Work in progress was overvalued by $45,000.

All of these misstatements must be communicated to management and requested to be adjusted in accordance with ISA 450.

The irrecoverable debt must be written off to avoid a modified opinion as it is individually material. A material misstatement cannot be off-set by other misstatements.

Even if management agree to write-off the irrecoverable debt, the other uncorrected misstatements are material in aggregate even though they are not material individually.

The adjustments required are:

Provision: DR Provision (SFP), CR Provision expense (P&L) – $15,000

Website development costs: DR Expenses (P&L), CR Website development costs (SFP) – $50,000

Work in progress: DR Closing inventory (P&L), CR Inventory (SFP)

– $45,000.

The overall adjustment required to the P&L is $80,000. This represents 7.6% of PBT and is material.

The misstatements will need to be adjusted to avoid a modified opinion.

Written representations

A written representation is: A written statement by management provided to the auditor to confirm certain matters or to support other audit evidence. [ISA 580 Written Representations, 7].

Purpose of written representations

ISA 580 Written Representations requires the auditor to obtain written representations from management:

That they have fulfilled their responsibilities for the preparation of the financial statements.

That they have provided the auditor with all relevant information.

That all transactions have been recorded and reflected in the financial statements.

To support other audit evidence relevant to the financial statements or specific assertions if deemed necessary by the auditor.

As required by specific ISAs.

[ISA 580, 6]

A representation to support other audit evidence may be appropriate where more reliable forms of evidence are not available, particularly in relation to matters requiring management judgment or knowledge restricted to management. Examples include:

Whether the selection and application of accounting policies are appropriate.

Whether the following matters have been measured, presented and disclosed in accordance with the relevant financial reporting framework:

– Plans or intentions that may affect the carrying value or classification of assets and liabilities.

– Liabilities, both contingent and actual.

– Title to, or control over, assets.

– Aspects of laws, regulations and contractual agreements that may affect the financial statements, including non-compliance.

That the directors have communicated all deficiencies in internal control to the auditor.

Specific assertions about classes of transactions, accounts balances and disclosures requiring management judgment.

[ISA 580, A10]

Note that written representations cannot be a substitute for more reliable evidence that should be available and do not constitute sufficient appropriate evidence on their own, about any of the matters with which they deal. [ISA 580, 4]

Written representations should only be sought to support other audit evidence.

Process for obtaining a written representation

In practice, the auditor will often draft the wording of the written representation letter but it must be printed on client headed paper, addressed to the auditor and signed by the client.

The letter must be signed by an appropriate senior member of client management, with appropriate responsibilities for the financial statements and knowledge of the matters concerned. This would normally be the chief executive and chief financial officer.

The date of the written representation letter should be the same as the date the financial statements are authorised. It must be obtained and signed before the auditor’s report is finalised.

Reliability of written representations

Written representations are client generated, and may be subject to bias. It is therefore a potentially unreliable form of audit evidence.

The auditor must consider the reliability of written representations in terms of:

Inconsistencies with other forms of evidence.

Concerns about the competence, integrity, ethical values or diligence of management.

Steps if written representations are inconsistent with other evidence

Consider the reliability of representations in general.

Reconsider the initial risk assessment.

Consider the need to perform further audit procedures. [ISA 580, A23]

If there are concerns about the competence, integrity, ethical values or diligence of management:

The auditor must consider whether the engagement can be conducted effectively.

If they conclude that it cannot then they should withdraw from the engagement, where permitted by laws and regulations.

If they are not permitted to withdraw they should consider the impact on the auditor’s report. It is likely that this would lead to a disclaimer of opinion.

[ISA 580, A24]

Steps if management refuse to provide written representations

Although possibly unreliable, written representations are a necessary and important source of evidence.

If management refuse to provide requested written representations, the auditor should:

Discuss the matter with management to understand why they are refusing.

Re-evaluate the integrity of management and consider the effect that this may have on the reliability of other representations (oral or written) and audit evidence in general.

Consider the implication for the auditor’s report.

[ISA 580, 19]

Audit reporting implications

The auditor should issue a disclaimer of opinion if:

The auditor concludes there is sufficient doubt about the integrity of management which means the written representations are not reliable, or

Management does not provide the written representations required in relation to confirming their responsibility to prepare the financial statements and to provide the auditor with information, and confirming completeness of transactions.

[ISA 580, 20]

Illustration 2 – Murray Co-written representation letter

Murray Co

1 Murray Mound, Wimbledon

London WN1 2LN

Wimble & Co

2 Court Lane, Wimbledon

London WN1 2LN

18 February 20X5

Dear Wimble & Co,

This written representation is provided in connection with your audit of the financial statements of Murray Company for the year-ended December 31, 20X4 for the purpose of expressing an opinion as to whether the financial statements give a true and fair view in accordance with International Financial Reporting Standards.

We confirm that:

Financial Statements

We have fulfilled our responsibilities, as set out in the terms of the audit engagement dated 25 November 20X4, for the preparation of the financial statements in accordance with International Financial Reporting Standards; in particular the financial statements give a true and fair view in accordance therewith.

Significant assumptions used by us in making accounting estimates, including those measured at fair value, are reasonable. (ISA 540)

All events subsequent to the date of the financial statements and for which International Financial Reporting Standards require adjustment or disclosure have been adjusted or disclosed. (ISA 560)

The effects of uncorrected misstatements are immaterial, both individually and in the aggregate, to the financial statements as a whole. A list of the uncorrected misstatements is attached.

(ISA 450)

The basis and amount of the warranty provision are reasonable. (specific matter)

Information provided

We have provided you with:

– Access to all information of which we are aware that is relevant to the preparation of the financial statements, such as records, documentation and other matters.

– Additional information that you have requested from us for the purpose of the audit.

– Unrestricted access to persons within the entity from whom you determined it necessary to obtain audit evidence.

All transactions have been recorded in the accounting records and are reflected in the financial statements.

We have disclosed to you the results of our assessment of the risk that the financial statements may be materially misstated as a result of fraud. (ISA 240)

We have disclosed to you all information in relation to fraud or suspected fraud that we are aware of and that affects the entity and involves:

– Management

– Employees who have significant roles in internal control; or

– Others where the fraud could have a material effect on the financial statements. (ISA 240)

We have disclosed to you all information in relation to allegations of fraud, or suspected fraud, affecting the entity’s financial statements communicated by employees, former employees, analysts, regulators or others. (ISA 240)

We have disclosed to you all known instances of non-compliance or suspected non-compliance with laws and regulations whose effects should be considered when preparing financial statements.

(ISA 250)

We have disclosed to you all information in relation to settlement of the unfair dismissal, including our intentions thereon. (specific matter)

We have disclosed to you all information in relation to the constructive dismissal brought by the previous Sales Director, including our intention thereon. (specific matter)

Ed Perry	Maria Williams
Edward Perry	Maria Williams
Finance Director, Murray Co	Managing Director, Murray Co

Test your understanding 3

Smithson Co provides scientific services to a wide range of clients. Typical assignments range from testing food for illegal additives to providing forensic analysis on items used to commit crimes to assist law enforcement officers.

The annual audit is nearly complete. As audit senior you have reported to the engagement partner that Smithson is having some financial difficulties. Income has fallen due to the adverse effect of two high-profile court cases, following which a number of clients withdrew their contracts with Smithson. A senior employee then left Smithson, stating lack of investment in new analysis machines was increasing the risk of incorrect information being provided by the company. A cash flow forecast prepared internally shows Smithson requiring significant additional cash within the next 12 months to maintain even the current level of services.

Required:

Define ‘going concern’ and discuss the auditor’s and directors’ responsibilities in respect of going concern.

(5 marks)

State the audit procedures that may be carried out to try to determine whether or not Smithson Co is a going concern.

(10 marks)

Explain the audit procedures and actions the auditor may take where the auditor has decided that Smithson Co is unlikely to be a going concern.

(5 marks)

(Total: 20 marks)

Test your understanding 4

Potterton is a listed company that manufactures body lotions under the ‘ReallyCool’ brand. The company’s year-end is 31 March 20X2, and today’s date is 1 June 20X2. Draft profit before taxation is $4 million.

The audit is nearing completion, but two issues remain outstanding:

On 27 May 20X2 a legal claim was made against the company on behalf of a teenager who suffered severe burns after using ‘ReallyCool ExtraZingy Lotion’ in July 20X1. Potterton is considering an out-of-court settlement of $100,000 per year for the remaining life of the claimant. However, no adjustment or disclosure has been made in the financial statements.

At a board meeting on 30 April 20X2, the directors of Potterton proposed a dividend of $2 million. It is highly likely that the shareholders will approve the dividend at the annual general meeting on 3 September 20X2. The directors have recorded the dividend in the draft statement of changes in equity for the year-ended 31 March 20X2.

Required:

Explain whether the two outstanding issues are adjusting or non-adjusting events, in accordance with IAS 10 Events after the Reporting Period.

(8 marks)

Describe appropriate audit procedures in order to reach a conclusion on the two outstanding issues.

(5 marks)

Explain the likely impact on the audit opinion if the directors refuse to make any further adjustments or disclosures in the financial statements.

(4 marks)

(Total: 17 marks)

Test your understanding 5

List SIX items that could be included in a written representation.

(3 marks)

List THREE reasons why auditors obtain written representations.

(3 marks)

Test your understanding 6

The audit of Leonora Co is nearly complete and you are performing your procedures in respect of going concern. During the audit you have identified several indicators that the company may not be able to continue as a going concern.

Which of the following is correct in terms of responsibilities for going concern?

A The auditor chooses the basis of preparation for the financial statements.

B The client should make adequate disclosure of going concern uncertainties and the auditor should assess the adequacy of them.

C The auditor will make disclosure of going concern uncertainties in the financial statements.

D The auditor will notify the shareholders immediately of any going concern issues identified during the audit.

State whether each of the following statements are true or false in respect of assessing the going concern status of Leonora Co.

		True	False

A	The auditor should prepare forecasts to
	assess whether Leonora Co are likely to be
	able to continue trading

B	The directors of Leonora Co should prepare
	forecasts for a period of at least 12 months
	to assess whether the company is likely to
	be able to continue trading

C	If the directors of Leonora Co prepare
	forecasts for a period of less than
	12 months, the auditor should ask them to
	extend their assessment period

D	If the directors of Leonora Co prepare
	forecasts for a period of less than
	12 months, the auditor should extend the
	assessment period by preparing a forecast
	for the additional 6 months

Which of the following is correct in respect of going concern? A All companies must prepare their financial statements on the

going concern basis.

B If there are material uncertainties regarding going concern, the financial statements must be prepared on the break up basis.

C Going concern means the company is no longer profitable.

D The directors of the company must disclose material uncertainties regarding going concern in the notes to the financial statements.

Which of the following are indicators of going concern problems?

Declining revenues.

Significant outstanding receivables.

Loan repayments due to be made.

Declining current and quick ratios.

(i), (ii) and (iii) only

(ii), (iii) and (iv) only

All of them

(iii) only

Which of the following procedures is not appropriate for obtaining evidence regarding the going concern assumption? A Obtain external confirmation from a customer regarding their

outstanding balance.

B Examine cash flow forecasts.

C Discuss with management their plans for the future.

D Inspect correspondence with the bank regarding loan or overdraft facilities.

Test your understanding 7

You are currently performing subsequent events procedures for the audit of Kookynie Co. From a review of the board minutes you identify that a customer is suing the company for an injury they suffered on the client’s premises on 5 February 20X0. The client’s year-end is 31 January 20X0. The directors are proposing to amend the financial statements to include a provision for the amount of compensation they expect to have to pay to the customer. Legal advice received indicates that the claim is possible to succeed.

Which of the following statements is true with regard to subsequent events?

A The auditor must perform audit procedures to identify events occurring after the date of the financial statements up to the date the auditor’s report is signed that could have an effect on the financial statements

B The auditor does not need to consider any events which occur after the date of the financial statements as it is outside of the reporting period

C The auditor has no responsibility after the auditor’s report has been signed, even if they become aware of events occurring which means the opinion is now incorrect

D The auditor only needs to consider subsequent events communicated to them by the directors

Which of the following statements is false in respect of subsequent events?

A The auditor must ensure the client has complied with IAS 10 Events After the Reporting Period when performing the audit of subsequent events

B The auditor must comply with IAS 10 Events After the Reporting Period when performing the audit of subsequent events

C The auditor must comply with ISA 560 Subsequent Events when performing the audit of subsequent events

D Events after the reporting period may be adjusting or non-adjusting

Which of the following is true in respect of adjusting events? A Adjusting events are those events which occur before the

auditor’s report has been signed

B Adjusting events are those which occur after the year-end date

C Adjusting events are those which occur after the year-end date and provide evidence of a condition existing at the year-end date

D Adjusting events require disclosure in the notes to the financial statements

In respect of the customer’s claim, which of the following statements is true?

A If the claim was probable rather than possible, a provision should be recognised in the financial statements dated 31 January 20X0

B The injury was caused after the year-end therefore was not a condition in existence at the year-end

C The injury was caused after the year-end therefore has no impact on the financial statements being audited

The claim is an adjusting event and the financial statements should reflect the claim

Which of following procedures would NOT be appropriate in respect of Kookynie Co’s subsequent events review?

A Inspect correspondence from the lawyers regarding the likely outcome of the case and the estimate of compensation if the claim is successful

B Discuss with management the details of the accident giving rise to the claim

C Obtain written representation from management that all known subsequent events have been disclosed to the auditor and reflected in the financial statements.

D Telephone the lawyer to discuss further details of the case of which the client may not be aware

Test your understanding 8

You are completing the audit of Balladonia Co and you are waiting for the client to sign and return the written representation letter. The directors have expressed concern about signing the letter. They have stated that the auditor has been provided with all of the information they require and therefore do not understand why the representation letter is necessary.

State whether each of the following statements is true or false in respect of written representations.

True False

As you have received all other information during the audit, the decision by management not to provide the written representation letter is not an issue that would affect the auditor’s report

A written representation is an important piece of evidence which the auditor must obtain

A written representation does not need to be obtained if the wording would be the same as last year’s written representation

Failure by management to provide a written representation letter may cast doubt over management integrity

Which of the following statements is false?

A Written representations include confirmation that management have fulfilled their responsibilities in respect of the financial statements and have provided the auditor will all records and information during the audit.

B Written representations should only be relied on where there is limited other evidence available such as matters of judgment or matters confined to management.

C The auditor would obtain a written representation regarding the reasonableness of a depreciation charge as this is an estimate.

D Failure to obtain a written representation is likely to result in a disclaimer of opinion.

Which of the following would be the auditor’s first course of action after being informed that management are unwilling to provide the written representation?

A Discuss the matter with management and try to resolve the issue

B Discuss the matter with those charged with governance and try to resolve the issue

C Discuss the matter with the shareholders and try to resolve the issue

D Modify the audit opinion

Written representation is required from management to confirm they believe the effects of any uncorrected misstatements are immaterial. Which of the following best describes a misstatement?

A An error in the financial statements

B A fraud which has a material effect on the financial statements C An omission of a balance from the financial statements

D A difference between what has been reported in the financial statements and what should have been reported in the financial statements

During the audit of Balladonia Co you discovered misstatements totalling $20,000. Profit before tax is $570,000. Which of the following describes the most appropriate course of action?

A Ignore the misstatements if they are deemed to be immaterial B Modify the audit opinion as a result of misstatement

C Request the client to correct the misstatements

D Modify the audit report with an Emphasis of Matter paragraph to highlight that misstatements are present in the financial statements

Test your understanding 1

To determine whether or not the financial statements should be adjusted in respect of each of the events described, IAS 10 Events After the Reporting Period needs to be applied. If the event provides evidence of conditions that existed at the reporting date (an adjusting event), then an adjustment should be made. If the event provides evidence of conditions that arose after the reporting date (a non-adjusting event), no adjustment is required but a disclosure may be necessary if the event is material and non-disclosure would render the financial statements misleading.

The auditor will only require the directors to amend the financial statements for adjusting events if the adjustment is material. When assessing materiality in the exam, it is sufficient to calculate materiality in relation to each measure individually, using the lower end of the thresholds for prudence. If the item is material to one or more of the measures then it requires adjustment.

Gold is Us was placed into administration after the year-end, which provides evidence of the recoverability of the receivables balance at the year-end. Therefore this is an adjusting event. The total value of the balance is $211,000 which is 1% of revenue, 2% of total assets and 20% of profit, and is therefore The receivables balance should be written off or an allowance for receivables created.

The sales director left the company after the year-end and is suing for constructive dismissal, which is an event that arose after the reporting date. Therefore this is a non-adjusting event. The total value of the claim is $280,000, which is 1.3% of revenue, 2.9% of assets and 26.7% of profit before tax and is therefore material. This may also be considered material by nature. The nature of the event and any estimates of the financial impact should therefore be disclosed.

A fire destroyed inventory after the year-end, which is therefore a non-adjusting event (as the inventory was not damaged at the year-end). The total value of inventory stored at the premises is $1,054,000, which is 5% of revenue, 11% of total assets and 101% of profit and is therefore material and the nature of the event and any estimates of the financial impact should be disclosed.

After the year-end a letter was received offering to settle a claim for unfair dismissal out-of-court. This is an event that provides evidence of the valuation of the provision at the year-end and is therefore an adjusting event. The current provision is for $40,000 and the adjustment would therefore be $15,000. This is not material being 0.07% of revenue, 0.15% of total assets and 1.43% profit before tax. Therefore no adjustment is necessary.

Test your understanding 2

Going concern indicators at Murray Co:

Indicator	Explanation

A major customer has	Unless the customer can be replaced, this
been placed into	will result in significant loss of future
administration	revenues. The debt outstanding is unlikely
	to be paid resulting in a negative impact on
	cash flow.

The sales director left	Loss of a key director will impact on the
the company and has	company’s sales. As Murray Co has already
yet to be replaced.	lost a major customer, without an
	experienced sales director to generate new
	sales the company will face significantly
	reduced sales and cash flows.

The sales director is	Murray Co will need to pay expensive legal
suing Murray Co for	costs in order to defend this litigation,
constructive dismissal.	squeezing cash flows even further. In
	addition, this may damage their reputation
	and make it difficult to recruit a suitable
	replacement or other key staff. Any
	compensation awarded to the sales director
	will mean further outflow of cash.

Murray Co is seeking	If Murray Co does obtain new funding
new funding through an	through a listing, alternative finance will
initial public offering of	need to be obtained in order to continue to
shares in the company.	operate. This may not be easy to obtain
	given their other problems.

Murray Co is operating	Murray Co is heavily dependent on a short-
close to its overdraft	term source of finance, that is repayable on
limit.	demand. It may be difficult to obtain further
	sources of finance if the overdraft reaches it
	limit.


	The cash flow forecast	If the company continues to have cash
	shows negative monthly	outflows then the overdraft will increase
	cash flows for the next	further and there may be no cash available
	twelve months.	to pay debts as they fall due.

	A number of suppliers	If suppliers are paid late they may refuse to
	have been paid late.	supply Murray Co with goods/components
		or impose cash on delivery terms which will
		disrupt production, and delay sales to
		customers. This may cause them to lose
		customers altogether.

	The loan facility is	The bank may withdraw the loan facility if
	secured, in part, on the	the asset on which it is secured is
	refurbished assembly	significantly impaired. Murray Co does not
	line which has broken	have sufficient cash to repay the loan.
	down.	Unless Murray Co can negotiate with the
		bank or raise alternative finance (or sell non-
		current assets), they will have no realistic
		alternative but to liquidate.

	The assembly line broke	If Murray Co cannot meet customer orders
	down during January,	due to manufacturing problems, refunds
	and six weeks later is	may have to be given and customer goodwill
	still not working.	may be lost along with future revenue, which
		will put further pressure on cash flows.

	A fire at the premises of	If Murray Co cannot meet customer orders
	the third party	due to this lost revenue. Refunds may have
	warehouse provider	to be given and customer goodwill may be
	destroyed approximately	lost along with future revenues which will put
	one half of Murray Co’s	further pressure on cash flows. If the losses
	inventory.	are not covered by insurance, this will
		significantly impact profit and cash flow.

Test your understanding 3

Going concern

Going concern means that the entity will continue in operational existence for the foreseeable future without the intention or the necessity of liquidation or otherwise ceasing trade. It is one of the accounting principles given in IAS 1 Presentation of Financial Statements.

The auditor should consider the appropriateness of management’s use of the going concern assumption in the preparation of the financial statements.

The auditor’s responsibilities are:

To carry out appropriate audit procedures that will identify whether or not an organisation can continue as a going concern.

To ensure that the organisation’s management have been realistic in their use of the going concern assumption when preparing the financial statements.

To report to the members where they consider that the going concern assumption has been used inappropriately, for example, when the financial statements indicate that the organisation is a going concern but audit procedures indicate this may not be the case.

It is the directors’ responsibility to prepare the financial statements on an appropriate basis, be that either the going concern or the breakup basis.

Audit procedures regarding going concern

– Obtain a copy of the cash flow forecast and assess the reasonableness of the assumptions used in the forecast.

– Discuss with the directors their view of whether Smithson can continue as a going concern. Ask for their reasons and try and determine whether these are reasonable.

– Enquire of the directors whether they have considered any other forms of finance for Smithson to make up the cash shortfall identified in the cash flow forecast.

– Obtain a copy of any interim financial statements of Smithson to determine the level of sales/income after the year-end and whether this matches the cash flow forecast.

– Enquire about the possible lack of capital investment within Smithson identified by the employee leaving. Review the purchase policy with the directors.

– Consider the extent to which Smithson rely on the senior employee who recently left the company. Ask the HR department whether the employee will be replaced soon.

– Obtain a solicitor’s letter and review to identify any legal claims against Smithson related to below standard services being provided to clients. Where possible, consider the financial impact on Smithson and whether insurance is available to mitigate any claims.

– Review Smithson’s order book to try and determine the value of future orders compared to previous years.

– Review the bank letter to determine the extent of any bank loans and whether repayments due in the next 12 months can be made without further borrowing.

– Review other events after the end of the financial year and determine whether these have an impact on Smithson.

– Obtain a written representation confirming the directors’ opinion that Smithson is a going concern.

Audit procedures and actions if Smithson is not considered to be a going concern

– Discuss the situation again with directors. Consider whether additional disclosures are required in the financial statements or whether the financial statements should be prepared on the break-up basis.

– Explain to the directors that if additional disclosure or restatement of the financial statements is not made then the auditor will have to modify the auditor’s report and opinion.

– Consider how the auditor’s report should be modified. Where the directors provide adequate disclosure of the going concern situation of Smithson, then a section should be included in the auditor’s report headed ‘Material Uncertainty Related to Going Concern’ to draw attention to the going concern disclosures.

– Where the directors do not make adequate disclosure of the going concern situation then modify the audit opinion due to material misstatement from inadequate disclosure.

– The modification will be an ‘except for’ qualification or an adverse opinion depending on whether the issue is material or material and pervasive.

– The ‘Basis for Opinion’ section will be amended to ‘Basis for Adverse Opinion’ or ‘Basis for Qualified Opinion’ to explain the reason for the modified opinion.

– If Smithson is a listed company, the Key Audit Matters section will reference the ‘Basis for Adverse/Qualified Opinion’ section.

Test your understanding 4

Analysis of events

Legal claim: The legal claim is an adjusting event because it provides evidence of a condition existing at the end of the reporting period. As at 31 March 20X2, the claimant had purchased and used the product, and the damage to the claimant’s skin had already occurred.

The legal claim is material, because, if the claimant lived for, say, another 40 years, the company would owe him/her $4 million. This is 100% of the current year draft profit before tax.

Therefore profit should be reduced and liabilities increased by the expected value of the claim.

Proposed dividend: The proposed dividend is a non-adjusting event because the condition arose after the end of the reporting period. No liability for the dividend can exist until the shareholders approve the dividend.

The proposed dividend is material because it constitutes 50% ($2m/$4m × 100) of the company’s profit before tax, as well as being material by nature.

Therefore the dividend should not be recognised in the financial statements for the year-ended 31 March 20X2. However, the proposed dividend should be disclosed in a note to the financial statements.

Audit procedures Legal claim:

– Review legal correspondence in order to understand the likely outcome of the legal claim.

– Review customer correspondence/legal files in order to identify other similar claims which could give rise to additional liabilities.

– Discuss with the production director the likely cause of the burns (e.g. allergy in user or inadequate printed instructions on product use) to determine the likelihood of any claim being successful in court.

– Review trade/consumer press to identify whether the claim might damage Reallycool’s reputation which could impact future revenues or even create a going concern threat.

– Propose adjustment of the financial statements to the directors.

Proposed dividend:

– Inspect board minutes in order to confirm the amount of the proposed dividend.

– Propose an adjustment to the financial statements to remove the dividend from being recognised in the statement of changes in equity but ensure that the dividend proposal is disclosed within the notes.

Impact on audit opinion

– The auditor must modify the audit opinion if the directors refuse to make the relevant adjustments in the financial statements requested by the auditors.

– Both the legal claim (which should have been recognised) and the proposed dividend (which should have been disclosed rather than recognised) are materially misstated.

– The auditor must express a qualified (‘except for’) opinion if they conclude that the misstatements are material, but not pervasive, to the financial statements.

– The auditor must express an adverse opinion if they conclude that misstatements are both material and pervasive to the financial statements.

– Given the size of the amounts involved, an adverse opinion may be appropriate in these circumstances.

– The ‘Basis for Opinion’ section will be amended to ‘Basis for Adverse’ or ‘Basis for Qualified Opinion’ to explain the reason for the modified opinion.

– As Potterton is listed, the Key Audit Matters section will reference the ‘Basis for Adverse/Qualified Opinion’ section.

Test your understanding 5

Items to be included in a written representation letter

– All books, records and relevant information have been made available to the auditors.

– Financial statements have been prepared in accordance with an applicable financial reporting framework.

– All transactions have been recorded and reflected in the financial statements.

– The effects of uncorrected misstatements are immaterial to the financial statements.

– Any instances of non-compliance with laws and regulations have been disclosed to the auditor.

– The directors believe the company can continue to trade as a going concern.

– The directors have no plans that will materially alter the carrying value or classification of assets or liabilities in the financial statements.

– No plans to abandon any product lines that will result in any excess or obsolete inventory.

– All subsequent events have been disclosed to the auditor and reflected appropriately in the financial statements.

– No irregularities involving management or employees that could have a material effect on the financial statements.

Reasons why the auditor obtains written representations

– Formal confirmation by management of their responsibilities.

– To support other evidence relevant to the financial statements if determined necessary by the auditor, e.g. matters requiring management judgment.

– Required by ISA 580 and other ISAs.

Test your understanding 6

(1)	B	The directors (client) must make the disclosures
		in the financial statements. The auditor will audit
		them.

(2)	A – False	The auditor should review the forecasts prepared
		by the directors. The auditor should not prepare
		them.

	B – True	The directors (client) should prepare the
		forecasts to assist with their assessment of going
		concern in order to determine the appropriate
		basis on which to prepare the financial
		statements.

	C – True	The directors are required to consider at least a
		12 month period for their going concern
		assessment. The auditor must ask them to
		extend their assessment if they fail to consider at
		least 12 months.

	D – False	The auditor should not extend the assessment or
		prepare forecasts for the client.

(3)	D	The financial statements should be prepared on
		the break up basis if the company is not a going
		concern. If there are material uncertainties
		regarding going concern, these must be
		disclosed by the directors. A company may be
		profitable but not have the cash to pay its debts
		when they fall due.

(4)	C	All are indicators of going concern problems.

(5)	A	Obtaining external confirmation from a customer
		may confirm the balance owed but does not
		provide evidence that the money will be received.

Test your understanding 7

(1)	A	The auditor has an active duty up to the date the
		auditor’s report is signed. If they become aware of
		events after this date that would cause them to modify
		their opinion they must take action.

(2)	B	IAS 10 Events After the Reporting Period refers to the
		accounting treatment the client should comply with.
		The auditor must comply with ISA 560 Subsequent
		Events.

(3)	C	Adjusting events provide evidence of conditions
		existing at the year-end (IAS 10, 3a).

(4)	B	As the injury was suffered after the year-end it is a
		non-adjusting event. Therefore a provision is not
		required at 31 January 20X0. If it is material, disclosure
		should be made.

(5)	D	The auditor has no right to contact the lawyer in this
		manner. A lawyer confirmation letter may be sent with
		client permission. It would not be professional for the
		lawyer to discuss details of the case that are not
		known to the client with the auditor.

Test your understanding 8

(1)	A – False	Written representations are required by ISA 580.
		Without it the auditor does not have sufficient
		appropriate evidence and as such must modify
		the auditor’s report.

	B – True

	C – False	The written representation must be dated just
		before the date of the auditor’s report. Even if the
		wording is the same, a written representation
		must be obtained each year.

	D – True	Management are informed in the engagement
		letter that written representations will be required.
		Failure to provide one indicates management are
		trying to conceal information from the auditor
		which casts doubt over their integrity.

(2)	C	Sufficient other evidence is available to assess
		the reasonableness of depreciation.

(3)	A	The first course of action would be to try and
		resolve the issue with management. If that failed
		the auditor could discuss the matter with those
		charged with governance. The shareholders
		would not be involved in this issue. The audit
		opinion would be modified if the issue could not
		be resolved with management or those charged
		with governance.

(4)	D	Errors, frauds and omissions are all types of
		misstatement. Therefore the best description of a
		misstatement is answer D. A difference between
		what should be reported and what has been
		reported can be caused by an error, fraud or
		omission.

(5)	C	Even if misstatements are immaterial they should
		not be ignored altogether. The client will be asked
		to correct them. There is no need to modify the
		auditor’s report or opinion if they remain
		uncorrected provided the refusal to correct does
		not indicate the presence of other misstatements.
		An Emphasis of Matter paragraph is not
		appropriate in this situation. There is no need to
		communicate immaterial matters to the users of
		the financial statements.

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