21-1

Chapter 21
Completing the Audit
Review Questions
21-1 A contingent liability is a potential future obligation to an outside party for an
unknown amount resulting from activities that have already taken place. Some
examples would be:
1. Pending litigation
2. Income tax disputes
3. Product warranties
An actual liability is a real future obligation to an outside party for a known amount from
activities that have already taken place. Some examples would be:
1. Notes payable
2. Accounts payable
3. Accrued interest payable
21-2 Being concerned about the possibility of contingent liabilities for income tax
disputes, there are various procedures you could use for an intensive investigation in
that area. One good approach would be an analysis of income tax expense. Unusual or
nonrecurring amounts should be further investigated to determine if they represent
situations of potential tax liability. Another helpful procedure in uncovering potential tax
liabilities is to review the general correspondence file for communication with law firms
or Canada Customs and Revenue Agency. This might give an indication that the
potential for a liability exists even though no actual litigation has ensued. Finally, an
examination of Canada Customs and Revenue Agency reports from prior years may
provide the most obvious indication of disputed tax matters.
21-3 The analysis of legal expense is an essential part of every audit engagement
because it may give indication of contingent liabilities which may become actual
liabilities in the future and require disclosure in the current financial statements. Since
any single contingency could be material it is important to verify all legal transactions,
even though the amount may be small. After the analysis of legal expense is completed,
the law firms to whom payment was made should be considered for letters of
confirmation for contingencies (communications with law firms/ lawyer's letters).
21-4 Pyson should determine the materiality of the lawsuits by requesting from
Merrill's lawyer(s) an assessment of the legal situation and the probable liability
involved. In addition, Pyson may have his own law firm assess the situations.
Proper disclosure on the financial statements will depend for the most part on the
21-2
lawyers' evaluation of the probable liabilities involved. If the evaluations indicate
highly probable, material amounts, disclosure will be necessary in the form of a
footnote, assuming the amount of the probable material loss cannot be
reasonably estimated. If the client refuses to make adequate disclosure of the
contingencies, a qualified or adverse opinion may be necessary.
21-5 If a law firm refused to provide the auditor with information about material existing
lawsuits or likely material possible (unasserted) claims, the audit opinion would have to
be modified to reflect the lack of available evidence. This is required by Section 5510.22
of the CICA Assurance Handbook, and has the effect of requiring management to give
its law firms permission to provide contingent liability information to auditors and to
encourage law firms to cooperate with auditors in obtaining information about
contingencies. Sections 6560 and 6560A imply that such cooperation is a matter of
course.
21-6 1) Subsequent events requiring adjustment: those that have a direct effect on
the financial statements. Examples: (i) the declaration of bankruptcy due to the
deteriorating financial condition of a customer with a large outstanding accounts
receivable balance; (ii) the settlement of a litigation for an amount different from the
amount recorded in the books.
2) Subsequent events requiring disclosure: those that have no direct effect
on the financial statements. Examples: (i) the decline in market value of securities held
for temporary investment or resale; (ii) the issuance of bonds or equity securities (iii) the
declaration of bankruptcy by a customer (with a large outstanding accounts receivable
balance) who was inadequately insured and lost everything due to a fire.
21-7 Chuis approach does not take into consideration the need to obtain a
confirmation from law firms as near the end of field work as possible. If the
confirmations are received near the balance sheet date, the period from the balance
sheet to the end of the auditor's field work will not be included in the law firm's
confirmation letter. Thus, her procedure would not have the most current information
regarding contingent liabilities, and would not have the opportunity to disclose pertinent
subsequent events.
21-8 The auditor would be interested in a client's future commitments to purchase raw
materials to ensure that this information is properly disclosed in the financial statements.
The commitment may be of interest to an investor as it is compared to the future price
movements of the material. A future commitment to purchase raw material may result in
the client paying more or less than the market price at a future time. In the former case,
it may be appropriate for the client to recognize a loss in the current year rather than
when the raw material is actually purchased.
21-3
21-9 The major considerations the auditor should take into account in determining
how extensive the subsequent events review should be are:
1. The financial strengths and stability of earnings.
2. The effectiveness of the company's internal control.
3. The number and significance of the adjustments proposed by the auditor.
4. The length of time between the balance sheet date and the completion of
the audit.
5. Changes in key personnel.
21-10 Subsequent events occurring between the balance sheet date and the date of
the auditor's report are those transactions and events that might affect the statements
being audited. Some examples of these types of events would be:
1. The declaration of bankruptcy due to deteriorating financial condition of a
customer with an outstanding accounts receivable balance.
2. The issuance of bonds or equity securities after the balance sheet date.
If these events and transactions have a material effect on the financial statements, they
may require adjustment of the current period financial statements or disclosure.
The subsequent discovery of facts existing at the date of the auditor's report occurs
when the auditor becomes aware that some information included in the financial
statements was materially misleading after the audited financial statements have been
released. Some examples of such facts would be:
1. Subsequent discovery of the inclusion of fictitious sales.
2. Subsequent discovery of the failure to write-off obsolete inventory.
In such cases when the auditor discovers the statements to be misleading, the auditor
has an obligation under Section 5405 of the CICA Assurance Handbook to make certain
that users who are relying on the financial statements are informed about the
misstatements. The Handbook requires the auditor first to discuss the matter with
management and, if required or appropriate, with the board of directors or the audit
committee. The auditor must advise each of the directors (Canada Business
Corporations Act, Sections 165(6)-(8)) and they have an obligation to inform the
shareholders and advise the Corporations Branch of the Department of Consumer and
Corporate Affairs. The directors are also required to prepare and issue a revised set of
financial statements or otherwise inform the shareholders.
21-11 The accumulation of audit evidence is crucial to the auditor in determining
whether the financial statements are stated in accordance with generally accepted
accounting principles, applied on a basis consistent with the preceding year. The
evaluation of the adequacy of the disclosures in financial statements is made to assure
21-4
that the account balances on the trial balance are properly aggregated and disclosed on
the financial statements.
Three examples where adequate disclosure could depend heavily upon the
accumulation of evidence are:
1. The disclosure of declines in inventory values below cost.
2. The separation of current and non-current receivables.
3. The disclosure of contingent liabilities of whose existence, the auditor has
not been informed.
Three examples where audit evidence does not normally significantly affect the
adequacy of the disclosure are:
1. Deciding whether a disposal of equipment should be recorded as an
extraordinary item.
2. The disclosure of an acquisition as a pooling of interests or a purchase.
3. The disclosure of contingencies of whose existence the auditor was
informed by the client.
21-12 This statement implies that the auditor should consider, as part of his or her
audit procedures, if there is a serious risk of the company being unable to realize assets
and discharge liabilities in the normal course of business for the foreseeable future.
In the U.S., the auditor is required to evaluate whether there is substantial doubt about
the client's ability to continue as a going concern for at least one year beyond the
balance sheet date.
In Canada, standards do not presently require the auditor to evaluate whether there is a
doubt about the client's ability to continue as a going concern for the foreseeable future.
However, Section 5510.52 suggests a number of conditions that may cast doubt on the
ability of the enterprise to continue as a going concern such as:
- recurring operating losses,
- serious deficiencies in operating capital,
- an inability to obtain financing sufficient for continued operations,
- an inability to comply with terms of existing loan agreements,
- the possibility of an adverse outcome of one or more contingencies,
- insufficient funds to meet liabilities,
- a plan to significantly curtail or liquidate operations,
- external factors which could force an otherwise solvent enterprise to
cease operations.
21-5
Based on the auditor's assessment of these factors, the auditor must determine if the
accounting treatment, presentation and disclosure by the entity is appropriate. If so, no
reservation is required.
21-13 A client representation letter is a letter from management that documents
management's most important oral representations during the audit.
A management letter is one directed to the client to inform him or her of certain
recommendations about the business which the public accountant believes would be
beneficial to the client.
Five items that might be included in a client representation letter are:
1. Existence or non-existence of litigation.
2. Evaluation of inventory stock as obsolete.
3. The adequacy of the disclosure of actual liabilities.
4. Existence or non-existence of unused letters of credit.
5. The recognition that the auditor is not primarily responsible for the
detection of fraud.
Five items that might be included in a management letter are:
1. Recommendation to switch inventory valuation methods.
2. Recommendation to institute a formal security system.
3. Recommendation to prepare more timely bank reconciliations.
4. Recommendation to segregate duties in a particular area.
5. Recommendation to have certain types of transactions authorized by
specific individuals.
21-14 Section 7500.13 of the CICA Assurance Handbook requires the auditor to read
the other information in the annual report and consider whether any of this information is
inconsistent with the financial statements on which he or she has reported. Types of
information the auditor examines include statements about financial condition in the
president's letter, displays and summaries of statistical financial information and
management discussion and analysis (MD&A).
21-15 Securities regulators in certain jurisdictions require public companies to provide
MD&A in their annual reports "to give the investor the ability to look at the company
issuing the financial statements through the eyes of management by providing a
historical and prospective analysis of the business of the issuer. MD&A provides
management with the opportunity to explain in narrative form its current financial
situation and future prospects."
21-6
21-16 A regular working paper review is the one that is done by someone who is
knowledgeable about the client and the unique circumstances in the audit. An
independent review is one done by a completely independent person who has had no
experience on the engagement. The purpose is to have a competent professional from
within the firm who has not been biased by the ongoing relationship between the regular
auditors and the client, perform an independent review.
Two examples of important potential findings in a regular review are:
1. Incorrect computations.
2. Inadequate scope.
Three examples of important potential findings in an independent review are:
1. A number of small amount adjustments waived which should be
accumulated into a real adjustment.
2. Too narrow and biased a scope in a particular area.
3. Inadequate disclosure of contingencies.
Multiple Choice Questions
21-17 a. (2) b. (4)
21-18 a. (2) b. (3) c. (2) d. (1)
21-19 a. (1) b. (2) c. (2) d. (1) e. (1)
Discussion Questions And Problems
21-20
a. Contingent liabilities are potential future obligations for an unknown amount arising
from activities that have already taken place. A commitment is an agreement to
commit the firm to a set of fixed conditions in the future, regardless of what
happens to profits or the economy as a whole.
Knowledge of both contingencies and commitments is extremely important to
users of financial statements because they represent the encumbrance of
potentially material amounts of resources during future periods, and thus affect the
future cash flows available to creditors and investors. Because of this, generally
accepted accounting principles require that material contingencies and
commitments be disclosed. The auditor has an obligation to discover the existence
of such items to assure that they are properly disclosed in order to have complied
with generally accepted auditing standards.
b. Three useful audit procedures for uncovering contingencies that Choi would likely
perform in the normal conduct of the audit, even if she had no responsibility for
uncovering contingencies, are:
21-7
1. Review Canada Customs and Revenue Agency reports of income tax
settlements.
2. Review minutes of meetings of board of directors and shareholders.
3. Confirm used and unused balance of lines of credit.
c. Three other procedures Choi is likely to perform specifically for the purpose of
identifying undisclosed contingencies are:
1. Make inquiries of management.
2. Analyze legal expenses for indication of contingent liabilities.
3. Confirm existence and status of litigation and other potential contingent
liabilities with law firms.
21-21 a. A contingent liability is a potential future obligation to an outside party for
an unknown amount resulting from activities that have already taken place. The most
important characteristic of a contingent liability is the uncertainty of the amount; if the
amount were known it would be included in the financial statements as an actual liability
rather than a contingency.
b. Audit procedures to learn about these items would be as follows:
1. Apply to all three items:
a) Discuss existence and nature of possible contingent liabilities with
management. In this connection obtain appropriate written
representations.
b) Review the minutes of directors' and shareholders' meetings for
indication of lawsuits or other contingencies.
c) Analyze legal expense for period under audit and review invoices
and statements of legal counsel for indications of contingent
liabilities.
d) Obtain confirmation from all major law firms performing legal
services for the client as to the status of pending litigation or other
contingent liabilities.
2. Additional procedures for individual items:
Guarantee of interest payments -
a) Discuss, specifically, any related party transactions with management.
Include in representations.
b) Review financial statements of affiliate, and where related party
transactions are apparent, make direct inquiries of affiliate management,
and perhaps even examine records of affiliate if necessary.
Stock dividend -
a) Confirm details of stock transactions with registrar and transfer agent.
21-8
b) Review records for unusual journal entries subsequent to year end.
c. Nature of adjusting entries or disclosure, if any, would be as follows:
1. If payment by Chen is uncertain, the $6,000 interest liability for the period
June 2 through December 1, 2001, could be reflected in the Marco
Corporation's accounting records by the following entry:
Interest Payments for Chen Corp. $6,000
Accrued Interest Payable - Chen Bonds $6,000
The debit entry should be included as other assets. Collection is uncertain
and the Marco Corporation may not have a right against the Chen Corp.
until all interest payments have been met and the bonds retired. If this
treatment is followed, the balance sheet should be footnoted to the effect
that the Marco Corporation is contingently liable for future interest
payments on Chen Corp. bonds in the amount of $96,000.
If the interest has been paid by the time the audit is completed, or if for
other reasons it seems certain that the payment will be made by Chen on
January 15, no entry should be made by Marco. In this circumstance a
footnote disclosing the contingent liability of $102,000 and the facts as to
the $6,000 should be included with the statements.
2. The lawsuit should be described in a footnote to the balance sheet. In
view of the court decision, retained earnings may be restricted for
$40,000, the amount of the first court decision. Also, in view of the court
decision any reasonable estimate of the amount the company expects to
pay as a result of the suit might be used in lieu of the $40,000. A current
liability will be set up as soon as a final decision is rendered or if an
agreement as to damages is reached. If liability is admitted to by Marco,
and only the amount is in dispute, a liability can be set up for the amount
admitted to by the company with a corresponding charge to expense or
shown as an extraordinary item if the amount is material.
3. The declaration of such a dividend does not create a liability which affects
the aggregate net worth in any way. The distribution of the dividend will
cause a reduction in retained earnings and an increase in capital stock.
No entry is necessary, but an indication of the action taken, and that such
a transfer will subsequently be made, should be shown as a footnote or as
a memorandum to Retained Earnings and Common Stock in the balance
sheet
21-9
21-22
a. 4 - The amount appeared collectable at the end of the field work.
b. 1 - The uncollectible amount was determined before end of field work.
c. 3 - Amount should have been determined to be uncollectible before end of
field work, but it was discovered after the issuance of the statements. The
financial statements should have been known to contain a misstatement
on 8-20-01.
d. 2 - The cause of the bankruptcy took place after the balance sheet date,
therefore the balance sheet was fairly stated at 6-30-01. Most auditors
probably require that the account be written off as uncollectible at 6-30-01,
but they are not required to do so. Footnote disclosure is necessary
because the subsequent event is material.
e. 2 - The sale took place after the balance sheet date but, since the loss
was material and will affect future profits, footnote disclosure is necessary.
f. 2 - The lawsuit originated in the current year, but the amount of the loss is
unknown.
g. 1 - The settlement should be reflected in the 6-30-01 financial statement
as an adjustment of current period income and not a prior period
adjustment.
h. 4 - The financial statements were believed to be fairly stated for 6-30-01 or
8-19-01.
i. 2 - The cause of the lawsuit occurred before the balance sheet date and
the lawsuit should be included in the 6-30-01 footnotes.
21-23 a. The practice of reviewing the working papers of subordinates on a
continuing basis rather than when the audit is completed, is a good one because it
enables Adams to refine her audit based on the information provided from the working
papers that are reviewed. In addition, since many areas of the audit relate to each other,
reviewing the working papers on a continuing basis gives the auditor a more integrated
picture of the company's operations. It is also an excellent practice from a supervision
point of view.
b. It is acceptable for Adams to prepare the financial statements provided she has
assured herself that she has obtained sufficient audit evidence to warrant their
fair presentation. This is a common practice on many audits because the public
accountant has greater expertise in financial statement presentation than the
client.
21-10
c. By not having a review of the working papers by another partner in the firm there
is no check against any bias and unintentional error that may exist on the part of
the auditor. Except for some degree of independence and technical competence,
Adams is in much the same position of the typical controller. An independent
review is essential in this case.
21-24 a. It is desirable to have a letter of representation in spite of the accumulated
audit evidence to impress upon management its responsibility for the representations in
the financial statements and to formally document the responses from the client to
inquiries about various aspects of the audit.
b. The letter of representation is not very useful as audit evidence since it is a
written statement from a non-independent source. In effect, the client who is
being audited makes certain representations related to the audit of himself.
Several other types of information commonly included in a letter of representation are:
1. The company has proper title to all of its assets.
2. All outstanding loans to officers of the company have been
identified.
3. All transactions for the year have been conducted at arm's length.
4. That financial statements are presented in accordance with GAAP.
5. All related party transactions are disclosed.
6. Completeness and availability of financial records, minutes of board
meetings, and other pertinent documents.
21-25 a.& b. 1. The provincial government's approval of a plan for the construction
of an express highway would have come to the public accountant's attention through his
or her inquiries of officers and key personnel, his or her examination of the minutes of
the meetings of the board of directors and shareholders, and reading of local
newspapers. The details of the item would not have to be disclosed as a separate
footnote because all fixed assets of the corporation, including the right to the
condemnation award, were to be sold as of March 1, 2002 (see item 6).
2. It is improbable that the public accountant would learn the source of the $25,000
unless it were revealed in a discussion with the president or his personal accountant,
or unless the auditor prepared the president's personal income tax return, in which
case the interest charges would have lead to the auditor's investigation of the use to
which the funds were put. Setting out the loan in the balance sheet as a loan from an
officer would be sufficient disclosure. The source from which the officer obtained the
funds would not be disclosed because it is the officer's personal business and has
no effect upon the corporation's financial statements. Indeed, disclosure of the funds'
source might be construed as detrimental to the officer.
21-11
3. The additional liability for the ore shipment would have been revealed to the public
accountant in his or her scanning of January transactions. The auditor's regular
examination of 2001 transactions and related documents such as purchase
contracts would have caused him or her to note the time for subsequent follow up to
determine the final liability. In addition the client's letter of representation might have
mentioned the potential liability. The item would not require separate disclosure by
footnote or otherwise and would be handled by adjusting the financial statement
amounts for purchases, ending raw materials inventory, and accounts payable by
the amount of the additional charge, $9,064. (72 - 50/50 = .44; .44 x 20,600 = 9,064)
4. The public accountant might learn of the agreement to purchase the treasurer's
stock ownership through inquiries of management and legal counsel, examination of
the minutes of the meetings of the board of directors and shareholders and
subsequent reading of the agreement. The absence of the treasurer might also
arouse the public accountant's curiosity. The details of the agreement would be
disclosed in a footnote because the use of company cash for the repurchase of
stock and the change in the amount of stock held by shareholders might have a
heavy impact on subsequent years' financial statements. Usually, a management
change, such as the treasurer's resignation, does not require disclosure in the
financial statements. The details underlying the separation (personal disagreements
and divorce) should not be disclosed because they are personal matters.
5. Through inquiries of management, review of financial statements for January,
scanning of transactions, and observations, the public accountant would learn of the
reduced sales and of the strike. Disclosure would not be made in the financial
statements of these conditions because such disclosure might create doubt as to the
reasons therefore and misleading inferences might be drawn.
6. The contract with Mammoth Industries would come to the public accountant's
attention through his or her inquiries of management and legal counsel, his or her
reading of the minutes of the meetings of the board of directors and shareholders,
and through examination of the contract. All important details of the contract should
be disclosed in a footnote because of the great effect upon the corporation's future.
The factors contributing to the entry into the contract need not be disclosed in
statements; while they might be of interest to readers, they are by no means
essential to make the statements not misleading.
21-26 a. & b. 1. A retroactive pay increase could be uncovered by reading of the
minutes and examining contracts, discussions with management, perhaps by reading
the local newspaper, and analysis of financial statements issued subsequent to the
balance sheet date.
Granting of a retroactive pay increase is likely to create a liability at the balance sheet
date for the earned but unpaid wages in the year under audit. A liability clearly exists if a
union contract was under negotiation at the balance sheet date but not settled until
21-12
later. If the retroactive pay increase was unexpected at the balance sheet date, the
expense could be related to the date of the settlement, but even then most public
accountants would require that retroactive wages be accrued at the balance sheet date.
The liability and related expense that should be accrued at the balance sheet date is the
amount of unpaid wages existing at the balance sheet date assuming the pay increase
is accrued. No mention in the auditor's report is necessary.
2. An additional tax assessment could be uncovered by examining subsequent cash
disbursements, a review of the minutes, examining Canada Customs & Revenue
Agency reports for all expenses not cleared, confirmation with law firms near the end
of the field work and through discussions with management.
The tax assessment should be accrued as a tax expense and a liability for the year
under audit and clearly disclosed if the amount is material. If the tax assessment is
accrued and adequately disclosed no auditor's report modification is necessary.
3. The antitrust suit may have been uncovered through inquiries of the client, client
representation letter, or confirmations from client's legal counsel.
An antitrust suit should be disclosed in a footnote.
4. The declaration of a stock dividend subsequent to the balance sheet date could be
uncovered by reading the minutes of the board of directors subsequent to the
balance sheet date, a confirmation with the independent stock registrar or by
discussion with management.
The stock dividend should be disclosed in a footnote, including the date of
declaration, the percent of the stock dividend and the effect on issued shares, capital
stock, paid-in capital and retained earnings. No auditor's report modification is
necessary.
5. The sale of a major capital asset at a substantial profit could be uncovered by
examining minutes of the board of directors, examining correspondence files,
reviewing cash receipts records of the subsequent period and through discussions
with management.
The sale should be disclosed in a footnote, and the explanation should include the
amount of the gain and the effect, if any, on future operations of the company. No
auditor's report modification is necessary.
21-27 a. In this situation, Little need only send confirmation requests to those law
firms who are involved with legal matters directly affecting the financial statements. The
confirmations should be sent reasonably near to the completion of the field work, but the
follow-up on non-responses and unsatisfactory responses should not be deferred until
the last day of field work. He should have examined the letter when it was returned and
21-13
performed follow-up work at that time. Furthermore, the standard letter should have
addressed itself to the lawsuit if the client had informed the auditor of its existence.
b. Regarding the third confirmation it is necessary to have a conference with
the law firm, client and auditor to determine the nature and significance of
the lawsuit.
It would be a serious violation of due care to ignore the information in the law firm's
letter. In rare circumstances, a denial of opinion is necessary if the information cannot
be obtained.
The auditor would also be required to follow up on the first confirmation.
21-28 The question does not state whether or not the annual report had been issued;
the student is going to have to make an assumption because subsequent actions by
Jarrett will depend on whether the financial statements/report can be changed easily
(i.e. they have not been issued) or not (i.e. they have been issued.)
Jarrett should first ascertain whether the misstatement was in the financial statements
or the president's report. If the misstatement was in the financial statements and they
had not been issued, then Jarrett should ask management to change them; if the
statements had been issued, Jarrett should treat the misstatements according to
Section 5405.12 to .18 and notify management. If the problem was in the annual report
and it had not been issued, Jarrett should ask management to change it; if the report
had been issued, Jarrett should notify management.
If Jarrett cannot gain satisfaction from management in any of the above situations, she
should consider what further action is warranted.
21-29 If the auditor becomes aware after the audited financial statements have been
released that some information included in the statements is materially misleading, the
auditor has an obligation under Section 5405 to make certain that users who rely on the
financial statements are informed about the misstatements. The Handbook requires the
auditor first to discuss the matter with management and, if required or appropriate, with
the board of directors or the audit committee. The auditor also has an obligation, under
the Canada Business Corporations Act to notify each of the directors. The directors are
required to prepare and issue revised financial statements or otherwise inform the
shareholders.
Cases
21-30
(a) Donations to political campaign funds are legal in the subsidiarys country.
CA should take steps to ensure that the payments are, in fact, legal donations to
government officials in the foreign country by informing head office management of the
21-14
situation and requesting that they obtain more evidential matter from the subsidiarys
management in order to substantiate the nature of the payments. This could be in the
form of receipts, correspondence, confirmation or similar evidential matter. CA should
also obtain a signed letter of representation from the subsidiary management.
If such evidential matter is not available, or is withheld by the company, CA faces
a scope qualification in the consolidated financial statements due to the materiality of
the payments on consolidated net income (50% of 20%=10% of consolidated net
income).
If sufficient evidential matter is obtained to provide CA with reasonable
assurance that the donations were, in fact, legal, the matter need not be considered
further with respect to financial statement disclosure or audit report qualification (there
are no existing requirements in Canada to disclose this since these payments represent
legitimate expenses to earn income). These payments would not require separate
classification or disclosure in the consolidated income statement.
In any event, CA should notify the board of directors (or the audit committee if
one exists) requesting clarification of corporate policy in this situation.
Additional consideration should be given to whether these donations might be
considered illegal in Canada. The Adams Report suggests that there may be certain
legal considerations if they are deemed to be illegal in Canada. In this case, they are
probably not, as political donations are legal in Canada. If they were deemed illegal in
Canada, the considerations in (ii) would apply.
(b) Donations to political campaign funds are illegal in the subsidiarys country.
As in (i), the amounts are material having a 10% impact on consolidated net income.
CA should inform head office management of the situation and request that they obtain
more evidential matter regarding the payments. Because the payments are illegal, CA
should reconsider the scope of the audit in this and other subsidiaries as well as the
head office audit because similar payments may exist. The board of directors (or audit
committee) should be informed of these payments.
Once the nature of the payments is determined, CA must consider any possible
contingent loss that might exist due to loss of business, fines, penalties, etc., if these
payments came to light.
If CA determines on the basis of evidence obtained that a material contingent
loss is unlikely to occur, there is no authoritative pronouncement in Canada that
requires disclosure of the illegal payments in the notes to the financial statement or
auditors report.
If a material contingent loss is likely, this must be disclosed in the consolidated
financial statements and the nature of the contingency (i.e., taxes, fines, potential loss
of business) described.
21-15
Based on the recommendations of The Adams Report, where illegal payments exist, as
in this situation, CA may elect to:
1. Insist that the directors make timely disclosure to the shareholders and the securities
commission.
2. Insist that full disclosure of the existence of illegal payments be made in a note to
the financial statements.
If the directors refuse to make these disclosures, CA should qualify the audit report.
If timely disclosure of these payments is not made by the directors, The Adams
Report recommends that CA immediately resign, contact both the company secretary
and the securities commission in writing and contact a lawyer regarding legal
responsibilities in this situation.
21-31
Memo to: Partner
From: CA
Subject: Proctor Industries (PI)
PI has two subsidiaries, Minor Inc. & Chemicals Inc., and thus the financial statements
must be consolidated. For Minor Inc., there is a minority interest of 40% which must
also be recorded in the balance sheet and 40% of Minors income must also be
allocated to the minority interest.
Minor Inc. is audited by another C.A. firm. The following should be considered:
Whether reliance is warranted on their figures.
Their competence, independence, and reputation.
Whether the accounting policies used were appropriate and whether to discuss them
with the audit committee.
The rotational audit approach is an efficient way of auditing branches. We should
document all the analytical review done on the other branches and explain all the
significant variations.
There is a severe time constraint because the financial statements are to be finalized in
one week. We should consider trying to extend this deadline because we may not be
able to meet it.
Internal control
We must review the internal controls yearly to ensure that they operate effectively,
efficiently, and continually throughout the period of intended reliance. We must obtain
reasonable assurance as to the completeness, accuracy and authorization of all
transactions.
Inventory
An error was made when an inventory item was recorded incorrectly. Therefore, the
following procedures should be completed:
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Reassess whether the inventory count procedures were sufficient and appropriate.
Since there are many branches, it might be difficult to get a reliable figure.
Improvements to count procedures will also help prevent errors being made in the
future.
The cycle tests should be expanded to find out whether the error is isolated or not.
Consider using CAATs to check the hash and control totals. This amount is not
likely to be material, but, if so, an adjustment should be made.
Accounts receivable
The confirmation of accounts receivable disclosed double billings of $18,000.
In addition to the procedures already performed, the following should be completed as
soon as possible:
Accounts receivable internal controls should be reassessed to determine whether
reliance was warranted. There should have been internal controls to ensure that
these types of errors are picked up (i.e., why not picked up in weekly report).
Expand cut-off tests (as errors appear around the year end) for accuracy. We
cannot assume that the errors are isolated to one branch simply because internal
controls are standard throughout the company. An error in one branch could be
present in another branch.
The sample should be expanded to cover the entire year as well as the cut-off
procedures.
Review the untested branches to ensure that this error was isolated.
Allowance for doubtful accounts
PIs estimate of the allowance for doubtful accounts appears to be too low. This matter
should be discussed with management and the audit committee. On the basis of our
audit work, we came up with a best estimate for the allowance of $250,000.
Therefore, the following procedures should be performed:
Expand the testing of subsequent receipts received by the company and review up
to today to see if the estimate should be revised.
Re-examine current bad-debt schedule.
Discuss the difference with management and recommend adjustment; otherwise,
audit qualification is necessary.
Minor Inc. refusal
The following items should be dealt with by the audit staff:
Consider approaching Schweitzer and Catts to find out what revenue recognition
policies they use and decide whether they are justified.
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We must then determine what the effect is on the financial statements. If it is not
material, then we can ignore the problem and record the $320,000 loss. If the loss is
material to PI, then the error should be followed up.
The difference is likely immaterial, so we should simply record it as an error.
The threat of opinions shopping and the expectation gap are serious matters. We
must discourage opinion shopping. We should offer our services to solve this dilemma.
Investment in Chemical Inc.
Chemicals Inc. is a subsidiary of PI, and consolidation is necessary using the purchase
method. Chemicals Inc. was never previously audited, and a qualification will probably
be necessary because of the opening balances. We must also disclose the fact that
prior years were not audited clearly in a note to the financial statements. Their year end
is August 31. PIs is September 30, so we must consider the year end of Chemicals
Inc., and apply audit procedures to Chemicals Inc. to ensure that all material
transactions from August 31 to September 30 are disclosed. We must also consider the
deemed year end at June/01: this will require preparation of financial statements and a
tax return.
The negative goodwill balance of $1.2 million should be allocated among the non-
monetary assets or liabilities it relates to. It appears that the contingent liability
regarding the chemical dumping is the reason for the negative goodwill and
consideration should be given to recording it there.
Subsequent events
We should review the minutes and get a legal letter to try to determine what the
potential further contingent liability will be.
Other
In regard to consolidating the financial statements, we must look at the inter-company
transactions, profit in extraordinary items, and the components of the investment
accounts.
We must assess the contingent liability regarding the dumping to decide whether it
should be disclosed or accrued for. If the outcome cannot be foreseen with some
certainty or the amount of the loss is not determinable, then note disclosure is
suggested.
Chemicals Inc. has denied these allegations, which do not appear to be determinable.
However, it sold the company for $1.2 million less than it was worth. Consider whether
amount of $1.2 million is an expected loss. If so, accrue. Otherwise, disclose the
reason for the contingency that the final financial statement effect is not
known/determinable and how the issue will be handled when it is solved (i.e., prior
period adjustment).