AUDITING THEORY

COMPLETING THE A UDIT

Characteristics of the proce dures perfor med in completing the audit:

a. The procedures are required to be performed
b. The procedures are performed near the end of the audit (on or near the last day of fieldwork)
c. The procedures do not pertain to specific transaction cycles or accounts
d. The procedures are usually performed by audit managers or other senior members of the audit team who
have extensive audit experience with the client
e. The procedures involve many subjective judgments by the auditor

AUDIT PROCEDURES IN COMPLETING THE A UDIT:

1. Search for unrecorded liabilities

● The auditor examines cash disburse ments made subsequent to balance sheet date. The
purpose is to verify if those disbursements for purchases or expenses incurred as of the balance sheet
date were properly accrued and recorded as liabilities in the current year.

2. Review related party transactions (to ensure that they have been properly identified, recorded and dis
closed in the financial statements)

Audit procedures to identify related parties:

● Performing detailed tests of transactions and balances
● Reviewing minutes of meetings of shareholders and those charged with governance
● Reviewing accounting records for large or unusual transactions and balances, paying particular
attention to transactions recognized at or near the end of the reporting period.
● Reviewing confirma tions of loans receivable and payable and confirmations from banks (such
review may indicate guarantor relationship and other related party transactions)
● Reviewing investment transactions (for example, purchase or sale of an equity interest in a joint
venture or other entity)

Audit procedures to determine completeness of related party infor mation prov ided by those
charged with governa nce and ma nagement:
1. Reviewing prior year’s working papers for names of known related parties
2. Review the entity’s procedures for identification of related parties
3. Inquire as to the affiliation of those charged with governance and officers with other entities
4. Review shareholder recor ds to determine the names of principal shareholders or, if appropriate,
obtain a listing of principal shareholders from the share registrar
5. Review minutes of meetings of shareholders and those char ged with governance and other
relevant statutory recor ds such as the register of director’s interest
6. Inquire of other auditors currently involved in the audit, or predecessor auditors, as to their
knowledge of additional related parties
7. Review the entity’s income tax returns and other information supplied to regulatory agencies
(such as SEC filings)
3. Identify and evaluate continge ncies (arising from litigation, claims, and assess ment s) and
commitments

a. Procedures to identify litigation and claims:

● Inquiry of management (and, where applicable, others within the entity, including in- house legal
counsel)
● Reviewing minutes of meetings of those char ged with governance (BOD and audit committee) and
correspondence between the entity and its external legal counsel
● Reviewing legal expense accounts (such as examining invoices for legal expenses)
● Using information obtained through risk assessment procedures

b. Seek direct communication with the entity’s external legal counsel (through a letter of inquiry) when
litigation or claims have been identified or when the auditor believes they may exist

(1) Letter of specific inquiry – this letter of inquiry would ordinarily include:
(a) A list of litigation and claims
(b) Management’s assessment of the outcome of the litigation or claim and its estimate of the
financial implica tions, including costs involved; and
(c) A request that the entity’s legal counsel confirm the reasonableness of management’s
assessments and provide the auditor with further information if the list is considered by the
entity’s legal counsel to be incomple te or incorrect.
(2) Letter of general inquiry – requests the entity’s external legal counsel to inform the auditor
of:
(a) Any lit igation and claims that the counsel is aware of
(b) Assessment of the outcome of the litigation and claims, and
(c) An estimate of the financial implications, including cos ts

c. Discuss with the entity’s external legal counsel the likely outcome of litigation and claims where:
 (1) The auditor determines that the matter is a significant risk
(2) The matter is complex
(3) There is disagreement between management and the entity’s external legal counsel

4. Review subsequent events that may require adjust ment of, or disclosure in the financial
statements

a. Procedures to identify subsequent events

(1) Reviewing procedures established by entity’s management to ensure that subsequent events are
identified
(2) Inquiring of management as to whether any subsequent events have occurred which might affect
the financial statements

(3) Reading minutes of the meetings (of shareholders, those charged with governance, audit and
executive committees) including those held after period end and inquiring about matters discussed
at meetings for which minutes are not yet available.
(4) Reading the entity’s latest available interim financial statements as well as budgets and cash flow
forecasts and other related management reports; compare them with the financial statements
under audit.
(5) Obtaining representation letter from management regarding whether any events occurred during
the subsequent period that require adjustments to or disclosure in the financial statements.
b. Consider whether material subsequent events are properly accounted for and adequately disclosed in
the financial statements

5. Assess the appropriateness of manage ment’s use of the going concer n assumption in the
preparation of the financial stateme nts
Audit procedures to identify conditions and events that may cast doubt about an entity’s ability
to cont inue as a going concern:
● Analytical procedures
● Subsequent events review
● Review of compliance with debt and loan agreements
● Reading minutes of meetings
● Inquiry of legal counsel
● Confirmation with related and third parties of arrangements for financial support

Exa mples of event or conditions that may s ignify existence of

a materia l going concer n uncertainty

Events or conditions that may give rise to business risks, that individually or collectively, may cas t doubt
about the entity’s ability to continue as a going concern:

Financial events and conditions:

● Net liability or net current liability position
● Maturing fixed- term borrowings without realistic prospects of renewal or repayment
● Indications of withdrawal of financial support by debtors and other creditors
● Negative operating cash flows
● Adverse key financial ratios
● Substantial operating losses
● Significant deterioration in value of assets used to generate cas h flows
● Arrears or discontinua nce of dividends
● Inability to pay creditors on due dates
● Inability to comply with the terms of loan agreements or o ther statutory requirements
● Change from credit to cas h-on-deliver y transa ctions with suppliers
● Inability to obtain financing for essential new product development or other essential
investments

Operating events and conditions:

● Loss of key management without replacement
● Loss of a major market, franchise, license, or principal supplier
● Labor difficulties or shortages of important supplies

Other events and conditions:

● Noncompliance with capital or statutory requirements
● Pending legal or regulatory proceedings against the entity that may, if successful, result in claims
that are unlikely to be satisfied
● Changes in legislation or government policy expected to adversely affect the entity

Mitigating Factors

There are factors that can mitigate the adverse effects of identified material going concern uncertainty.
The auditor should consider whether management has plans for and the ability to implement
alternative mea ns of maintaining adequate cash flows to mitigate events and conditions that may
cas t doubt about the entity’s ability to continue as a going concern.
6. Obtain written representations from management (on matters material to the financial statements)
● Manage me nt representation letter is a letter from the management confirming its
responsibility and its oral representations.
● The auditor’s responsibility is to obtain written representation, whereas the management’s responsibility
is to provide written representations (this responsibility is included in the engagement letter that sets
out the terms of an audit engagement).
● The auditor’s responsibility on representations relating to matters that are material to the financial
statements:
a. Seek corroborative audit evidence from sources inside or outside the entity;
b. Evaluate whether the representations made by management appear reasonable and consistent with
other audit evidence obtained, including other representations; and
c. Consider whether the individuals making the representations can be expected to be well informed
on the particular matters.

Purposes of a ma nagement representation letter:

a. Main/ primary: To emphasize or impress upon management its ultimate responsibility for the
financial statements
b. Other purposes:
● To confirm oral representations made by management during the audit
● To reduce the possibility of misunderstanding between the auditor and the client concerning the
matters that are the subject of the representations
● To document management’s acceptance acknowledgment of its responsibility for fair
presentation of the financial statements
● To provide corroborative evidence when audit evidence may not be reasonably expected to
be available (for example, audit evidence to corroborate management’s intention to hold a specific
investment for long-term appreciation or to discontinue a line of business)
● To complement, but not replace or substitute, other audit procedures or other audit evidence
that the auditor could reasonably expect to be available

Basic ele me nts of a ma nagement representation letter:

a. Addressee: Should be addressed to the auditor
b. Contents: Should contain the specified infor mat ion
c. Date: Should be appropriately dated (ordinarily coincides with date of the auditor’s report)
d. Signatory: Should be appropriately signed by the members of management who have
primary or overall responsibility for financia l and operating aspects of the entity

Appropriate signatory of a ma nagement representation letter:

● Owner-manager
● Chief/senior executive officer
● Chief/senior financial officer
● Other members of management

For ms of ma nagement representations:

Management representations may be verbal, whether solicited or unsolicited, or wr itten, whether
explicitly such as contained in a management representation letter or implicitly such as contained in
financial information provided. Written representations are better audit evidence than oral representation.
Written representations incl ude:
● A representation letter from management – known as the management representation
letter or client’s representation letter
● A letter from the auditor (confir matory letter) – outlining the auditor’s understanding of
 management’s representations, duly acknowledged and confirmed by management
● Relevant minutes of meetings (of the board of directors or similar body)
● Signed copy of the financial statements
● Matters communicated in discussions or ele ctronically such as e-mails or telephone messages.
● Schedules, analyses, and reports prepared by the entity, and management’s notations and
comments therein

Limitations of manage me nt representations:

Although management representations are considered part of evidential matter, they (are):
● Not a substitute for performing other audit procedures or a means to reduce the auditor’s
responsibility
● Not as the sole source of evidence on significant audit matters
● Cannot be substitute for other audit evidence that the auditor could reasonably expect to be
available
● Cannot reduce the auditor’s responsibility

Application of materia lity:

1. Representations may be limited to matters that are considered either individually or
collectively material to the financial statements
2. Materiality limits would not apply when obtaining written client representation on:
a. Fraud or irregularities involving management
b. Availability of minutes of meetings

Effect if management refuses to provide the necessary written representations:

Refusal by management to provide a written representation requested by the auditor that the auditor
deems necessary constitutes a scope limitation and would result in a qualified opinion or a disclaimer of
opinion. In such circums tances, also consider:
a. Any reliance pla ced on other representations made by management during the audit; and
b. Any additional implica tions of the refusal on the auditor’s report.

When ma nagement representation is contradicted by other audit evidence: The auditor should
investigate the circums tances and, when necessary, reconsider the reliability of other representations
made by management

Specific matters included in a ma nagement representation letter:

Exa mple of a ma nagement representation letter:

The following letter is not intended to be a standard letter. Representations by management will vary
from one entity to another and from one period to the next.
 (Entity Letterhead)

(To Auditor) (Date)

This representation letter is provided in connection with your audit of the financial statements of ABC
Company for the year ended December 31, 19X1 for the purpose of expressing an opinion as to whether
the financial statements present fairly, in all material respects, the financial position of ABC Company as
of December 31, 19X1 and of the results of its operations and its cash flows for the year then ended in
accordance with (indicate applicable financial reporting framework).

We acknowledge our respons ibility for the fair presentation of the financia l statements
in accorda nce with (indicate applicable financial reporting framework).

We confirm, to the best of our knowledge and belief, the following representations:
● There have been no irregularities involving management or employees who have a significant role in
internal control or that could have a material effect on the financial statements.
● We have made available to you all books of account and supporting documentation and all minutes of
meetings of shareholders and the board of directors (namely those held on March 15, 19X1 and
September 30, 19X1, respectively).
● We confirm the completeness of the information provided regarding the identification of related
parties.
● If required, add “On behalf of the board of directors (or similar body).”
● The financial statements are free of material misstatements, including omissions.
● The Company has complied with all aspects of contractual agreements that could have a material
effect on the financial statements in the event of noncomplia nce.
● There has been no noncompliance with requirements of regulatory authorities that could have a
material effect on the financial statements in the event of noncomplia nce.
● The following have been properly recorded and, when appropriate, adequately disclosed in the
financial statements:
⮚ The identity of, and balances and transactions with, related parties.
⮚ Losses arising from sale and purchase commitments.
⮚ Agreements and options to buy back assets previously sold.
⮚ Assets pledged as collateral.
● We have no plans or intentions that may materially alter the carrying value or classifica tion of assets
and liabilities reflected in the financial statements.
● We have no plans to abandon lines of product or other plans or intentions that will result in any
excess or obsolete inventory, and no inventory is stated at an amount in excess of net realizable
value.
● The Company has satisfactory title to all assets and there are no liens or encumbra nces on the
company’s assets, except for those that are disclosed in Note X to the financial statements.
● We have recor ded or disclosed, as appropriate, all liabilities, both actual and contingent, and have
disclosed in Note X to the financial statements all guarantees that we have given to third parties.
● Other than . . . described in Note X to the financial statements, there have been no events
subsequent to period end which require adjustment of or disclosure in the financial statements or
Notes thereto.
● The . . . claim by XYZ Company has been settled for the total sum of XXX which has been properly
accrued in the financial statements. No other claims in connection with litigation have been or are
expected to be received.
● There are no formal or informal compensating balance arrangements with any of our cash and
investment accounts. Except as disclosed in Note X to the financial statements, we have no other line
of credit arrangements.
● We have properly recorded or disclosed in the financial statements the ca pital stock repurchase
options and agreements, and capital stock reserved for options, warrants, conversions and other
requirements.

Yours truly,

(Senior Executive Officer)

(Senior Financial Officer)

7. Perfor m final analytical procedures

● Purpose: The purpose of performing analytical procedures in the overall review stage of the audit is to
assist the auditor when forming an overall conclusion as to whether the financial statements are
consistent with the auditor’s understanding of the entity. Such procedures assist in arriving at the overall
conclusion as to the reasonableness of the financial statements.
● Audit focus: Auditor’s focus when performing analytical procedures in the overall review stage:
 a. Identifying unusual fluctuations or transactions or unexpected a ccount balances that were not
previously identified
⮚ Once identified, they would require investigation, adequate explanation and appropriate
corroborative evidence by performing additional tests o f details.
b. Assessing the validity of the conclusions reached and evaluating the overall financial statements
presentation

8. Evaluate audit findings

● Throughout the course of the audit, the auditors will propose adjusting entries for all material
misstateme nts (whether ca used by error or fraud) that are discovered in the client’s financial
records. Any material misstatement that the auditors have detected must be corrected; otherwise, they
ca nnot issue an unqualified opinion on the financial statements. Unrecorded misstatements are
combined as total likely misstateme nt in the financial statements and considered.

9. Review of audit wor king papers (audit docume ntation)

● The review is usually performed by manager, partner, and possibly a second partner review
performed by a partner who is not otherwise involved in the engagement but to provide an independent
review of the work performed.
● The review process helps provide assurance that audit risk is an appropriately low level, working paper
documenta tion is adequate, and that the evidence supports the opinion being rendered.

10. Obtain approva l of the client regarding disclosures and adjust ments made to the financia l
statements

11. Evaluate the overall financial stateme nt presentation

● Review adequacy of dis closures using a disclos ure checklist that lists all specific disclosures required
by GAAP and the SEC, if appropriate

12. Review of other infor mation or docume nts that contain the audited financial stateme nts and
ascertain their consistency

13. Communicate with manage me nt and those charged with governance regarding the scope of the
audit and other matters of interest to the client
● Reporting to audit committee
● Report on internal control using a management letter
● Such management letter contains:
a. Reportable conditions which refer to significant deficiencies in the design or operation of the
internal control structure that could adversely affect the financial statements
b. Recommendations for improvement in the existing internal control structure

SUBSEQUENT DISCOV ERY OF OMITTED PROCEDURES A FTER SUBMISSION OF THE A UDIT REPORT:

● Omitted audit procedures may be discovered (after the audit report has been submitted) during a firm's
internal inspection program or during peer review.
● Auditor’s action:
a. The auditor should assess the importance of the omitted procedures to his ability to support the audit
opinion.
b. The auditor should determine whether other audit procedures that were applied tend to compensate
for the omitted audit procedures. If so, no further action is necessary.
c. If, on the other hand, the omitted audit procedures impair the auditor's ability to support the previously
issued opinion, and there are people relying (or likely to rely) on the report, then the auditor should
promptly undertake to a pply the omitted procedures or the corresponding alternative procedures.
d. If, after applying the omitted procedures, the auditor determines that the financial statements are
materially misstated and that the auditor's report is inappropriate, the auditor should discuss the matter
with the management and take steps to prevent future reliance on the report.