Auditing and Accounting for Small- and Medium-Sized Entities

Tuesday, March 10, 2015

Clarified Auditing Standard--Terms of Engagment--Part 1 (AU-C 210)

Objective of the auditor

The auditor’s objective is to accept an audit engagement for a new or existing audit client only when the basis upon which it is to be performed has been agreed upon through:

· Establishing whether the preconditions for an audit are present and

· Confirming that a common understanding of the terms of the audit engagement exists between the auditor and management and, when appropriate, those charged with governance.

Definitions

· Preconditions for an audit. The use by management of an acceptable financial reporting framework in the preparation of the financial statements and the agreement of management and, when appropriate, those charged with governance, to the premise on which an audit is conducted.

· Recurring audit. An audit engagement for an existing audit client for whom the auditor performed the preceding audit.

Requirements

· Preconditions for an audit—covers whether the preconditions for an audit are present which include:

o Determining whether the financial reporting framework to be applied in the preparation of the financial statements is acceptable

o Obtaining the agreement of management that it acknowledges and understands its responsibility for:

§ The preparation and fair presentation of the financial statements in accordance with the applicable financial reporting framework;

§ The design, implementation, and maintenance of internal controls relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error; and

§ To provide the auditor with:

ü Access to all information of which management is aware that is relevant to the preparation and fair presentation of the financial statements, such as records, documentation, and other matters;

ü Additional information that the auditor may request from management for the purpose of the audit; and

ü Unrestricted access to persons within the entity from whom the auditor determines it necessary to obtain audit evidence.

· Management-imposed limitation on scope prior to audit engagement acceptance that would result in a disclaimer of opinion. If this entity:

o Imposes a scope limitation on the auditor such that the auditor believes the limitation will result in the auditor disclaiming an opinion on the financial statements as a whole, the auditor should not accept such a limited engagement as an audit engagement.

o However if the entity is required by law or regulation to have an audit and it imposes such a scope limitation and a disclaimer of opinion is acceptable under the applicable law or to the regulator, the auditor is permitted, but not required, to accept the engagement.

· Other factors affecting audit engagement acceptance

o If the preconditions for an audit are not present, and the auditor is not required by law or regulation to accept the proposed audit engagement, the auditor should discuss the matter with management and decline to accept the proposed engagement.

o If the auditor has determined that the financial reporting framework to be applied in the preparation of the financial statements is unacceptable or if the agreement referred to above has not been obtained the auditor should not accept the engagement.

· Agreement on audit engagement terms

o The auditor should agree upon the terms of the audit engagement with management or those charged with governance, as appropriate.

o The terms of the audit engagement should be documented in an audit engagement letter or other suitable form of written agreement and should include the following:

§ The objective and scope of the audit of the financial statements.

§ The responsibilities of the auditor.

§ The responsibilities of management.

§ A statement that because of the inherent limitations of an audit, together with the inherent limitations of internal control, an unavoidable risk exists that some material misstatements may not be detected, even though the audit is properly planned and performed in accordance with GAAS.

§ Identification of the applicable financial reporting framework for the preparation of the financial statements.

§ Reference to the expected form and content of any reports to be issued by the auditor and a statement that circumstances may arise in which a report may differ from its expected form and content.

Practical Note

Because an engagement letter forms a contract between the reporting entity and the auditor, and because both parties to the contract must understand its contents for it to be valid, the letter should be delivered by the engagement leader or partner.

My next article will discuss other engagement letter issues, as well as some of the audit planning issues that should be discussed with management of a reporting entity when the engagement leader or partner delivers the engagement letter.

My exclusive presentation of webcasts and self-study courses covering various applications of auditing standards can be accessed by clicking the appropriate box on the left side of my home page, www.cpafirmsupport.com. Registered users on my website receive a 20% discount on CPE materials presented by myself and numerous other authors on a variety of professional topics. My assistance in CPA firm quality control consulting, audit planning and peer review preparation can be obtained by sending an email using the “Contact Us” tab on my home page.

Clarified Auditing Standard--Audit Documentation (Redrafted) (AU-C 230)

This Clarified Auditing Standard is a redraft of SAS No. 103 published in 2006. It contains no significant change to practice. The requirements in this standard underpin the specific documentation requirements in other Clarified Auditing Standards. As in the previous standard, the basic requirement for audit documentation preparation is that it must be sufficient to enable an experienced auditor having no previous connection with the audit to determine what the auditor did, what the auditor found and what the auditor did about what was found! While this is a liberal paraphrase of the specifics in the standard, it is the guiding principle for the preparation of all audit documentation.

Basic Objective of the Auditor

The basic objective of the auditor is to prepare documentation that provides a good record of evidence that is the basis for the auditor’s report; as well evidence that the audit was planned and performed in accordance with generally accepted auditing standards and any applicable legal and regulatory requirements.

Definitions – This SAS contains the following terms:

· Audit documentation. The record of audit procedures performed, audit evidence obtained, auditor actions and conclusions. Audit documentation is also referred to as working papers or workpapers.

· Audit file. One or more folders in hardcopy or electronic form that contains the evidence that constitutes the engagement documentation.

· Documentation completion date. A date no later than 60 days following the report release date at which a complete and final set of documentation is assembled in an audit file.

· Experienced auditor. An internal or external individual who has practical audit experience, understands the audit process, understands generally accepted auditing standards and any applicable industry standards, is familiar with the entity’s business environment and any legal or regulatory requirements that apply.

· Report release date. The date the auditor releases an audit report for distribution with the financial statements. (This date differs from the date statements are available for issue, which is the date management has finally approved the financial statements and the auditor has completed all applicable quality control review procedures. The date statements are issued may be the same as the report release date.)

Requirements

Documentation of the Audit Procedures Performed and Audit Evidence Obtained:

Audit documentation should provide an experienced auditor and understanding of:

· The nature, extent and timing of audit procedures planned and performed including:

o Identifying characteristics of items tested. This would include all client documents inspected, including those used in tests of controls or systems walk-through procedures.

o Initials of the preparer and the date procedures were completed.

o Initials of the reviewer, extent of the review and the date of the review.

· Planning and/or completion documents may be useful summaries for use by internal and external reviewers.

· The evidence obtained and the results of audit procedures including:

o Obtaining copies or extracts of significant contracts or agreements.

o Making a record of the discussion of significant matters with management or persons charged with governance, the persons with whom the matters were discussed and when the discussions occurred.

· Significant issues discovered during the audit, along with the professional judgments made and conclusions reached.

· Documentation required by other Clarified Auditing Standards (SASs) and applicable quality control standards (QC10).

· Documentation of the professional judgment and professional skepticism applied in performing the work and evaluating the results, the foundation of which begins with the assessed risks at the financial statement and assertion levels.

Matters arising after the Date of the Auditor’s Report:

When new or additional audit procedures are performed after the date of the auditor’s report, documentation should include a description of the circumstances, additional procedures and related evidence and conclusions and the effect on the auditor’s report.

Practical Note:

Audit documentation normally includes audit plans, analyses, memorandums, summaries of significant findings or issues, confirmation and representation letters, various practice aids and correspondence. Such documentation should demonstrate compliance with generally accepted auditing standards and Statement on Quality Control Standard No. 8 (QC 10).

All documentation that contains substantive audit evidence must include the identifying characteristics of the documents inspected, inquiries of client personnel performing procedures and their responses and the details of any observation procedures. A spreadsheet documenting all unusual matters discovered during planning and performance of the engagement, along with inquiries made of management, their responses and the auditor’s actions and conclusions, is a practical way to document audit findings and conclusions.

The Auditor's Communication with Those Charged with Governance (AU-C 260)

Objectives of the auditor’s communications with those charged with governance are to:

Communicate clearly the responsibilities of the auditor in relation to the financial statement audit and an overview of the planned scope and timing of the audit and to obtain information relevant to the audit from those charged with governance.
Provide timely observations arising from the audit that are significant and relevant to their responsibility to oversee the financial reporting process.
Promote effective two-way communication.

Definitions

Those charged with governance. The person(s) or organization(s) (for example, a corporate trustee) with responsibility for overseeing the strategic direction of the entity and the obligations related to the accountability of the entity. This includes overseeing the financial reporting process. Those charged with governance may include management personnel; for example, executive members of a governance board or an owner-manager.

Management. The person(s) with executive responsibility for the conduct of the entity’s operations. For some entities, management includes some or all of those charged with governance; for example, executive members of a governance board or an owner-manager.

Requirements

This SAS contains the following requirements:

· Determine who is charged with governance of the entity.

Communications with the audit committee or other subgroup of those charged with governance may need to be supplemented by communications to the entire governing body. When all of those charged with governance are involved in managing the entity the communications do not need to be repeated to the same persons.

· Matters to be communicated should include:

o Planning phase:

§ The auditor’s responsibilities in relation to the financial statement audit.

§ Planned scope and timing of the audit.

o Completion phase:

§ Significant findings or issues from the audit.

§ Uncorrected misstatements

When not all of those charged with governance are involved in management the auditor should also communicate to the governing body:

· Material corrected misstatements that were brought to the attention of management through the audit process.

· Significant findings or issues (including the Auditor’s views) that arose through audit procedures and were discussed with or communicated to management.

· Written representations that the auditor is requesting.

The Communication Process

· Establishing the Communication Process. The form, timing and expected content of the auditor’s communication should be communicated.

· Forms of Communication. The auditor should communicate the significant findings or issues from the audit, orally or in writing. The significant of the matters, whether they have been resolved, legal or regulatory requirements and other matters may affect whether the communication is oral or written. Matters arising during the performance of the audit that were communicated to those charged with governance and resolved need not be communicated again.

· Restricted Use. The communication is a by-product report and the auditor should indicated its use is restricted to those charged with governance and management and should not be used by anyone other than the specified parties (AU-C Section 905).

· Timing of Communications. Communications should be timely; practically they should occur before the audit report is released.

· Adequacy of the Communication Process. The auditor should evaluate if the two-way communication has been adequate. If it has not been adequate, the auditor should evaluate the effect on any auditing procedures performed and take appropriate action.

Documentation. Documentation of the oral and written communications with management and the governing body should be included in engagement files.

Practical Notes:

· Communication of the auditor’s responsibilities should include:

o A discussion of the reasonable assurance, not absolute, that is, provided by an audit in accordance with GAAS.

o That internal control is considered in designing an audit strategy but that no opinion of offered as to its effectiveness.

o That significant matters related to the audit, determined by the auditor’s professional judgment, will be communicated to those charged with governance.

· Matters related to the planned scope and timing of the audit to be communicated may include:

o How the auditor plans to address significant risks of material misstatement.

o The impact of risks of material misstatement on the consideration of materiality levels.

o Other matters related to the structure and responsibilities of the board of governance.

· Significant audit findings concerning accounting estimates and qualitative aspects of significant accounting practices may be communicated.

· Significant difficulties encountered during the audit, such as delayed or unavailable expected information, management restrictions and additional time necessary to obtain appropriate audit evidence may be communicated.

My next article will include an illustrative written communication for those persons charged with governance.

Clarified Auditing Standards—Documenting Professional Judgment and Professional Skepticism

In my last article, the definitions of professional skepticism and professional judgment from the foundational clarified standards were presented. As required by the clarified SAS, Audit Documentation, all applicable requirements in professional standards must be documented in engagement files. Following is an illustrative Planning Document for group audits that demonstrates an efficient way to prepare the required documentation of professional skepticism and professional judgment.

Planning Document

Client: _________________________________________________________________

Engagement Date: _______________________________________________________

Instructions:

This document should be completed by the group engagement in-charge accountant and reviewed by the group engagement leader (partner, sole proprietor) before engagement personnel begin fieldwork. It should describe engagement procedures accomplished and/or planned for both the group and component audits. It may contain cross-references to other planning documentation as applicable.

I. Group Engagement Administration:

A. Delivery of Group Engagement Letter:

The engagement letter is one of the primary tools for obtaining client understanding of their responsibilities and auditors’ responsibilities. A good understanding before the engagement begins will prevent misunderstandings from arising later. To accomplish this, the group engagement leader should deliver the letter and discuss its contents with the group CEO and/or representative member of the board of group governance. The letter should indicate the components for which the group auditor is taking audit responsibility and the component auditors’ reports to which it will refer in the group audit report.

Discussion of the letter with the party or parties engaging the CPA firm should be one of the primary sources for discovering potential misstatements, fraud or illegal acts, as well as other information relevant to the group audit. The group audit partner should determine that component auditor partners have delivered and discussed their engagement letters with responsible management persons, even if the group auditor is not taking responsibility for the component auditor’s work.

B. Use of Client Assistance or Paraprofessionals:

Client assistance should be used to the maximum extent possible on every engagement. When client personnel are unavailable, consider using firm paraprofessionals to perform accounting services and clerical work in connection with the engagement.

C. Planning for Proper Workspace:

The group engagement leader has the responsibility to arrange adequate workspace before the fieldwork begins. Poor lighting, lack of adequate heat or air conditioning, desks or tables that are too small, or work locations that are not near client accounting personnel are examples of situations that hinder the efficient completion of an engagement.

D. Assignment of Staff Personnel:

Assigning the right people to engagements ensures high quality and helps complete the engagements in the minimum amount of time. SQCS No. 8, effective January 1, 2012, requires CPA firm documentation of this element of quality control. Personnel should be assigned to engagements and tasks that are commensurate with their experience and capabilities. When persons assigned don’t have experience and capabilities commensurate with engagement risks, more and more frequent supervision is required from the engagement leader. A primary audit response to risk at the financial statement level required by audit and quality control standards is to assign experienced staff persons to the high-risk area or provide more supervision to lesser experienced persons.

When the group auditor is taking responsibility for component auditor’s work, the component auditor should confirm compliance with this element of quality control and required audit standard, and that appropriate documentation has been included in its engagement documentation files.

E. Target Dates:

Timely engagement completion involves setting target dates during planning. These target dates should be entered in the firm’s staff scheduling system.

Communications to component auditors should include target dates for the group auditor’s involvement when taking responsibility for the component auditor’s work, as well as dates financial information is required by the group auditor from all components

F. Use of Specialists:

Consider using outside specialists whenever any auditing procedures outside the firm’s expertise are expected to be performed. Such circumstances may include actuarial computations for pension funds, questions of law, observations of inventories of products or materials, required tests of client accounting software, and complex accounting and auditing problem situations.

When the auditor outsources any services in connection with an engagement, the engagement letter should contain a paragraph notifying the client. The auditor is also required to obtain a confidentiality agreement from the person or organization performing outsourced services.

When group audit specialists are engaged to perform work that will also be applicable to components, the group auditor’s communication to component auditors should discuss the selection of the specialists and their processes.

G. Electronic Auditing Opportunities:

Trial balance and financial statement preparation software, electronic practice aids, file container software, spreadsheets, word processing software, document scanners, data extraction software (such as Idea, Monarch or ACL) and “cloud” services should be used to create efficiencies on the group and component audit engagements. List the specific, planned applications for discussion among the group engagement team and for communication to component auditors.

H Audit Budgets:

Prepare a group audit budget based on circumstances, not fees, during engagement planning. Summarize the budget here for discussion among the group engagement team. Include a separate section for involvement in the work of component auditors.

II. Group Technical Audit Planning Decisions

A. Describe the process for selecting significant components.

Cross-reference this section to a separate memorandum or other documentation summarizing organizational, operational and financial information for all components. Summarize the components determined to be significant and whether the group engagement team will take responsibility for component auditors’ work or, instead, refer to component auditors in the group audit report.

B. Risk of misstatement at the group financial statement level:

Use of Group Statements:

Describe high-risk uses of statements.

Potential for Group Going-Concern Problems:

Describe continued losses, high debt and external situations that threaten the continued existence of the group or any of its components.

Integrity of Group Management:

Discuss specific information that could cast doubt on group or component management’s integrity.

Evaluate the risk of material misstatement at the group and component financial statement levels and document the subjective impact on audit responses and engagement procedures.

C. Document the group and components’ risk of misstatements evaluation at the assertion level (financial statement classification level for smaller entities), and the impact on the group and components’ audit strategy by major financial statement classification. This and other sections may be cross-referenced to other documentation.

D. Group Materiality Judgments:

Present a summary of the tolerable misstatement (performance materiality) and lower limit for individually significant items calculations and document group engagement team reasoning for group and component financial statements materiality levels.

E. Group Sampling and Non-Sampling Decisions:

Describe the reasons for making decisions to sample or not sample at the group and component levels. If decisions are made to sample, explain the rationale for sample size calculations.

F. Group Audit Strategies:

Describe the general group audit strategy including detailed substantive tests of balances, risk assessment procedures, tests of controls and/or extensive analytical procedures. Cross-reference this section to other group audit documentation for specific audit strategies at the group and component financial statement classification levels.

G. Nature of Group Audit Procedures:

Summarize the nature and extent of work for significant components and components to be referred to in the group audit report. Describe the nature, extent and timing of tests of balances procedures and analytical procedures for material financial statement classifications or cross-reference to other documentation describing planned procedures for material financial statement classifications at the group and component levels.

H. Significant Time-Savings Opportunities:

Describe here the opportunities to save time on the group and/or component audits not discussed elsewhere.

I. Group Engagement Team Meeting:

Summarize the significant potential risks of misstatement at the group and component levels due to error or fraud, planned audit responses and other matters discussed at the group engagement team meeting. All group engagement personnel, including partners or sole practitioners, are required to attend this meeting. Matters discussed affecting the work of component auditors should be communicated to them.

J. Planned Involvement with Component Auditors

Summarize here, if not present above, the extent of involvement in the work of component auditors when the group engagement team plans to take responsibility for their work and/or when component auditors reports will be referred to in the group audit report. This should include both administrative and technical activities similar to those summarized above for the group audit. This planned involvement should be part of the group engagement team’s communication to component auditors.

Prepared by:________________________________Date:_________________________

Reviewed by:_______________________________ Date:_________________________

Numerous webcasts and self-study courses covering various applications of auditing standards can be accessed by clicking the appropriate box on the left side of my home page, www.cpafirmsupport.com. Registered users on my website can obtain a 20% discount on CPE materials presented by myself and numerous other authors on a variety of professional topics.

Clarified Auditing Standards—Principles and Objectives of Audits

This is the first article in a new series focusing on the Clarified Auditing Standards issued by the Auditing Standards Board (ASB) of the AICPA. The first 39 standards were issued in SAS No. 122; other numbered standards have been issued subsequently. The content of each of the standards will be outlined and most articles will include a discussion of practical considerations related to the application of the SASs. The first Clarified Auditing Standard was issued in two parts:

· Statement on Auditing Standard (SAS): Preface to Codification of Statements on Auditing Standards, Principles Underlying an Audit Conducted in Accordance With Generally Accepted Auditing Standards, and

· SAS: Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance With Generally Accepted Auditing Standards.

Changes from Previous Standards

These standards supersede SAS No. 95, as amended, which contained the general, field work, and reporting standards (the 10 standards).

The Ten Generally Accepted Auditing Standards (GAAS) were considered by the ASB in formulating this SAS as follows.

SASs are codified within the framework of the 10 standards, viewed as the historical basis for generally accepted auditing standards (GAAS). The clarity drafting conventions adopted by the ASB include establishing an objective or objectives for each SAS.

The SAS establishes the overall objectives of the auditor, which are to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thus, enabling the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework; and to report on the financial statements, or otherwise as required by the SASs, in accordance with the auditor’s findings.

Each SAS contains an objective, or objectives that provide a link between the requirements and the overall objectives of the auditor. The SASs taken together provide the standards for the auditor’s work in fulfilling the overall objectives of the auditor.

If an auditor fulfills the overall objective of the audit and meets applicable ethical requirements, such as the AICPA Code of Professional Conduct, the ASB believes that the auditor will have fulfilled the requirements currently stated in the 10 standards. For this reason, the SAS does not contain 10 unconditional requirements that are the direct equivalent of the 10 standards.

Replacement of the 10 standards with principles

To preserve the functions of the 10 standards, the ASB has developed the Principles Governing the Conduct of an Audit in Accordance With Generally Accepted Auditing Standards (referred to as the principles).

The principles identified in the SAS have been drafted in the present tense, are not requirements and do not carry any authority. They are the fundamental principles that govern an audit and are supported by the objectives and requirements of the individual SASs.

Structure of the Principles

· The purpose of an audit (purpose). To provide financial statement users with an opinion by the auditor on whether the statements are presented fairly, in all material respects, in a manner that conforms to an applicable financial reporting framework

· Personal responsibilities of the auditor (responsibilities). These include competence and capabilities, compliance with appropriate ethical standards and approaching the work with appropriate professional skepticism and judgment.

· Auditor actions in performing the audit (performance). Perform the work necessary to be reasonably, but not absolutely, sure that the financial statements are free from material misstatement due to fraud or error.

· Reporting (reporting). Based on the results of the performance of the audit, express an opinion or state that an opinion cannot be expressed on the financial statements.

Definitions of Financial Reporting Frameworks

Financial reporting framework. A set of accounting principles that are used to determine measurement, recognition, presentation, and disclosure of all material items for preparing financial statements in accordance with principles generally accepted in the U.S.(GAAP), International Financial Reporting Standards (IFRSs), issued by the International Accounting Standards Board (IASB), or a special purpose framework prepared on a comprehensive basis of accounting other than GAAP (OCBOA– now referred as Special Purpose Framework). Note: The AICPA’s Financial Reporting Framework for Small- and Medium-Sized Entities is a special purpose framework.

Applicable financial reporting framework— The financial reporting framework adopted by management in the preparation and presentation of its financial statements.

Fair-presentation framework— Refers to a financial reporting framework that requires compliance with the requirements of the framework and acknowledges explicitly or implicitly that, to achieve fair presentation of the financial statements, it may be necessary for management to provide disclosures beyond those specifically required by the framework; or acknowledges explicitly that it may be necessary for management to depart from a requirement of the framework to achieve fair presentation of the financial statements. Such departures are expected to be necessary only in extremely rare circumstances. Current reporting requirements do not permit departures from GAAP unless they can be justified under Rule 203-1 of the AICPA Code of Professional Conduct, i.e, when the application of an accounting standard causes financial statements to be misleading.

Regulatory and contractual-based framework—Refers to a financial reporting framework that requires compliance with the requirements of the defined framework. This type of framework is referred to in the International Standards of Auditing (ISAs) as a compliance framework; the term was changed for purposes of GAAS to regulatory or contractual-based framework to avoid confusion with the term compliance audit.

Practical Considerations

Underpinning the principles in this standard, the concepts of professional skepticism and professional judgment are discussed in the application material. Professional skepticism includes being alert for contradictory audit evidence, information that brings doubt as to the reliability of documents and managements responses to inquiries and errors or fraud that indicate the need for additional substantive procedures.

Professional judgment is necessary on every engagement when considering audit risk and materiality, the nature, extent and timing of audit procedures, evaluating the appropriateness and reasonableness of financial statement assertions and the applicable financial reporting framework. Professional judgment is defined as the application of training, knowledge and experience, and knowledge of professional standards, in decision-making about actions necessary in any accounting or auditing engagement.

The auditor’s professional skepticism and professional judgment applied in planning, performing and completing an audit must be clearly documented in engagement files. Many auditors use a Planning Document or Planning Memo to document the exercise of professional judgment and professional skepticism applied in planning an audit, developing a cost-efficient audit strategy and modifying audit programs. An illustrative Planning Document will be present in the next article.