1. Introduction to Completion and Review
The completion and review stage is the final phase of an audit. It's when the auditor performs a series of wrap-up procedures to form a conclusion and prepare the auditor's report. Key activities include reviewing subsequent events, assessing the company's ability to continue as a going concern, and evaluating any misstatements identified during the audit.
Strategic Maneuvering: The "Final Push"
This stage is about synthesis. You're bringing all your audit evidence together to make key judgments. Exam questions often combine topics from this chapter, so you need to understand how subsequent events can impact going concern, how uncorrected misstatements affect the audit opinion, and how written representations support your conclusions.
2. Subsequent Events (IAS 10)
A subsequent event is an event occurring between the year-end date and the date the auditor's report is signed. Auditors have an "active duty" to look for these events and a "passive duty" to act if they become aware of issues after the report is signed. The classification of an event as adjusting or non-adjusting is critical, as it determines the required accounting treatment.
- Adjusting Events: Provide evidence of conditions that existed at the year-end. The financial statements must be adjusted. Examples include the bankruptcy of a customer or the discovery of fraud.
- Non-adjusting Events: Are indicative of conditions that arose after the year-end. The financial statements are not adjusted, but a disclosure in the notes is required if the event is material. Examples include a fire, a new share issue, or a major acquisition.
Test your understanding 1: Murray Co subsequent events review
Financial statement extracts
| 31 Dec 20X4 ($000) | 31 Dec 20X3 ($000) | |
|---|---|---|
| Revenue | 21,960 | 19,580 |
| Total assets | 9,697 | 7,288 |
| Profit before tax | 1,048 | 248 |
Events:
(1) On 2 January 20X5, Golf is Us, a major customer of Murray Co, was placed into administration owing $211,000.
(2) On 3 January 20X5, the sales director left the company. The sales director is suing Murray Co for constructive dismissal. If successful, the claim amounts to $280,000.
(3) On 5 February 20X5 there was a fire at the premises of the third party warehouse provider, which destroyed all inventory held there. Approximately one half of Murray Co's inventory was stored in these premises. The total value of inventory stored at the premises was $1,054,000.
(4) The financial statements include a $40,000 provision for an unfair dismissal case brought by an ex-employee of Murray Co. On 7 February 20X5 a letter was received from the claimant's solicitors stating that they would be willing to settle out-of-court for $25,000. It is likely the company will agree to this.
Required: For each of the events above discuss whether the financial statements require amendment in order to avoid a modified audit opinion.
Solution:
- Event 1 (Golf is Us): This is an adjusting event. The bankruptcy provides evidence of the recoverability of the receivable at the year-end. The $211,000 is material (20% of profit). The financial statements should be adjusted by writing off the debt.
- Event 2 (Sales director claim): This is a non-adjusting event. The claim arose after the year-end. The amount of $280,000 is material, so disclosure should be made in the notes.
- Event 3 (Fire): This is a non-adjusting event. The fire occurred after the year-end. The $1,054,000 loss is material, so disclosure is required.
- Event 4 (Unfair dismissal settlement): This is an adjusting event. The out-of-court offer provides new evidence on the valuation of the provision at the year-end. The adjustment is not material, so no amendment is strictly necessary to avoid a modified opinion, though management should be encouraged to correct it.
3. Going Concern (ISA 570)
Going concern is the assumption that a company will continue in business for the foreseeable future (at least 12 months from the date the financial statements are signed). The directors are responsible for this assessment and for disclosing any material uncertainties. The auditor's role is to obtain evidence on the appropriateness of this assumption.
Indicators of going concern problems include negative cash flows, defaulted loan agreements, net liabilities, loss of key staff, or over-reliance on a single customer.
Test your understanding 2: Murray Co going concern review
On 2 January 20X5, Golf is Us, a major customer of Murray Co, was placed into administration owing $211,000.
On 3 January 20X5, the sales director left the company and has yet to be replaced. The sales director is suing Murray Co for constructive dismissal.
On 5 January 20X5 there was a fire at the premises of the third party warehouse provider, which destroyed all inventory held there. Approximately one half of Murray Co's inventory was stored in these premises.
The assembly line for ergometers (rowing machines) was refurbished during the year at a cost of $1 million. The additional $1.5 million loan facility provided to Murray Co during the year is secured, in part, on the refurbished assembly line. The assembly line broke down during January and six weeks later is still not working.
The company is seeking new funding through an initial public offering of shares in the company (i.e. listing on the stock exchange). In the event that the initial public offering does not proceed, this will require Murray Co's existing banking arrangements to be renegotiated and additional funding to be raised from either existing or new investors.
The financial statements of Murray Co show an overdraft at 31 December 20X4 of $180,000 (20X3: $120,000). The overdraft limit is $250,000. The cash flow forecast shows negative monthly cash flows for the next twelve months. As a result of cash shortages in February 20X5, a number of suppliers were paid late.
Required: Using the information provided, explain the potential indicators that Murray Co is not a going concern.
Solution:
- Financial indicators: Negative cash flows, operating near its overdraft limit, and late payments to suppliers all indicate a lack of working capital.
- Operational indicators: The fire at the warehouse, the broken assembly line, and the loss of a key sales director all threaten future revenue and ability to trade.
- External indicators: The loss of a major customer (Golf is Us) and the uncertainty of securing new funding through an IPO are significant external threats to the company's future.
4. Evaluation of Misstatements (ISA 450)
Auditors must accumulate a list of all misstatements identified during the audit, even if they are individually small. Management should be requested to correct all misstatements. If they refuse, the auditor must evaluate the aggregate effect to determine if it is material. If the total is material, a modified opinion may be necessary.
5. Written Representations (ISA 580)
A written representation is a letter from management to the auditor confirming certain matters, especially those based on management's judgment or knowledge. It is a necessary form of audit evidence, but it is not a substitute for other, more reliable evidence.
Exam Focus: Refusal to Sign
If management refuses to provide a written representation, it is a serious issue. It casts doubt on their integrity and the reliability of all other evidence. This will likely lead to a disclaimer of opinion.
Test Your Understanding: Summary Questions
Smithson Co provides scientific services to a wide range of clients. Typical assignments range from testing food for illegal additives to providing forensic analysis on items used to commit crimes to assist law enforcement officers. The annual audit is nearly complete. As audit senior you have reported to the engagement partner that Smithson Co is having some financial difficulties. Income has fallen due to the adverse effect of two high-profile court cases, following which a number of clients withdrew their contracts with Smithson Co. A senior employee then left Smithson Co, stating lack of investment in new analysis machines was increasing the risk of incorrect information being provided by the company. A cash flow forecast prepared internally shows Smithson Co requiring significant additional cash within the next 12 months to maintain even the current level of services.
Required:
(a) Define 'going concern' and discuss the auditor's and directors' responsibilities in respect of going concern. (5 marks)
(b) State the audit procedures that may be carried out to try to determine whether or not Smithson Co is a going concern. (10 marks)
(c) Explain the audit procedures and actions the auditor may take where the auditor has decided that Smithson Co is unlikely to be a going concern. (5 marks)
Solution:
(a) Going Concern Definition & Responsibilities: Going concern is the assumption that an entity will continue in business for the foreseeable future. Directors are responsible for this assessment and for disclosing any material uncertainties. The auditor's role is to obtain sufficient evidence on the appropriateness of this assumption.
(b) Audit Procedures:
- Review management's cash flow forecast, paying attention to the reasonableness of assumptions.
- Review subsequent events, such as post-year-end correspondence with clients, to assess the impact of lost contracts.
- Discuss with management their plans to raise additional cash and inspect any related agreements.
(c) Actions if not a going concern:
- Discuss with directors to ensure they prepare the financial statements on a break-up basis.
- If they refuse to use the break-up basis, issue an adverse opinion, as the financial statements are materially and pervasively misstated.
Potterton Co is a listed company that manufactures body lotions under the 'ReallyCool' brand. The company's year-end is 31 March 20X5, and today's date is 1 July 20X5. Draft profit before taxation is $4 million.
Outstanding issues:
(1) On 27 May 20X5 a legal claim was made against the company on behalf of a teenager who suffered severe burns after using 'ReallyCool ExtraZingy Lotion' in July 20X4. Potterton Co is considering an out-of-court settlement of $100,000 per year for the remaining life of the claimant. However, no adjustment or disclosure has been made in the financial statements.
(2) At a board meeting on 30 April 20X5, the directors of Potterton Co proposed a dividend of $2 million. It is highly likely that the shareholders will approve the dividend at the annual general meeting on 3 September 20X5. The directors have recorded the dividend in the draft statement of changes in equity for the year-ended 31 March 20X5.
Required:
(a) Explain whether the two outstanding issues are adjusting or non-adjusting events, in accordance with IAS 10 Events after the Reporting Period. (8 marks)
(b) Describe appropriate audit procedures in order to reach a conclusion on the two outstanding issues. (5 marks)
(c) Explain the likely impact on the audit opinion if the directors refuse to make any further adjustments or disclosures in the financial statements of Potterton Co. (4 marks)
Solution:
(a) Analysis of events:
- Legal claim: This is an adjusting event. The claim provides evidence of a condition that existed at the year-end (the product was sold and used in the prior period). The potential liability is material, so a provision should be recognized.
- Proposed dividend: This is a non-adjusting event. The dividend was proposed after the year-end and no liability exists until it is approved by shareholders. It should be disclosed, not recognized.
(b) Audit Procedures:
- Legal claim: Review legal correspondence to understand the likelihood of the claim and the amount of the settlement.
- Proposed dividend: Inspect board minutes to confirm the amount of the proposed dividend and ensure it is disclosed in the notes.
(c) Impact on audit opinion:
- The unadjusted provision and incorrectly recognized dividend are material misstatements. This will likely lead to a **qualified opinion** if the auditor concludes they are material but not pervasive, or an **adverse opinion** if they are considered pervasive.