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Sales Tax Audit Engagement Letter

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Sales Tax Audit Engagement Letter Powered By Docstoc
					        AUDITING CHAPTER 7
The Audit Process and Detecting Fraud
Topic 1: Audit Process
What are the steps in a financial statement audit?
1. Communication with audit committee
2. Accepting, continuing engagements
3. Establish an understanding with the client
4. Understand client’s business strategies
5. Planning
6. Interim audit work
7. Year-end audit work


                                                     1
        AUDIT COMMITTEES: History
1940 SEC ASR #19 encouraged
1978 required by NYSE
1999 the Blue Ribbon Committee recommended on Improving the
Effectiveness of Audit Committee and suggested that audit committees
      Monitor GAAP compliance and use of “the best accounting principles”
      Members not having family or financial ties to the company
      Report to shareholders
Post 2000 SEC & Sarbanes-Oxley rules mandates
      Reviews of public company financial statement interim reports
      Disclosure in proxy statements whether audit committee discussed
          Financial statements with management
          Estimates, uncertainties, unusual transactions, new accounting principles,
          independence with auditor
2. A   public company’s audit committee should consist of:
a.     Representatives of management, shareholders, suppliers, and customers.
b.     The audit partner, chief financial officer, legal counsel, and at least one outsider.
c.     Representatives of the major equity interests (bonds, preferred stock, common stock).
d.     Board members who are not officers or employees.                       (AICPA Adapted) 2
      QUALITY OF EARNINGS
Auditor must discuss quality not just acceptability of
accounting principles & earnings with Audit committee
(SAS 89)
   Consistency in use of accounting principles
   Clarity, completeness of financial statements
Other typical responsibilities of audit committees
include:
   The scope and timing of the audit,
   Internal control,
   Internal audit,
   Accounting changes,
   The results of the audit.
   Disclosures within management’s financial statements, and
   The quality of reported earnings.
                                                                3
       ACCEPTING, CONTINUING
          ENGAGEMENTS
  Establish policies, procedures to accept, continue clients
  (Stmt. Quality Control Stds. No. 1 )
Case 7-14 Jones is approached by a prospective client who
  wishes to engage him to perform an audit that in prior years
  was performed by another auditor. Discuss the procedures
  Jones should follow in accepting or declining the engagement.
  For new client                              What are the steps in a financial statement
      Review financial statements               audit?
                                              1. Communication with audit committee
      Inquire about reputation, bankruptcy   2. Accepting, continuing engagements
                                              3. Establish an understanding with the client
      Evaluate ability to service client     4. Understand client’s business strategies
      Investigate key managers               5. Planning
                                              6. Interim audit work
                                              7. Year-end audit work




                                                                                       4
      COMMUNICATIONS WITH
         PREDECESSOR
   Successor auditor initiates communication
   Predecessor auditor obtains permission to disclose
   confidential information (Rule 301)
   Is prior auditor’s resignation, replacement linked to
   (SAS 84)
   Disagreement with management?
     Management integrity?

     Other reasons?

4. Communication with a predecessor auditor is initiated by:
a. Management
b. The successor auditor
c. The audit committee of the board of directors
d. The chair of the board of directors
                                                               5
  Case 7-12 Predecessor and Successor Auditors
The audit committee of the board of directors of Unicorn Corp. asked Tish
    & Field, LLP, to audit Unicorn’s financial statements. Tish & Field
    explained the need to make an inquiry of the predecessor auditor and
    requested permission to do so. Unicorn’s management agreed to
    predecessor auditor to respond fully to Tish & Field’s inquiries.
After communicating with the predecessor auditor, Tish & Field drafted an
    engagement letter that was mailed to the audit committee of Unicorn’s
    board of directors. The engagement letter described arrangements
    concerning the involvement of the predecessor auditor and other
    matters.
1. What information should Tish & Field have obtained during their
    inquiry of the predecessor auditor prior to accepting the engagement?
2. Describe what other matters Tish & Field would likely have included in
    the engagement letter.




                                                                       6
 UNDERSTANDING                                      What are the steps in a financial statement
                                                       audit?
                                                    1. Communication with audit committee
 WITH CLIENT                                        2. Accepting, continuing engagements
                                                    3. Establish an understanding with the client
   Objectives & limitations of engagement           4. Understand client’s business strategies
                                                    5. Planning
   Management’s responsibilities                    6. Interim audit work
       Financial statements                        7. Year-end audit work

       Establishing, maintaining effective internal controls over financial
        reporting
       Assuring compliance with laws & regulations
       Making records, information available
       Confirming representations made during engagement
   Example: financial statement audit
     Objective: express opinion whether statements
            Present fairly
            In all material respects
            In conformity with GAAP SAS 83 & SSAE 7
5. Management is not responsibility for:
a. The audited financial statements            c. The auditors’ report
b. Preparing spreadsheets for the auditor      d. Compliance with laws and regulations
                                                                                             7
       ENGAGEMENT LETTERS
 Drafted by auditor for CEO’s signature
 Written agreement to state purpose of engagement & role of
 auditor
 Optional but recommended by SAS 84 which requires some
 form of written understanding in work papers
 SAS 108 requires establishment of understanding with client
 through written communication (engagement letter)

10. To avoid misunderstandings between a practitioner
     and client, engagement arrangements are written in:
a. A legal letter
b. An engagement letter
c. A client representation letter
d. A letter on reportable conditions


                                                               8
                                        Cheever & Yates, LLP
                                             Suite 2600
                                        650 Madison Avenue
                                         New York, NY 10022
March 24, 2006
Mr. Raymond Carver, President
The Wilson Company
                                                              The scope of the audit
15 Artubus Drive
Stony Brook, NY 11790
                                         The objective of the audit
Dear Mr. Carver:
   This will confirm our understanding of the arrangements for our audit of the financial statements
   of The Wilson Company for the year ended December 31, 2005.

    We will audit the company's balance sheet at December 31, 2005, and the related
    statements of income, retained earnings, and cash flows for the year then ended for the
    purpose of expressing an opinion on them. Our audit will be made in accordance with
    generally accepted auditing standards. Our procedures will include tests of documentary
    evidence supporting the transactions recorded in the accounts, tests of the physical
    existence of inventories, and direct confirmation of receivables and certain other assets
    and liabilities by correspondence with selected customers, creditors, legal counsel, and
    banks. At the conclusion of our audit, we will request certain written representations from
    management about the financial statements and related matters.


                                                          Management representations


                                                                                                 9
       Unavoidable risk                         Management’s responsibility for the
                                                      financial statements
Management is responsible for the fair presentation of financial statements in conformity with
generally accepted accounting principles and for the development, implementation, and
maintenance of adequate internal controls. Although we may consult with you about accounting
principles, management is responsible for their selection and application. Our engagement is subject
to the risk that material errors, irregularities, or illegal acts, if they exist, will not be detected.
However, we will inform you of any such matters that come to our attention.

We will review the company's federal and state income tax returns for the fiscal year ended
December 31, 2005. These returns, we understand, will be prepared by the controller. Further, we will
be available during the year to consult with you on the tax effects of any proposed transactions or
contemplated change in business policies.
                                                      Fees and billing arrangements

Our fee for these services will be at our regular per diem rates, plus travel and other out-of-
pocket costs. Invoices will be rendered every two weeks and are payable on presentation.
We are pleased to have this opportunity to serve you.
If this letter expresses your understanding, please sign the enclosed copy where indicated and
return it to us.
                                                               Sincerely,
                                                               Cheever & Yates, LLP
Arrangements accepted:
_____________________________                         ___________________
President, The Wilson Company                         Date

              Request for client confirmation
                                                                                                   10
           PROPOSED ADJUSTING
          JOURNAL ENTRIES (AJE)
        Understanding with Client (Planning Stage)
                    Management understands responsibility to:
 Engagement
    Letter              record material proposed adjustments
                        Represent that unrecorded proposed AJEs are immaterial
        Management Representations (Year End)
 Management         Management represents in representation letter that:
Representation          Proposed but unrecorded AJEs are immaterial,
    Letter              both individually and in the aggregate
                        Summary of proposed AJEs
        Communication with Audit Committee (Year End)
    Audit           Auditor informs audit committee
  Committee             management’s responsibilities for adjustments
   Meeting
                        Proposed but unrecorded AJEs are immaterial,
                        both individually and in the aggregate
                                                                                 11
                                           What are the steps in a financial statement
                                              audit?
UNDERSTANDING                              1. Communication with audit committee
                                           2. Accepting, continuing engagements


CLIENT’S BUSINESS                          3. Establish an understanding with the client
                                           4. Understand client’s business strategies
                                           5. Planning
                                           6. Interim audit work
Understanding the following aspects of the 7. Year-end audit work

     entity and its environment, including internal control:
  Industry, regulatory and other external factors
  Nature of the entity
  Objectives and strategies and related business risks that may
   result in a material misstatement of the financial statements
  Measurement and review of the entity’s financial performance
  Internal control, including the selection and application of
   accounting policies
Auditor considers effects of client business & strategies on
  Risks
  Strategies to overcome risk
  Transactions, events as products of management’s strategies
                                                                                  12
CLIENT STRATEGY TEMPLATE
Strategies
    Growth strategy
    Financial goals & operating priorities
Characteristics of business
    Major business units
    Markets
    Products
    Customers
    Competitors
    Strategic alliances & joint ventures
    Potential adverse influences
                                              13
           Client Strategy Template: Merck & Company

Strategies

 Growth Strategy: Demonstrate the value of medicines to patients, payers & providers. Discover new
 medicines through breakthrough research.

 Financial Goals & Operating Priorities: Remain in the top quartile of leading health care companies.
 Maximize revenue growth. Preserve the profitability of core pharmaceutical business through continuous
 improvements in productivity and organizational effectiveness. Achieve the full potential of managed
 pharmaceutical care.
Characteristics of the Business
 Major Business Units: The Americas, Europe/Middle East/Africa, Asia Pacific, Merck-Medco Managed Care,
 Vaccines
 Markets: Elevated cholesterol, Hypertension/heart failure, Anti-ulcerants, Antibiotics, Ophthalmologicals,
 Vaccines/Biologicals, Human immunodeficiency virus (HIV), Osteoperosis, Animal health/crop protection
 Products: Cozaar (high blood pressure), Zocor (elevated cholesterol), Fosamax (postmenopausal
 osteoporosis), Proscar (symptomatic benign prostate enlargement), Pepcid (ulcers & gastroesophageal reflux
 disease), Mefoxin (antibiotic), Primaxin (antibiotic), Dolobid (arthritis & pain), Indocin (arthritis), Chibroxin
 (conjunctivitis), Timoptic (glaucoma), Singulair (asthma), Pneumovax 23 (adult pneumonia), Recombivax HB
 (hepatitis B), Ivermectin (animal parasites), Thiabendazole (crop fungal infestation), Maxalt (migraine
 headaches)
 Customers: End Users (Human, Animal), Heath Care Providers, Insurance Companies, Center for Disease
 Control
 Competitors: American Home Products, Bayer, Bristol-Myers Squibb, Eli Lilly, Johnson & Johnson, Pharmacia
 & Upjohn, Pfizer, Schering-Plough, Warner-Lambert
 Strategic Alliances/Joint Ventures: Astra, DuPont, Johnson & Johnson, Chugai, Pasteur Merieux, Merial
                                                                                                   14
                     Client Strategy Template: Merck & Company
Strategies
Growth Strategy: Demonstrate the value of medicines to patients, payers & providers. Discover new
medicines through breakthrough research.

Financial Goals & Operating Priorities: Remain in the top quartile of leading health care companies.
Maximize revenue growth. Preserve the profitability of core pharmaceutical business through continuous
improvements in productivity and organizational effectiveness. Achieve the full potential of managed
pharmaceutical care.
Characteristics of the Business

          Issues                                       Threat to Merck
    1     Limited drug pipeline        > Leads to > At-risk growth strategy

          Managed care, generics > Leads to > Competitive pricing


                 2    Translates to a threat to Merck’s
                      Financial Goals


                             3      Q? How would an auditor know this?

 Managed Care, Generics, Declining Exclusivity Periods., Federal Drug Administration, Patent Expiration,
 Market Acceptance & Demand, Global & Domestic Politics, Interest Rates, Currency Fluctuations,
 Knowledge Transmission
                                                                                                    15
            Threats to Merck & Audit Risk
At-risk growth strategy
   Deutsche Bank Securities analyst’s report:
Company may need to “... consider a significant merger to … boost its
   growth prospects.”
   Dow Jones News Service:
“... there is concern in the market about its future growth ... because
   the company faces a number of upcoming patent expirations.”
Competitive pricing
 Discount demands from managed care groups.
 Federal and state legislative proposals to reduce healthcare costs.
 Increased patient co-payments for prescription drugs.
 Physician incentives to prescribe generics.
 Employer pressures to curb increases in healthcare costs


                                                                       16
FIRST & SECOND QUARTER
PLANNING
 First-Quarter (April-May)                            Second-Quarter (July-August)
    Review prior-year audit work                       Review 2nd quarter results
    Review 1st quarter results                         Finalize budget
    Prepare preliminary audit                          Perform analytical procedures
    time budget                                        Prepare preliminary planning
    Consider adverse influences                         memo
What are the steps in a financial statement audit?     Coordinate staff with client
1. Communication with audit committee
2. Accepting, continuing engagements                   Prepare interim audit programs
3. Establish an understanding with the client
4. Understand client’s business strategies       Which of the following procedures would an auditor
                                               11.
5. Planning                                       most likely perform when planning an audit?
6. Interim audit work
                                               a. Review prior-year audit documents
7. Year-end audit work
                                              b. Inquire about potential litigation, claims, and
                                                  assessments.
                                              c. Obtain a representation letter from management
                                              d. Determine whether internal controls are applied as
                                                  prescribed
                                                                                                17
               INTERIM AUDIT WORK:
                     Controls & Programs
19. A purpose of reviewing first-quarter financial results during audit planning is to:
a. Identify unexpected fluctuations occurring in account balances since the prior-year financial
    statements
b. Become familiar with accounts likely to appear in the financial statements
c. Plan evidence to be gathered in auditing accounts that are new to the first-quarter financial
    statements
d. Assess first-quarter financial position, results of operations, and cash flows


                                                  What are the steps in a financial statement audit?
                                                  1. Communication with audit committee
     September-October                            2. Accepting, continuing engagements
                                                  3. Establish an understanding with the client
       Understand internal control                4. Understand client’s business strategies
       Perform tests of controls                  5. Planning
                                                  6. Interim audit work
       Assess control risk                        7. Year-end audit work

     November
       Prepare preliminary audit programs
                                                                                                       18
   YEAR-END AUDIT WORK
                                   What are the steps in a financial statement audit?
                                   1. Communication with audit committee
                                   2. Accepting, continuing engagements
December                           3. Establish an understanding with the client
   Coordinate with client          4. Understand client’s business strategies
                                   5. Planning
   Finalize audit program          6. Interim audit work
                                   7. Year-end audit work
January-February
   Perform substantive tests, analytical procedures
   Evaluate audit test results
     Material errors, fraud
   Subsequent events
Year-end Audit Documentation
   Management, legal representations
   Audit documentation review
     Staff work reviewed
   Audit reports

                                                                                 19
Topic 2: Auditor’s responsibility to detect, report fraud


                  ERRORS VS. FRAUD
   SAS No. 99, “Consideration of Fraud in a Financial Statement Audit”
       “Fraud is a broad legal concept and auditors do not make legal
       determinations of whether fraud has occurred. Rather, the auditor's
       interest specifically relates to acts that result in a material
       misstatement of the financial statements. The primary factor that
       distinguishes fraud from error is whether the underlying action that
       results in the misstatement of the financial statements is intentional or
       unintentional. For purposes of the Statement, fraud is an intentional
       act that results in a material misstatement in financial statements that
       are the subject of an audit.”




                                                                            20
             ERRORS VS. FRAUD
  Errors
    Unintentional misstatements or omissions in financial statements

  Fraud
    Fraudulent financial reporting: intentional misstatement or

     omission (earnings management)
    Misappropriation of assets: embezzlement ( thefts of cash,

     securities, etc.)
  Risk of misstatement from fraud

15.Which of the following, if material, would be a fraud?
a. Errors in the application of accounting principles
b. Clerical errors in accounting data underlying the financial statements
c. Misinterpretation of facts that existed when the financial statements were
   prepared
d. Misappropriation of an asset or groups of assets

                                                                           21
                    RISK OF FRAUD:
                 Auditor’s Responsibility
What is an auditor’s responsibility for fraud?
1. Exercise professional skepticism,
2. Discuss among staff the risk of fraud driving material
   misstatement,
3. Obtain information needed to identify risk,
4. Identify risks that may cause material misstatement,
5. Assess the risks,
6. Respond to the assessment, and
7. Evaluate audit evidence.

14. Which of the following would auditors most likely discuss in a brainstorming session
    to identify and assess fraud risk?
a. Pressures on client employees
b. Audit time budgets
c. The audit committee’s awareness of fraud
d. Former auditors employed by the client
                                                                                      22
                RISK OF FRAUD:
            Professional Skepticism
Professional skepticism
  No presumption of dishonesty balanced with possibility of
   misstatement due to fraud
“The auditor should conduct the engagement with a mindset that recognizes
the possibility that a material misstatement due to fraud could be present,
regardless of any past experience with the entity and regardless of the auditor’s
belief about management’s honesty and integrity.”

 Presume two fraud risks:
                                                                          e.g.,
  > Improper revenue recognition                                          Sunbeam,
    • Apply analytical procedures to disaggregated data                   Global
    • Confirm sales contract terms                                        Crossing,
    • Inquire of sales, marketing & GC sales or shipments near year end   Enron, Rite
    • Witness shipments at year end                                       Aid,
 > Internal control override                                              WorldCom,
    • Examine journal entries                                             Xerox …
    • Review accounting estimates
    • Evaluate business purpose for unusual transactions
                                                                                    23
RISK OF FRAUD: Other Aspects
Professional skepticism
  No presumption of dishonesty balanced with possibility of
                                           Current Assets  NetFixedAssets 
   misstatement due to fraud          1                                  
                                                                            
                                                                             t                                     t

                                                      Total Assets                           t
                                         Current Assets  NetFixedAssets 
Fraud screens                        1 
                                        
                                                                         t 1
                                                                              
                                                                              
                                                                                                                   t 1

                                                     Total Assets                         t 1


  Some financial ratios help         WorkingCapital                    t  ( t  1)

                                         Cash
      Asset quality                                      t  ( t  1)

                                      CurrentTaxes Payable                            t  ( t  1)


      Total accruals to total assets  Current Portionof Longs Debt
                                                    TotalAsset
                                                                 Term                                          t  ( t  1)

                                                                                           t

      Days sales in receivables        Accounts Re ceivable t / Sales t
                                                Accounts Re ceivable                      t 1        / Sales t  1

18.   An increase in a company’s asset-equity ratio could suggest that:
a.    The market value of assets is increasing
b.    Working capital has shifted from receivables and inventory to cash
c.    Assets with less certain benefits are increasing
d.    The proportion of collectible receivables is increasing                                             24
      IDENTIFYING, ASSESSING RISK
                             Incentive
               OF FRAUD
        Fraud triangle
          Incentives, pressures to commit fraud Opportunity
          Opportunities to commit fraud                 Rationalization

          Management’s rationalizations for committing fraud



       16. Which of the following is an inappropriate reaction to a material fraud detected in
            a publicly traded company?
       a. Report the matter to the SEC
       b. Discuss the matter with the audit committee of the board of directors
       c. Obtain further evidence
       d. Suggest that the client consult with legal counsel about questions of law

17. Which of the following statements best describes an auditor’s responsibility to detect fraud?
a. The auditor is responsible for failing to detect fraud when the failure clearly results from not
    performing audit procedures described in the engagement letter
b. The auditor must extend auditing procedures to search actively for fraud
c. The auditor must assess the risk that material fraud may exist
d. The auditor is responsible for failing to detect fraud only when an unqualified opinion is issued.
                                                                                                25

				
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