Top Auditing Issues FOR 2015 CPE COURSE BONUS CPE COURSE! PERRY M. HENDERSON, CPA, MPA JAMES L. ULVOG, CPA

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1 Top Auditing Issues FOR 2015 CPE COURSE PERRY M. HENDERSON, CPA, MPA JAMES L. ULVOG, CPA BONUS CPE COURSE! Earn CPE Credit and stay on top of key Accounting issues. Go to CCHGroup.com/PrintCPE

2 Top Auditing Issues FOR 2015 CPE COURSE Perry M. Henderson, CPA, MPA James L. Ulvog, CPA 1

3 Contributors Technical Review... Kelen Camehl Production Coordinator... Mariela de la Torre; Jennifer Schencker Production... Lynn J. Brown This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought CCH Incorporated. All Rights Reserved W. Peterson Ave. Chicago, IL CCHGroup.com No claim is made to original government works; however, within this Product or Publication, the following are subject to CCH Incorporated s copyright: (1) the gathering, compilation, and arrangement of such government materials; (2) the magnetic translation and digital conversion of data, if applicable; (3) the historical, statutory and other notes and references; and (4) the commentary and other materials. 2

4 Introduction CCH's Top Auditing Issues for 2015 CPE Course helps professionals stay abreast of the most significant new auditing standards and important developments. It does so by identifying the events of the past year that have developed into hot issues and by reviewing the opportunities and pitfalls presented by these changes. This course is structured in four Modules. The first Module covers risk assessment and audit documentation. Chapter 1 provides a top-level summary and overview of the definitions and significant requirements of the Risk Assessment sections of the Clarified Statements on Auditing Standards, and additional practical implementation guidance in selected key areas. Chapter 2 provides in-depth coverage of the AICPA s AU-C section 230, Audit Documentation, and a summary of the documentation requirements lodged in other AU-C sections. The content of Module 1 is: Chapter 1 Risk Assessment Standards Overview Chapter 2 Audit Documentation The second Module covers Financial Reporting Framework for Small- and Medium-sized Enterprises. Chapter 3 introduces FRF for SMEs and provides an overview of the accounting model. Chapter 4 describes the general principles for the statements of financial position, operations, and cash flow. It also describes the very brief guidance in the framework for derivatives and sales of financial assets. Treatment of changes in accounting principle and correction of errors is described. Chapter 5 describes the requirements in the framework for inventory, PP&E, discontinued operations, and equity. It also covers the broader, general topics of commitments, contingencies, related party transactions, and subsequent events. Chapter 6 describes the accounting for investments, with a focus on the simplicity in the FRF for SMEs framework. Consolidation and acquisition of another entity through business combination is explained. Chapter 7 describes the general principles used to guide revenue recognition. It also describes the accounting for intangible assets and leases. Chapter 8 describes the accounting for retirement and other postemployment benefits and also income taxes. Both areas are noticeably simpler than the corresponding rules in GAAP. The content of Module 2 is: Chapter 3 FRF for SMEs An Alternative to GAAP Introduction Chapter 4 FRF for SMEs An Alternative to GAAP Basic Financial Statements Chapter 5 FRF for SMEs An Alternative to GAAP General Issues Chapter 6 FRF for SMEs An Alternative to GAAP Investments and Consolidation Chapter 7 FRF for SMEs An Alternative to GAAP Revenue, Intangibles, Leases Chapter 8 FRF for SMEs An Alternative to GAAP Pensions, Income Taxes The third Module covers a mix of topics dealing with quality control and peer review, internal audit, and GAAP relief for private business. Chapter 9 summarizes the definitions and requirements of SQCS 8, relevant to the monitoring element of quality control, the provisions of PRP Section 10,000, and provides commentary on the elements of an effective monitoring program, and offers guidance on monitoring steps for practical implementation. Chapter 10 summarizes the definitions and requirements of SQCS 8, relevant to engagement quality control review, provides commentary on the elements of an effective engagement quality control review program, and 3

5 offers practical implementation guidance. Chapter 11 provides an update and overview of important changes affecting both the administrative processes, substantive requirements, and their practical implications for the peer review process. Chapter 12 reviews the Statement on Auditing Standards Number 128, Using the Work of Internal Auditors (SAS 128) issued by the Auditing Standards Board. Chapter 13 describes the alternatives identified by the Private Company Council (PCC) to simplify accounting requirements for private business. The content for Module 3 is: Chapter 9 Monitoring as an Element of Quality Control Chapter 10 Engagement Quality Control Review Chapter 11 Peer Review Update Chapter 12 Using the Work of Internal Auditors Chapter 13 Private Company Council Relief from some GAAP Rules for Private Business The fourth Module covers audit evidence and consideration for fraud. Chapter 14 is intended as a top-level summary and overview of the significant definitions and requirements of the twelve pronouncements that make up the Audit Evidence section of the clarified audit standards. Chapter 15 examines fraud in the financial statement audit from an academic and professional perspective that is concerned with conceptual models, and a professional liability insurance company s claims experience. The content of Module 4 is: Chapter 14 Audit Evidence Chapter 15 Fraud in a Financial Statement Audit Study Questions. Throughout the course you will find Study Questions to help you test your knowledge, and comments that are vital to understanding a particular strategy or idea. Answers to the Study Questions with feedback on both correct and incorrect responses are provided in a special section beginning at 10,100. Quizzer. This course is divided into four Modules. Take your time and review all course Modules. When you feel confident that you thoroughly understand the material, turn to the CPE Quizzer. Complete one, or all, Module Quizzers for continuing professional education credit. Go to CCHGroup.com/PrintCPE to complete your Quizzer online. The CCH Testing Center website lets you complete your CPE Quizzers online for immediate results and no Express Grading Fee. Your Training History provides convenient storage for your CPE course Certificates. Further information is provided in the CPE Quizzer instructions at 10,200. November 2014 Perry M. Henderson, CPA, MPA James L. Ulvog, CPA CCH'S PLEDGE TO QUALITY Thank you for choosing this CCH Continuing Education product. We will continue to produce high quality products that challenge your intellect and give you the best option for your Continuing Education requirements. Should you have a concern about this or any other CCH CPE product, please call our Customer Service Department at

6 COURSE OBJECTIVES Upon completion of this course, the reader should be able to: List key requirements of the risk assessment standards and describe the effects of the auditor s risk assessment on the nature, timing and extent of further audit procedures List the audit documentation requirements of the AICPA s AU-C section 230, Audit Documentation, and describe current implementation issues in the practical application of audit documentation standards Describe the Reporting Framework for Small- and Medium-Sized Entities. (FRF for SMEs) and identify the type of entities for which FRF for SMEs is most appropriate Describe the general financial statement recognition and presentation concepts contained in the FRF for SMEs framework Describe the FRF for SME requirements for inventory, long-lived assets, stock-based compensation, related party transactions, subsequent events, subsidiaries, and investments Describe the criteria for recognizing, measuring, and amortizing goodwill and other intangible assets Identify the accounting policy choices in accounting for income taxes, retirement, and other postemployment benefits List the requirements of Statements on Quality Control Standards No. 8, A Firm s System of Quality Control (SQCS 8) related to monitoring and explain their application to a variety of practical situations List the requirements of Statements on Quality Control Standards No. 8, A Firm s System of Quality Control (SQCS 8) related to engagement quality control review and explain their application to a variety of practical situations Identify changes to previous peer review practice created by the revised Peer Review Program Manual Describe the factors used to evaluate whether the internal audit function can be used to obtain audit evidence List the types of entities which generally may elect to follow the accounting treatments approved by FASB and PCC Describe the three alternative accounting approaches approved by PCC, including the effective date and transition Explain significant audit planning and performance requirements related to audit evidence and recognize areas of significant audit risk that require specific forms of audit evidence Explain the various conceptual models for assessing fraud risk and the implications of evolving models of fraud risk and malpractice claims experience for audit practice One complimentary copy of this course is provided with certain copies of CCH publications. Additional copies of this course may be downloaded from CCHGroup.com/PrintCPE or ordered by calling (ask for product ). 5

7 About the Author Perry M. Henderson has over thirty years of experience in public accounting. For over twenty years, he has been a sole practitioner providing audit and accounting services to nonprofit organizations and privately held businesses. He has performed peer reviews of about five hundred accounting firms and has served on the Peer Review Committee and Professional Conduct Committee of the California Society of CPAs, and the Executive Committee of the AICPA Governmental Audit Quality Center. He is the author of the CPA's Guide to Quality Control and Peer Reviews, and of Top Auditing Issues since He also has contributed material to several other CCH publications, and to various publications of the AICPA and the California Society of CPAs. Mr. Henderson holds a bachelor's degree from Claremont McKenna College and a master's degree in public administration from the University of Oklahoma. He has been as an adjunct faculty member at the University of Redlands. His greatest ambition in life is to become a character in a Jimmy Buffett song. James L. Ulvog gained seventeen years of experience in public accounting prior to starting his own accounting firm with the focus of serving the non-profit community. Since starting his own firm, Mr. Ulvog has worked with over fifty different NPOs, including twenty-one churches and thirteen organizations with an international focus. Prior to January 2002, Mr. Ulvog was a Senior Audit Manager at a national accounting firm widely recognized for its expertise in serving the non-profit community. During thirteen years at the firm, he gained extensive hands-on experience working with medium-to-large churches and non-profit organizations. He also performed twenty audits of field programs during the course of eleven overseas trips. Mr. Ulvog has written eight continuing education courses for CCH, all of which address compilation and review services. Other public accounting experience was with two of the international accounting firms, where he served for over four years. His audit experience included engagements with financial institutions, construction companies, insurance and investment companies, and colleges. Mr. Ulvog graduated with honors from the University of Maryland and earned his MBA from the University of South Dakota. He is a member of the American Institute of Certified Public Accountants and the California Society of CPAs. 6

8 Contents MODULE 1: RISK ASSESSMENT AND AUDIT DOCUMENTATION 1 Risk Assessment Standards Overviews Welcome Learning Objectives Introduction Definitions Requirements Audit Documentation Welcome Learning Objectives Introduction Nature and Purpose of Audit Documentation Objectives Definitions Requirements Considerations for Smaller, Less Complex Entities Permanent File Documentation Relationship to Other Auditing Literature MODULE 2: FINANCIAL REPORTING FRAMEWORK FOR SMALL- AND MEDIUM-SIZED ENTERPRISES 3 FRF for SMEs An Alternative to GAAP Introduction Welcome Learning Objectives Introduction What is FRF for SMEs, Where did it Come From, and Where Does it Fit in the World of Accounting Rules? FRF for SMEs An Alternative to GAAP Basic Financial Statements Welcome Learning Objectives Introduction Statement of Financial Position General Principles for Certain Financial Assets and Liabilities Financial Instruments with Liability and Equity Components Accounting Changes and Correction of Errors FRF for SMEs An Alternative to GAAP General Issues Welcome Learning Objectives Introduction Inventories PP&E

9 Disposal of Long-Lived Assets and Discontinued Operations Equity Commitments Contingencies Related Party Transactions Subsequent Events FRF for SMEs An Alternative to GAAP Investments and Consolidation Welcome Learning Objectives Introduction Equity, Debt, and Other Investments Subsidiaries Consolidated Financial Statements and Noncontrolling Interests Business Combinations New Basis (Push-Down) Accounting FRF for SMEs An alternative to GAAP Revenue, Intangibles, Leases Welcome Learning Objectives Introduction Intangible Assets Revenue Leases Nonmonetary Transactions FRF for SMEs An Alternative to GAAP Pensions, Income Taxes Welcome Learning Objectives Introduction Retirement and Other Postemployment Benefits Income Taxes MODULE 3: QUALITY CONTROL, PEER REVIEW, INTERNAL AUDIT, AND PCC 9 Monitoring as an Element of Quality Control Welcome Learning Objectives Introduction Definitions Requirements Elements of a Monitoring Program Monitoring Steps Engagement Quality Control Review Welcome Learning Objectives

10 Introduction Definitions Requirements Commentary Peer Review Update Welcome Learning Objectives Introduction Peer Review Information System Manager (Prism) Peer Review Program Manual Updates Becoming a Peer Reviewer Using the Work of Internal Auditors Welcome Learning Objectives Introduction Presumptively Mandatory Requirements Gathering Audit Evidence Determining Whether, and in Which Areas, the Internal Audit Function can be Used to Obtain Audit Evidence and to What Extent Direct Assistance Determining Whether the Internal Audit Function can be Used to Provide Direct Assistance and to What Extent Private Company Council Relief from Some GAAP Rules for Private Business Welcome Learning Objectives Introduction Items on the Agenda Framework for Private Company Council Goodwill Interest Rate Swaps Consolidation of Variable Interest Entities that Provide Leasing Audit Opinions and Accountant s Reports MODULE 4: AUDIT EVIDENCE AND CONSIDERATION OF FRAUD 14 Audit Evidence Welcome Learning Objectives Introduction Audit Evidence Audit Evidence Specific Considerations for Selected Items External Confirmations Opening Balances Analytical Procedures Audit Sampling

11 Auditing Accounting Estimates Related Parties Subsequent Events and Subsequently Discovered Facts Going Concern Written Representations Consideration of Omitted Procedures Fraud in a Financial Statement Audit Welcome Learning Objectives Introduction Evolving Models of Fraud Risk Malpractice Claims Involving Fraud Answers to Study Questions... 10,100 Module 1 Chapter ,101 Module 1 Chapter ,102 Module 2 Chapter ,103 Module 2 Chapter ,104 Module 2 Chapter ,105 Module 2 Chapter ,106 Module 2 Chapter ,107 Module 2 Chapter ,108 Module 3 Chapter ,109 Module 3 Chapter ,110 Module 3 Chapter ,111 Module 3 Chapter ,112 Module 3 Chapter ,113 Module 4 Chapter ,114 Module 4 Chapter ,115 CPE Quizzer Instructions... 10,200 CPE Quizzer Questions: Module ,301 CPE Quizzer Questions: Module ,302 CPE Quizzer Questions: Module ,303 CPE Quizzer Questions: Module ,304 Answer Sheets... 10,400 Module ,401 Module ,402 Module ,403 Module ,404 Evaluation Form... 10,500 CCH Learning Center... 10,600 10

12 CHAPTER 1: Risk Assessment Standards Overview 101 WELCOME This chapter provides a top-level summary and overview of the definitions and significant requirements of the Risk Assessment sections of the Clarified Statements on Auditing Standards, and additional practical implementation guidance in selected key areas. 102 LEARNING OBJECTIVES Upon completion of this chapter, the reader should be able to: Define key terms related to risk assessment List key requirements of the risk assessment standards Describe procedures applicable to planning an audit, including the auditor's risk assessment Describe the effects of the auditor's risk assessment on the nature, timing and extent of further audit procedures 103 INTRODUCTION The Clarified Statements on Auditing Standards contain six AU-C sections under the heading of Risk Assessment and Response to Assessed Risks: AU-C Section 300, Planning an Audit AU-C Section 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement AU-C Section 320, Materiality in Planning and Performing an Audit AU-C Section 330, Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained AU-C Section 402, Audit Considerations Relating to an Entity Using a Service Organization AU-C Section 450, Evaluation of Misstatements Identified During the Audit With the adoption of the Clarified Standards effective for audits of periods ended on or after December 31, 2012, these Sections effectively replaced the previously existing Statements on Auditing Standards (SAS) Nos This revision did not see significant new requirements in this group of standards. As with the Clarity project in general, there has been some reorganization of content. The many unconditional requirements of the previous standards have all been changed to presumptively mandatory requirements those that should, rather than must be observed. The Application and Other Explanatory Material (AOEM) now provides many of the detailed procedures/considerations that were previously contained within the requirements. This chapter provides a top-level summary and overview of the definitions and significant requirements of these Sections, and additional practical implementation guidance in selected key areas. 11

13 104 DEFINITIONS These Sections define the following terms for purposes of generally accepted auditing standards (GAAS): Assertions Representations, whether explicit or otherwise, made by management and embodied in the financial statements used by the auditor to consider the different types of potential misstatements that may occur. OBSERVATION The AOEM to AU-C Section 315 notes that assertions used by auditors to consider the types of misstatements that may occur fall into three categories: Assertions about transaction classes and events, such as: - Occurrence - Completeness - Accuracy - Cutoff - Classification Assertions about account balances at period end: - Existence - Rights and obligations - Completeness - Valuation and allocation Assertions about presentation and disclosure: - Occurrence - Rights and obligations - Completeness - Classification - Understandability - Accuracy - Valuation Business Risk A risk resulting from significant conditions, circumstances, events, actions or inactions that could adversely affect an entity's ability to: Achieve its objectives Execute its strategies Avoid setting inappropriate objectives or strategies Complimentary User Entity Controls Controls that a service organization assumes will be implemented by user entities. These controls are identified in the service organization's description of its system if they are necessary to achieve its control objectives. Internal Control A process effected by management, those charged with governance, and others that is designed to provide reasonable assurance about the achievement of the entity's objectives with respect to: The reliability of financial reporting The effectiveness and efficiency of operations Compliance with applicable laws and regulations 12

14 Controls over the safeguarding of assets against unauthorized use, acquisition or disposition may include controls related to both financial reporting and operating objectives. Misstatement A difference between a reported amount, classification, presentation or disclosure in the financial statements and that which is required for those statements to be fairly presented in accordance with the applicable financial reporting framework. Misstatements can arise from fraud or error. OBSERVATION The term applicable financial reporting framework replaces the term basis of accounting as used in previous Standards. Performance Materiality Amount or amounts set by the auditor at less than materiality for the financial statements as a whole, for the purpose of reducing the probability that the aggregate of undetected and uncorrected misstatements will exceed materiality for the statements as a whole. This term also refers, when applicable, to amounts less than the materiality levels for particular account balances, transaction classes, or disclosures. Relevant Assertion A financial statement assertion that has a reasonable possibility of containing one or more misstatements that would cause material misstatement of the financial statements. The determination of whether an assertion is relevant is made without regard to the effect of internal controls. Risk Assessment Procedures Audit procedures performed to: Gain an understanding of the entity, its environment, and its internal control Identify and assess risk of material misstatement, caused by either fraud or error, at the: - Financial statement level - Relevant assertion level Service Auditor A practitioner who reports on controls at a service organization. Service Organization An organization that provides services to a user entity that are relevant to its internal control over financial reporting. Service Organization's System The policies and procedures designed, implemented and documented by the service organization's management to provide user entities with the services covered by the service auditor's report. Management's description of the service organization's system identifies the: Services covered Period or date to which the description relates Specified control objectives Party specifying the control objectives, if not specified by management Related controls Significant Risk An identified and assessed risk of material misstatement that requires special consideration in the auditor's professional judgment. 13

15 Subservice Organization A service organization used by another service organization to perform some of the services provided to user entities. Substantive Procedure An audit procedure designed to detect material misstatements at the assertion level. These procedures comprise: Tests of details Substantive analytical procedures Tests of Controls Audit procedures designed to evaluate the operating effectiveness of controls in preventing, or in detecting and correcting material misstatements at the assertion level. Type 1 Report A report on management's description of a service organization's system and the suitability of the design of controls, that comprises: Management's description of the system Certain written assertions by management with respect to the system A service auditor's opinion on management's assertions Type 2 Report A report on management's description of a service organization's system and the suitability of the design and operating effectiveness of controls, that comprises: Management's description of the system Certain written assertions by management with respect to the system A service auditor's opinion on management's assertions, including a description of the auditor's tests of controls and their results Uncorrected Misstatements Misstatements accumulated by the auditor that have not been corrected. User Auditor An auditor who audits and reports on the financial statements of a user entity. User Entity An entity using a service organization, and whose financial statements are being audited. STUDY QUESTIONS 1. AU-C Section 315 identifies certain assertions which it groups into which of the following broad categories? a. Existence, rights and obligations, completeness, and valuation and allocation b. Account balances at period end, classes of transactions and events, and presentation and disclosure c. Occurrence, rights and obligations, completeness, classification, understandability, accuracy and valuation 14

16 d. Occurrence, completeness, accuracy, cutoff, and classification 2. Which of the following statements regarding the term relevant assertion is correct? a. Auditors should consider the effects of internal control in determining the relevance of an assertion. b. A relevant assertion is a financial statement assertion that has a reasonable possibility of containing a material misstatement. c. A relevant assertion is an explicit representation by management that is embodied in the financial statements. d. Auditors should deem assertions that have at least a remote possibility of containing one or more material misstatements to be relevant assertions. 105 REQUIREMENTS Throughout all AU-C Sections, presumptively mandatory requirements are signaled by the word "should." Auditors must comply with presumptively mandatory requirements in all cases in which they are relevant, except in rare circumstances when that procedure would not be effective in achieving the intent of the requirement. AU-C Sections also contain AOEM paragraphs which are cross-referenced to the related requirements. They provide additional guidance and explanations for carrying out the requirements of the standard. These are an integral part of each requirement. Even though they contain no requirements, auditors should read and understand their entire text, and should be prepared to justify departures from them in their work. These Sections contain only presumptively mandatory requirements. There are no unconditional requirements. The following sections provide an overview, by AU-C Section, of the significant performance requirements of these Sections. The documentation requirements are covered in detail in the chapter entitled "Audit Documentation". AU-C Section 300, Planning an Audit AU-C Section 300 states that planning an audit involves establishing an overall audit strategy, and developing an audit plan. The auditor's objective is to plan the audit so that it will be effectively performed. This Section contains the following requirements: Involvement of key engagement team members. The engagement partner and other key engagement team members should be involved in planning the audit. This includes planning and participating in an engagement team discussion. Preliminary engagement activities. At the beginning of the audit, auditors should: Evaluate whether the client and engagement should be continued. Evaluate compliance with relevant ethical requirements. Establish an understanding of the terms of the engagement. Planning activities. Auditors should establish an overall audit strategy that: Sets the scope, timing and direction of the audit Guides the development of the audit plan In establishing an overall audit strategy, auditors should: Identify engagement characteristics that define its scope 15

17 Ascertain the reporting objectives in order to plan: - Engagement timing - The nature of required communications Consider factors that in the auditor's professional judgment are significant in directing the engagement team Consider the results of preliminary engagement activities Consider, if applicable, knowledge gained on other engagements performed for the entity Ascertain the nature, timing and extent of resources needed to perform the audit Auditors should develop an audit plan that describes: The planned risk assessment procedures The nature and extent of planned further audit procedures at the relevant assertion level Other planned procedures required to achieve conformity with GAAS OBSERVATION Audit plan is the term used in the Clarified Standards for what is commonly known as the audit program. Auditors should also: Update and change the overall audit strategy and audit plan as needed during the audit Plan the nature, timing and extent of the direction and supervision of the engagement team and the review of its work Involvement of specialists. Auditors should consider whether specialized skills are needed to perform the audit. If so, they should: Seek the assistance of a professional possessing such skills. Have sufficient knowledge to: - Communicate the objectives of that professional's work - Evaluate whether the specified audit procedures will meet the auditor's objectives - Evaluate the results Initial audits. Before starting an initial audit, auditors should: Ensure that appropriate procedures for the acceptance of the client and engagement have been followed, and that their conclusions are appropriate Communicate with the predecessor auditor, when there has been a change of auditors STUDY QUESTION 3. According to AU-C Section 300, a properly developed audit plan should describe: a. Characteristics that define the scope of the engagement b. The nature and extent of planned further audit procedures at the financial statement level c. Planned risk assessment procedures d. Knowledge obtained on other engagements performed for the entity 16

18 AU-C Section 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement AU-C Section 315 addresses the auditor's responsibility to identify and assess the risks of material misstatement to the financial statements through understanding the entity, its environment, and its internal control. The auditor's objective is to identify and assess those risks, whether due to fraud or error, at the financial statement and relevant assertion levels through developing such an understanding, in order to provide a basis for designing and implementing responses to those assessed risks. AU-C Section 315 contains the following requirements: Risk assessment procedures and related activities. Auditors should perform risk assessment procedures to provide a basis for identifying and assessing risks of material misstatement at the financial statement and relevant assertion levels. These procedures in themselves, do not, however, provide sufficient appropriate evidence to support an audit opinion. Risk assessment procedures should include: Inquiries of management and others who may have information to assist in identifying risks of material misstatement caused by fraud or error Analytical procedures Observation and inspection Auditors should consider: Whether information obtained from the following is relevant to identifying risks of material misstatement: - The client and engagement acceptance and continuance process - Information obtained from other engagements, if any, performed for the entity The results of the fraud risk assessment, along with other information obtained in identifying risks of material misstatement Auditors should determine if they intend to use information from a previous audit or experience with the entity, whether changes have occurred that would affect its relevance to the current audit. The engagement partner should: Conduct a discussion with other key engagement team members about: - The susceptibility of the financial statements to material misstatement - The application of the applicable financial reporting framework to the entity's facts and circumstances Determine which of the matters discussed are to be communicated to other team members Understanding the entity, its environment, and internal control. Auditors should obtain an understanding of the following matters related to the entity and its environment: Relevant industry, regulatory, and other external factors The applicable financial reporting framework The nature of the entity, including the following matters, to enable the auditor to understand account balances, transaction classes and disclosures expected in the financial statements: - Nature of operations - Ownership and governance structures - Investment types, plans, and objectives - Entity structure - Entity financing Selection and application of accounting policies (including changes), and whether they are: 17

19 - Appropriate for the entity's business - Consistent with the applicable financial reporting framework - Consistent with industry practice Entity objectives, strategies and related business risks that may lead to risks of material misstatement How management or others measure and review entity financial performance Auditors should obtain an understanding of the following matters related to internal control: The design and implementation of internal controls, which should be evaluated by performing procedures in addition to inquiry of entity personnel. The control environment, including and evaluation of whether: - There is a culture of honesty and ethical behavior. - The strengths of the control environment collectively provide a foundation for the other components of internal control. - Other control components are undermined by deficiencies in the control environment. Whether the entity has a process for: - Identifying business risks related to financial reporting - Estimating the significance of those risks - Assessing the likelihood of their occurrence - Deciding on actions to address risks If the entity has established a risk assessment process, the auditor should gain an understanding of the process and its results. When auditors identify risks that management failed to identify, they should evaluate: Whether management's process would have been expected to identify the risks. - If not, why the process failed to identify the risks. Whether the process is appropriate. Whether a significant deficiency or material weakness in internal control exists. If the entity has not established a risk assessment process, or if it is an informal process, auditors should: Discuss with management whether business risks related to financial reporting have been identified, and how they have been addressed. Evaluate whether the absence of a documented risk assessment process is appropriate in the circumstances, or determine whether it represents a significant deficiency or a material weakness in internal control. Auditors should obtain an understanding of: The information system, including processes related to financial reporting, such as: - Significant classes of transactions - Procedures for initiating, authorizing, recording, processing, correcting, transferring to the general ledger and reporting transactions in the financial statements. - Related accounting records - How the system captures events and conditions, other than transactions, that are significant to the financial statements. - The financial reporting process - Controls over journal entries How financial reporting roles and responsibilities, and significant financial reporting matters are communicated, both internally and externally. Control activities relevant to the audit, including the process of reconciling detailed records to the general ledger. 18

20 Entity responses to risks arising from IT. Major entity activities to monitor internal control over financial reporting. How remedial actions for internal control deficiencies are initiated. The nature of internal audit responsibilities, if applicable, including its activities and how it fits into the organizational structure. Sources of information used in the entity's monitoring activities, and the basis on which management assesses its reliability. OBSERVATION Auditors are not required to gain an understanding of all the control activities related to each significant transaction class, account balance, disclosure, or relevant assertion. Identifying and assessing risks of material misstatement. Auditors should identify and assess the risks of material misstatement at both the financial statement and relevant assertion levels, to provide a basis for designing and performing further audit procedures. For this purpose, they should: Identify risks throughout the process of obtaining and understanding of the entity and its environment. Assess identified risks and their pervasiveness to the financial statements as a whole. Relate identified risks to the potential for misstatement at the relevant assertion level, considering plans to test controls. Consider the likelihood of misstatement, including multiple misstatements, and whether it could result in material misstatement. Auditors should consider whether any of the risks identified are, in their professional judgment, significant risks. This consideration should exclude the effects of related internal controls, but should take into account: Whether the risk is a fraud risk Whether the risk is related to recent significant economic, accounting, or other developments The complexity of transactions Whether there are significant transactions with related parties. The degree of subjectivity in measurement. Transactions outside the normal course of business. Transactions that otherwise appear unusual. When auditors determine that a significant risk exists, they should obtain an understanding of the entity's relevant controls. Based on that understanding, they should evaluate whether those controls are suitably designed and implemented to mitigate the risk. Sometimes it is not possible or practicable to obtain sufficient appropriate audit evidence about a risk from substantive procedures alone. This is often true of high-volume transaction classes with highly automated processing and little human intervention. Controls over the associated risks therefore become relevant to the audit. Auditors should obtain an understanding of the entity's controls over these risks. Initial risk assessments at the assertion level may change during an audit as a result of additional audit evidence. Accordingly, auditors should modify further planned audit procedures as needed. OBSERVATION The AOEM to AU-C Section 315 contains appendices that provide examples of: Industry, regulatory and other external factors 19

21 Nature of the entity matters Objectives, strategies and business risk considerations Measurement and review of financial performance considerations Internal control components Conditions and events that may indicate risks of material misstatement STUDY QUESTIONS 4. An auditor's consideration of whether any of the risks identified are significant risks should take into account all of the following except: a. Whether the entity's internal controls would mitigate the risk b. Whether the risk is a fraud risk c. Whether the risk is related to recent significant economic developments d. Whether the transaction involves related parties 5. Auditors should identify and assess the risks of material misstatement at the: a. Financial statement and relevant assertion levels b. Transaction class, account balance and disclosure level c. Financial statement level only d. Relevant assertion level only AU-C Section 320, Materiality in Planning and Performing an Audit AU-C Section 320 addresses the auditor's responsibility to apply the concept of materiality in planning and performing an audit. The auditor's objective is to apply this concept appropriately. AU-C Section 320 recognizes that misstatements are considered to be material if they could reasonably be expected, individually or in the aggregate, to influence the economic decisions of statement users. Judgments about materiality are made in light of the surrounding circumstances, and may be affected by both the size and nature of a misstatement. Auditors make these judgments based on a consideration of the common financial information needs of the users as a group. The possible effects on specific individual users is not considered because their needs may vary widely. This Section states that materiality determination is a matter of professional judgment. It is reasonable for auditors to assume that financial statement users: Have a reasonable understanding of business and economic activities and accounting Are willing to study the financial statements with reasonable diligence Understand that financial statements are prepared, presented and audited to levels of materiality. Recognize that there are inherent uncertainties in the measurement of financial statement amounts. Make reasonable economic decisions based on financial statement information. Materiality determined in planning the audit does not necessarily dictate an amount below which uncorrected 20

22 misstatements will always be evaluated as immaterial. AU-C Section 320 contains the following requirements: Determining materiality and performance materiality. In establishing an overall audit strategy, auditors should determine materiality for the financial statements as a whole. Auditors should also: Determine lower levels of materiality for particular account balances, transaction classes or disclosures when misstatements in them could reasonably be expected to influence the economic decisions of users. Determine performance materiality in order to assess risks of material misstatement and design further audit procedures. Revision as audit progresses. Auditors should: Revise materiality during the audit if they become aware of information that would have caused them to determine different amounts initially. Determine whether it is necessary to revise performance materiality or further audit procedures when materiality is revised during the audit. STUDY QUESTION 6. AU-C Section 320 makes all of the following assumptions relating to financial statement users except: a. Financial statement users are willing to study the statements with appropriate diligence. b. They have a reasonable understanding of economic and business activities and accounting. c. The individual needs of specific individual financial statement users have been considered by the auditor in determining materiality. d. Financial statement users recognize that there are uncertainties inherent in the measurement of financial statement amounts. AU-C Section 330, Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained This Section addresses the auditor's responsibility to design and implement responses to identified and assessed risks of material misstatement and to the audit evidence obtained. The auditor's objective is to obtain sufficient appropriate audit evidence about the assessed risks of material misstatement by designing and implementing appropriate responses to those risks. AU-C Section 330 contains the following requirements: Overall responses. Auditors should design and implement overall responses to assessed risks of material misstatement at the financial statement level. Audit procedures at the relevant assertion level. Auditors should design and perform further audit procedures based on, and responsive to, the assessed risks of material misstatement at the relevant assertion level. In designing those procedures, auditors should: Consider the reasons for the assessed risks of material misstatement at the relevant assertion level for each transaction class, account balance and disclosure, including: - Inherent risk, which is the likelihood of material misstatement due to particular characteristics of the transaction class, account balance or disclosure. 21

23 - Control risk, which is whether the risk assessment takes into account relevant controls. Obtain more persuasive evidence the higher the assessed risk. Tests of controls. Auditors should design and perform tests of controls to obtain evidence about their operating effectiveness if: Their risk assessment at the relevant assertion level includes an expectation that the controls are operating effectively, or Substantive procedures alone cannot provide sufficient appropriate evidence at the relevant assertion level. Auditors should obtain more persuasive evidence the greater the reliance they place on controls. In designing and performing tests of control, auditors should: Perform other procedures in combination with inquiry to obtain evidence about operating effectiveness of controls, including: - How the controls were applied at relevant times during the audit period - The consistency of application - By whom and by what means controls are applied - Whether the person performing the control has the necessary competence and authority to perform it effectively. Determine whether controls to be tested depend upon other controls, and if so, whether it is necessary to obtain evidence about their operating effectiveness. With respect to the timing of control tests, auditors should: Test controls for the particular time or throughout the period for which they plan to rely on them, subject to the following: - When using test results from an interim period, auditors should obtain evidence about significant changes since that period, and - Determine the additional evidence needed for the remaining period. - Test operating effectiveness of controls over risks that the auditor has determined to be significant in the current period. In determining whether to use the results of control tests from previous audits, consider certain specific factors detailed in this Section, including the effects of other control elements, and the risks of material misstatement. When using the results of control tests from previous audits, establish by means of inquiry and observation or inspection, the continuing relevance of that information. - Retest controls in the current audit when changes affect the relevance of the evidence from prior audits. - Retest at least some controls in each audit, and all controls at least every third audit. Evaluate whether substantive procedures indicate that controls are ineffective. Make specific inquiries to understand the potential consequences of observed deviations from controls upon which the auditor plans to rely. Substantive procedures. Auditors should: Design and perform substantive procedures for all relevant assertions related to each material transaction class, account balance and disclosure, irrespective of the assessed risks of material misstatement. Consider whether external confirmations are to be obtained as substantive procedures. Confirm accounts receivable except when any of the following apply: 22

24 - The overall balance is immaterial. - Confirmations would be ineffective. - The assessed level of risk of material misstatement at the relevant assertion level is low, and other planned procedures address the risk. OBSERVATION An auditor would ordinarily decide not to send out confirmation requests when prior experience with the client or the industry indicates that response rates will be low, or that responses will be inaccurate or unreliable. In this case, a subsequent collections test might be used to support the existence and valuation assertions for the accounts receivable. Perform substantive procedures related to the financial statement closing process, such as: - Agreeing or reconciling the statements with the underlying accounting records. - Examining material journal entries and other adjustments made during statement preparation. Perform substantive procedures that are specifically responsive to significant risks of material misstatement at the relevant assertion level. When those procedures consist only of substantive procedures, they should include tests of details. OBSERVATION In audits of small entities, auditors often decide that it is ineffective to test internal controls. When this is the case, and there is a significant risk of material misstatement at the relevant assertion level for a transaction class, balance or disclosure, this requirements means that auditors should include tests of details in their procedures, and should not rely solely on substantive analytical procedures. When substantive procedures are performed at an interim date, auditors should obtain a reasonable basis for extending the conclusions from the interim date to the period-end by performing : - Substantive procedures and tests of control for the remaining period, or - Further substantive procedures only, when considered sufficient If unexpected misstatements are detected at an interim date, auditors should evaluate whether to modify their risk assessments and planned substantive procedures for the remaining period. Selecting items for testing. In selecting items for tests of controls or details, auditors should determine the means of selection that are effective in meeting the purpose of the audit procedure. Adequacy of presentation and disclosure. Auditors should perform procedures to evaluate whether overall statement presentation and disclosures are in accordance with the applicable financial reporting framework. Evaluating audit evidence. Before the conclusion of the audit, auditors should evaluate whether the assessments of the risks of material misstatement at the relevant assertion level remain appropriate. Auditors should conclude whether sufficient appropriate audit evidence has been obtained. In so doing, they should consider all relevant evidence, regardless of whether it corroborates or contradicts the financial statement assertions. If sufficient appropriate evidence has not been obtained, auditors should attempt to obtain further evidence. If this is not possible, the auditor should express either a qualified opinion or a disclaimer. STUDY QUESTIONS 7. Auditors should test controls: a. When substantive procedures do not by themselves provide sufficient appropriate evidence at the relevant assertion level 23

25 b. Regardless of whether the risk assessment includes an expectation of their operating effectiveness c. Once every three years d. Whenever there is a significant assessed risk of material misstatement at the relevant assertion level 8. Which of the following statements about the requirements of AU-C Section 330 related to substantive procedures is correct? a. Substantive procedures should be performed in all audits for all relevant assertions related to each class of transactions, account balance, and disclosure regardless of materiality. b. Substantive procedures should be performed in all audits for all relevant assertions related to each material class of transactions, account balance, and disclosure regardless of the assessed risk of material misstatement. c. Substantive procedures performed on each material class of transactions, account balance, and disclosure should include tests of details and substantive analytical procedures. d. Substantive procedures are performed to detect material misstatements down to the transaction class, account balance and disclosure level. AU-C Section 402, Audit Considerations Relating to an Entity Using a Service Organization This Section addresses the user auditor's responsibility for obtaining sufficient appropriate audit evidence in an audit of a user entity that employs a service organization. It expands on the application of AU-C Sections 315 and 330 to the audit of a service organization's user entity. The user auditor's objectives are to: Obtain an understanding of services provided by the service organization, and their effect on the user entity's internal control, in order to identify and assess risks of material misstatement. Design and perform audit procedures responsive to those risks. AU-C Section 402 contains the following requirements related to risk assessment: Obtaining an understanding of services provided. User auditors should: Obtain an understanding of how the user entity employs the services of a service organization in its operations, including: - Their nature and significance - Their effect on the user entity's internal control - The nature and materiality of data processed - The financial reporting processes affected - The degree of interaction between the service organization and user entity - The relationship between the service organization and user entity, including contractual terms Evaluate the design and implementation of user entity controls related to the services provided and transactions processed by the service organization Determine whether their understanding is sufficient to provide a basis for identifying and assessing risks of material misstatement 24

26 When unable to obtain a sufficient understanding from the user entity, obtain that understanding through one or more of the following procedures: - Reading a type 1 or type 2 service auditor's report - Contacting the service organization, through the user entity, to obtain specific information - Visiting the service organization, or using another auditor, to perform procedures to provide necessary information about its controls Be satisfied regarding the following when determining the sufficiency and appropriateness audit evidence provided by a service auditor's report: - The service auditor competence and independence - The adequacy of the standards under which the service auditor's report was issued When planning to use a service auditor's report to support an understanding about the service organization's controls: - Evaluate whether that report is as of a date or covers a period that is appropriate for the user auditor's purposes. - Evaluate the sufficiency and appropriateness of evidence provided for the understanding of user entity controls. - Determine whether complimentary user entity controls identified by the service organization are relevant, and if so, whether the user entity has such controls in place. Responding to assessed risks. In responding to assessed risks, user auditors should: Determine whether sufficient appropriate audit evidence concerning the relevant assertions is available from records at the user entity and, if not, perform or use another auditor to perform further audit procedures at the service organization. Obtain evidence about the operating effectiveness of service organization controls through one or more of the following procedures, when their risk assessment includes an expectation of their effectiveness: - Reading a type 2 service auditor's report - Performing, or using another auditor to perform control tests at the service organization When using a type 2 report as audit evidence, determine whether it provides sufficient appropriate evidence about the effectiveness of controls to support the user auditor's risk assessment by: - Evaluating whether the report covers a period that is appropriate for the user auditor's purposes - Determining whether complimentary user entity controls identified by the service organization are relevant, and if so: Whether the user entity has such controls in place Testing their effectiveness - Evaluating the adequacy of the time period covered by the control tests and the time elapsed since their performance - Evaluating whether the service auditor's control tests and their results are relevant to the user entity's financial statement assertions and provide sufficient appropriate evidence to support the user auditor's risk assessment. When planning to use a service auditor's report that excludes services provided by a subservice organization that are relevant to the audit of the user entity, user auditors should apply the requirements of this Section to the services provided by the subservice organization. Fraud, noncompliance with laws, and uncorrected misstatements related to the activities at the Service Organization. User auditors should: Inquire of user entity management about whether the service organization has reported any fraud, noncompliance with laws and regulations, or uncorrected misstatements affecting the financial 25

27 statements, or whether user entity management is otherwise aware of such matters. Evaluate how such matters, if any, affect their further audit procedures, and the effect on their conclusions and auditor's report. STUDY QUESTION 9. In responding to assessed risks related to a user entity's use of a service organization, user auditors should: a. Obtain evidence about the operating effectiveness of service organization controls by reading a type 1 service auditor's report when the risk assessment includes an expectation of their effectiveness b. Evaluate the design and implementation of user entity controls related to the transactions processed and services provided by the service organization c. Obtain an understanding of the nature and significance of the services provided by the service organization to the user entity's operations d. Determine whether sufficient appropriate evidence concerning the relevant assertions is available from the user entity's records AU-C Section 450, Evaluation of Misstatements Identified During the Audit AU-C Section 450 addresses the auditor's responsibility and objectives in evaluating the effects of: Identified misstatements on the audit Uncorrected misstatements, if any, on the financial statements AU-C Section 450 contains the following requirements: Accumulation of misstatements. Auditors should accumulate misstatement identified during the audit, other than those that are clearly trivial. OBSERVATION The AOEM states explicitly that "clearly trivial" is not just another term for "not material." Clearly trivial matters will be of a smaller and wholly different order of magnitude than materiality determined under AU-C Section 320. They will be clearly inconsequential, either individually or in the aggregate, whether judged by any criteria of size, nature or circumstance. A matter is not clearly trivial if there is any doubt about whether it is. Consideration of misstatements. Auditors should determine whether the overall audit strategy and audit plan need revisions if: The nature and circumstances of identified misstatements indicate that other misstatements may exist that could be material when aggregated with other misstatements, or The aggregate of misstatements accumulated in the audit approaches materiality. Communication and correction of misstatements. Auditors should: Timely communicate all misstatements accumulated during the audit to the appropriate level of management. Request management to correct those misstatements. If management refuses to correct the misstatements, consider the substantive reasons for and evaluate whether the financial statements as a whole are free from material misstatement. 26

28 Perform additional procedures to determine if misstatements remain, when management has, at the auditor's request, examined a transaction class, account balance or disclosure and corrected misstatements that were detected. Evaluating the effect of uncorrected misstatements. Before evaluating the effects of uncorrected misstatements, auditors should reassess materiality to confirm whether it remains appropriate in light of actual financial results. Auditors should also determine whether uncorrected misstatements are material individually or in the aggregate, taking into consideration: Their size and nature in relation to both the financial statements as a whole and particular transaction classes, balances, and disclosures The circumstances of their occurrence The effect of uncorrected misstatements from prior periods on the financial statements as a whole and particular transaction classes, balances, and disclosures STUDY QUESTION 10. According to AOEM of AU-C Section 450, which of the following statements about "clearly trivial" misstatements is correct? a. Immaterial misstatements are considered clearly trivial. b. Clearly trivial misstatements are determined solely with reference to their size. c. A misstatement may be considered clearly trivial individually, without regard to its effects when aggregated with other misstatements. d. A matter cannot be considered clearly trivial if there is any doubt about whether it is. 27

29 CHAPTER 2: Audit Documentation 201 WELCOME This chapter provides in-depth coverage of the AICPA's AU-C Section 230, Audit Documentation, and a summary of the documentation requirements lodged in other AU-C Sections. 202 LEARNING OBJECTIVES Upon completion of this chapter, the reader should be able to: Define key terms related to audit documentation List the audit documentation requirements of the AICPA's AU-C Section 230, Audit Documentation (AU-C Section 230) Explain the relationships between AU-C Section 230 and other auditing standards Describe current implementation issues in the practical application of audit documentation standards 203 INTRODUCTION The codified Clarity Standards do not contain significant new documentation requirements for auditors. They do, however, rearrange some of the documentation requirements into different sections, and move some of the requirements of previous standards into the new "Application and Other Explanatory Material" (AOEM) sections. This chapter provides in-depth coverage of the AICPA's AU-C Section 230 which is the main source of requirements on this topic, and a summary of the documentation requirements lodged in 20 other relevant AU-C Sections. The chapter also offers observations, examples, and illustrations to provide guidance in some of the most commonly observed implementation issues for audit documentation. 204 NATURE AND PURPOSE OF AUDIT DOCUMENTATION Audit documentation that meets the requirements of AU-C Section 230, and the specific documentation requirements of other relevant AU-C Sections, provides evidence that: The basis for a conclusion about the achievement of the auditor's overall objectives, as listed in AU-C Section 200, is met. The audit was planned and performed in accordance with generally accepted auditing standards (GAAS) and applicable legal and regulatory requirements. It may also serve additional purposes, including: Assisting the engagement team in planning and performing the audit. Assisting engagement supervisors in directing and supervising the audit work and in discharging their review responsibilities. Enabling the engagement team to show its accountability for its work by documenting the: - Procedures performed - Audit evidence examined - Conclusions reached 28

30 Recording significant matters for future audits of the same entity. Enabling the conduct of quality control reviews under QC Section 10, A Firm's System of Quality Control. Enabling the conduct of external inspections or peer reviews under applicable legal, regulatory or other requirements. Assisting successor auditors who review predecessors' audit documentation. Assisting auditors to understand the prior year's work in planning the current audit. 205 OBJECTIVES AU-C Section 230 states that the auditor's objectives are to prepare audit documentation that provides: A sufficient and appropriate record of the basis for the auditor's report Evidence that the audit was planned and performed in accordance with GAAS and applicable legal and regulatory requirements. 206 DEFINITIONS AU-C Section 230 defines the following terms: Audit Documentation The record of audit procedures performed, relevant evidence obtained, and conclusions the auditor reached. Terms such as workpapers or working papers are sometimes also used. Audit File One or more folders or other storage media in physical or electronic form, containing the audit documentation for a specific engagement. Documentation Completion Date The date, no later than 60 days after the report release date on which the auditor has assembled for retention a final and complete set of documentation in an audit file. Experienced Auditor An individual, either internal or external to the firm, who has practical audit experience and a reasonable understanding of: Audit processes GAAS Applicable legal and regulatory requirements The entity's business environment Auditing and financial reporting issues relevant to the entity's industry OBSERVATION The AOEM section of AU-C Section 230 prescribes that having practical audit experience means having skills and competencies that will enable an auditor to perform the audit. It does not mean that the auditor is required to have performed comparable audits. Report Release Date The date the auditor grants the entity permission to use his or her report in connection with the financial statements. 29

31 OBSERVATION The AICPA's peer review process has noted that firms often forget to document the report release date. This is an important date because it starts the clock running on the documentation completion date and the record retention period. STUDY QUESTIONS 1. Which of the following statements with respect to the documentation completion date under AU-C Section 230 is correct? a. The documentation completion date should be the same as the report release date. b. The documentation completion date may be no later than 45 days after the report release date. c. The documentation completion date may be no later than 60 days after the report release date. d. The documentation completion date is the date on which the auditor obtained sufficient appropriate audit evidence to support the opinion. 2. AU-C Section 230 defines the report release date as: a. The date that the auditor grants permission for the audit report to be used in connection with the financial statements b. Forty five days prior to the documentation completion date c. The last date of audit field work d. The date on which the auditor obtained sufficient appropriate audit evidence to support the opinion 207 REQUIREMENTS Throughout AU-C Section 230 (and other AU-C sections) unconditional requirements are identified by the word "must," and are required to be performed in all circumstances where they are applicable. Presumptively mandatory requirements are signaled by the word "should." Auditors must comply with presumptively mandatory requirements in all cases in which they are relevant, except in rare circumstances when that procedure would not be effective in achieving the intent of the requirement. AU-C Section 230 also contains AOEM paragraphs which are cross-referenced to the related requirements. They provide additional guidance and explanations for carrying out the requirements of the standard. These are an integral part of each requirement. Even though they contain no unconditional requirements, auditors should read and understand their entire text, and should be prepared to justify departures from it in their work. Unconditional Requirement AU-C Section 230 contains the following unconditional requirement. Departure from a relevant requirement. When, in rare circumstances, an auditor finds it necessary to depart from a relevant presumptively mandatory requirement, the auditor must document the justification for the departure, and how the alternative procedures performed were sufficient to achieve the objectives of the presumptively mandatory requirement. 30

32 OBSERVATION A requirement is irrelevant only in cases in which: The AU-C section does not apply, as for example when an entity has no internal audit function, nothing in the AU-C section pertaining to internal audits is relevant, or The requirement is conditional and the condition does not exist, as for example the requirement to communicate to management material weaknesses in internal control when none exist. Presumptively Mandatory Requirements AU-C Section 230 contains the following presumptively mandatory requirements: Timely preparation of audit documentation. Auditors should prepare audit documentation on a timely basis. Form, content and extent of audit documentation. Auditors should prepare audit documentation that is sufficient to allow an experienced auditor with no previous connection to the audit to understand: The nature, timing and extent of audit procedures performed to comply with GAAS and applicable legal and regulatory requirements The results of the audit procedures performed The audit evidence obtained Significant findings or issued arising during the audit, and conclusions thereon Significant professional judgments made in reaching those conclusions When documenting the nature, timing and extent of audit procedures performed, auditors should record: Identifying characteristics of the specific items or matters tested Who performed the work The date the work was completed Who reviewed the work The date and extent of the review EXAMPLE Examples of acceptable document identifiers are: Unique item numbers, such as purchase order or check numbers. All items over a specified amount from a specific source, such as the cash disbursements journal. For inquiry procedures, the dates of the inquiries, the names and job descriptions of persons involved, and the nature of the inquiry. For observation procedures, the process or subject of the observation, persons involved and their responsibilities, and when and where the observation was made. For inquiry procedures, the subject matter and date of the inquiry, and names and job designations of entity personnel. For systematic samples, the population of documents, starting point, and interval, such as "every 10 th item starting with the 5 th, from the May cash disbursements journal." 31

33 STUDY QUESTION 3. Which of the following constitutes an acceptable document identifier for the specific items tested? a. For observation procedures, the process or subject of the observation, and when the observation took place b. For inquiry procedures, the names of persons inquired c. For systematic samples, the population of documents and interval, such as " every 10 th item from the December 31 st accounts receivable aging" d. Unique item numbers, such as purchase order or check numbers Audit documentation should include: Copies or abstracts of significant contracts or agreements, for audit procedures related to inspection of those documents. Documentation of discussions of significant findings or issues discussed with management, those charged with governance, and others, including: - The nature of the finding or issue - When and with whom the discussion took place When auditors identify information that is inconsistent with the final conclusion on a significant finding or issue, they should document how the inconsistency was addressed. EXAMPLE AU-C Section 230 allows considerable judgment as to the exact content of audit documentation. The AOEM specifically lists the following items as examples of materials that make up audit documentation: Audit plans Analyses Issues memoranda Summaries of significant findings or issues Letters of confirmation Representation letters Checklists Correspondence, including , concerning significant findings or issues The AOEM also states that the form, content and extent of audit documentation depends on factors such as: Entity size and complexity Nature of audit procedures to be performed Risks of material misstatement Significance of audit evidence obtained Nature and extent of exceptions identified 32

34 Need to document a conclusion or the basis for a conclusion that is not readily determinable from the documentation of work performed or evidence obtained Audit methodology and tools Extent of judgment involved in performing work and evaluating results OBSERVATION The AOEM makes it clear that oral explanations, on their own, do not constitute sufficient support for the audit work or for its conclusions. They may, however, be used to clarify or explain information contained in the audit documentation. The accounting profession has moved to the point where there is a presumption that if something is not documented, it was not done. Some state laws include a "rebuttable presumption" to this effect, and the AICPA practice monitoring programs take a similar position. An occasional oral explanation can interpret a comment or test but if there is nothing present in the files to be interpreted, then it will be difficult to defend the contention that it took place. OBSERVATION Some practitioners have asked if they need to record every thought they had during an audit, and retain a copy of every document they looked at. The answer is "no." The AOEM acknowledges that it is neither necessary nor practicable to document every matter considered or every professional judgment made during an audit. Drafts, notes that reflect preliminary or incorrect thinking, or information that is incorrect or superseded need not be retained. Furthermore, it is not necessary to document separately, as in a checklist, compliance with matters for which compliance is already demonstrated in the audit file. The existence of a signed engagement letter, for example, demonstrates that the auditor has agreed to the terms of the engagement with management or those charged with governance. OBSERVATION The AOEM notes that certain requirements apply generally throughout an audit, but there may be no single way to document them. Professional skepticism, for example, may be evidenced by specific procedures performed to corroborate management's responses to audit inquiries. STUDY QUESTION 4. AU-C 230 lists each of the following items that may ordinarily be contained in audit documentation, except: a. Audit plans b. Summaries of significant findings or issues c. Complete copies of all contracts or agreements inspected as part of the audit work d. Representation letters Matters arising after the date of the auditor's report. When, in rare circumstances, auditors perform new or additional procedures or draw new conclusions after the date of the auditor's report, they should document the: Circumstances encountered New or additional procedures performed Audit evidence obtained Conclusions reached 33

35 Effect of the conclusions on the auditor's report When and by whom the resulting changes to the audit documentation were made and reviewed Assembly and retention of the final audit file. This section states that auditors should: Document the report release date in the audit documentation Assemble the audit documentation and complete the administrative process no later than 60 days after the report release date. Not delete or discard any audit documentation after the documentation completion date or prior to the end of the specified retention period, which should be no less than five years from the report release date. When auditors find it necessary to modify or add to existing audit documentation after the documentation completion date, other than in circumstances described above in "matters arising after the date of the auditor's report," they should document: - The specific reasons for the change - When and by whom the changes were made or reviewed Adopt reasonable procedures to maintain the confidentiality of client information OBSERVATION Auditors should be aware of statutory and regulatory requirements for document retention in the jurisdictions in which they practice. These may require audit documentation to be retained for more than five years. OBSERVATION The AOEM states that after the report date, the auditor may make changes to the audit documentation that are administrative in nature, such as to: Complete the documentation and assembly of evidence that has been obtained prior to the report date. Add information, such as an original of a document that was previouslyfaxed, that was received after the report date. Perform routine file assembly work, such as: - Discarding superseded documentation - Sorting and collating - Cross-referencing final workpapers - Signing off on file completion checklists 208 CONSIDERATIONS FOR SMALLER, LESS COMPLEX ENTITIES The AOEM notes that the documentation for the audit of a smaller, less complex entity, is generally less extensive than for a larger, more complicated audit. Auditors may find it efficient in such audits to record various aspects of the audit together in one document, with cross-references to supporting workpapers as appropriate. It offers as examples: The understanding of the entity and its internal control The overall audit strategy and audit plan Materiality Risk assessment Significant findings, issues and conclusions 34

36 In a significant change from the pre-clarification SAS-103, the AOEM to AU-C Section 230 now states that when a sole practitioner or the engagement partner in a small firm performs all of the audit work, the audit documentation will not include matters that might have been documented solely to instruct or inform members of an engagement team, or to provide evidence of review by other team members. For example, no documentation will be necessary for: Team discussions Supervision 209 PERMANENT FILE DOCUMENTATION AU-C Section 230's requirements for document retention, and the requirement not to remove anything from the audit documentation after the documentation completion date raise interesting questions about "permanent file" documentation. Under pre-sas 103 practice, auditors customarily assembled certain types of audit documentation into "permanent files" when they expected it to be useful in future audits, and not to change much from year to year. Examples of the kinds of documentation kept in permanent files might include: Articles of incorporation and bylaws Internal control questionnaires, flowcharts or memoranda Long-term notes payable Long-term contracts, such as lease agreements Pension plan or other employee benefit plan documents Organization charts Personnel manuals Documents like these were often "rolled forward" from one year to the next in a permanent file with little or no change, and then discarded when they were no longer applicable or useful, or when they became superseded by other information. This practice has several problems under current standards. The most obvious of these is that if a document that was necessary to support a previously issued opinion becomes obsolete for example, if a lease agreement expires it can no longer simply be removed from the "perm file" and discarded, as long as the document retention period for that audit is still open. A more subtle issue has to do with "perm file" documents such as internal control documentation that ordinarily might be expected to change only incrementally from one year to the next. It is important to preserve the original content of any audit documentation for the duration of the document retention period. This means that, for example, when a checkbox on an internal control questionnaire changes from "yes" last year to "no" this year, it is unacceptable to erase the old "yes" answer and insert the new "no" answer. The old questionnaire has to be retained because it is still necessary to support the old audit. Some auditors address this issue by using a system of color codes, in which all changes to a document in a particular year are noted in a unique color, but none of the previously recorded information is obliterated. Some practitioners have gone as far as to suggest that there can no longer be "perm files" under the new standards. Under this theory, all documentation necessary for each individual audit must be contained within that year's audit file. An auditor certainly would not go wrong following this approach. However, that auditor might end up with voluminous documentation files that in themselves presented some significant efficiency and documentation management challenges. One alternative to this approach might be to divide permanent files into "active" and "superseded" sections. Each item in the "perm file" can be indexed in the appropriate audit's workpapers, and the transfer of items from the active to the superseded section documented on a master permanent file indexing form. 35

37 An example of a form that can be used for this purpose appears below, as Illustration 1-1. ILLUSTRATION 1-1: AU-C SECTION 230 PERMANENT FILE INDEX PERMANENT FILE INDEX CLIENT: National Distribution Corp This form is to be used in the post-sas 103 environment, to document the movement and disposition of documents into and out of the "active permanent file." Such documents are those that would be expected to be useful over more than one audit period, such as articles of incorporation, lease agreements, accounting and personnel manuals and the like. Effective with the implementation of SAS 103, (y/e 12/31/06 and after) it is the firm's policy to maintain two sets of permanent files, as applicable, for each audit engagement. The first is the "active permanent file," which accumulates documents that have ongoing relevance to the current year's audit. The second is the "superseded permanent file," which archives for document retention purpose, the documents that are no longer necessary for the current audit, but which must be maintained for the 5 year document retention period to support previous audits. Pre-SAS 103 documents will be designated as such by a checkmark in the "Pre-SAS 103" column. For documents entered into the active permanent file post SAS 103 implementation, the date entered and initials of the person entering the document will be noted in the "date entered/entered by" column. When a document is transferred from the active to the superseded permanent file, the date of transfer and initials of person making the transfer will be noted in the "date tr'd/trf'd by" column. A copy of this index will be maintained in both the active and superseded permanent files. PostSAS 103 P/F- Title Pre-SAS 103 Date entered Date trf'd Trf'd by Entered by 1 Articles of Incorporation x 2 By Laws x 3 Employee handbook, rev 10/1/05 x 2/2/10-pmh 3.1 Employee handbook, rev 1/1/10 2/2/10-pmh 4 Lease agreements: 4.1 First Street property-3yrs ending 12/14 1/15/12-pmh 1/7/15-pmh 4.2 First Street property-3 yrs ending 12/17 1/7/15-pmh 5 Bonus plan-eff 1/1/14 1/8/15-pmh In this illustration, National Distribution Corporation's articles of incorporation, and by-laws, have been in the permanent file since before the effective date of SAS 103, and are unchanged for the current period. The employee handbook (10/1/05 revision) was inserted in the active file before the effective date of SAS 103, and 36

38 has been superseded as of 1/1/10. On 2/2/10, the new version was inserted into the active file and the old version transferred to the superseded file. The lease agreement on the First Street property for the 3 years ending 12/14 was inserted in the active file on 1/15/12 and has been superseded in the current audit period by a new lease expiring in 12/17. The index form shows that on 1/7/15 the auditor, "pmh" transferred the expired lease to the superseded file and inserted the new lease into the active file. Also, on 1/8/15, "pmh" inserted a new bonus plan into the active file. One of the keys to making this system work is never to re-use a permanent file index number. For example, the expired lease agreement, which is indexed as "P/F-4.1" retains that index number when it is transferred from the active to the superseded file. This way, the workpaper indexing in the documentation for the audits that it pertains to will still lead a reader of that documentation to the appropriate location in the superseded perm file. 210 RELATIONSHIP TO OTHER AUDITING LITERATURE In addition to the general requirements of AU-C Section 230, many other auditing standards contain specific documentation requirements. AU-C Section 230 does not change those requirements. This section summarizes them and provides practical implementation guidance. PCAOB Standards AU-C Section 230 parallels the PCAOB's Auditing Standard No. 3, Audit Documentation (AS-3) philosophically and in many practical respects but has several important differences: The "experienced auditor" criterion of AU-C Section 230 is more restrictive than the PCAOB's. The PCAOB requires only that the person "have a reasonable understanding of audit activities" and have "studied the company's industry as well as the accounting and auditing issues relevant to the industry." It does not require that an experienced auditor be qualified to perform the audit himself or herself. This less restrictive requirement is apparently necessary to allow PCAOB inspectors, who may not be capable themselves of performing the audits that they inspect, to carry out their duties. The documentation completion date under AS-3 must come 45 days after the report date, rather than the 60 days required in AU-C Section 230. The documentation retention period under AS-3 is seven years from the report release date, rather than the five years required by AU-C Section 230. AS-3 requires a detailed engagement completion document, which is not required by AU-C Section 230. AU-C Section 230 applies solely to audits of non-sec issuers. Auditors of SEC issuers should study the complete text of AS-3, which is available on the PCAOB's website at AU-C Section 210, Terms of Engagement. AU-C Section 210 states that auditors should: Agree upon the terms of the audit engagement with management or those charged with governance Document the agreed-upon terms in an engagement letter or other suitable written agreement, which should include: - The objective and scope of the audit - The auditor's responsibilities - Management's responsibilities - A statement that the inherent limitations of an audit and of internal control create a risk that material misstatements may not be detected - Identification of the applicable financial reporting framework - Reference to the expected form and content of any reports to be issued - A statement that circumstances may cause a different report than expected to be issued Assess whether circumstances require the terms of and recurring audit to be revised Document a reminder of the engagement terms to management, when the terms are not revised 37

39 Document changes in the engagement terms in an engagement letter or other suitable written agreement AU-C Section 220, Quality Control for an Engagement Conducted in Accordance With Generally Accepted Auditing Standards. AU-C Section 220 states that audit documentation should include: Compliance issues related to relevant ethical requirements, and their resolution Conclusions on compliance with independence requirements, and related discussions with the firm supporting those conclusions Conclusions regarding client and engagement acceptance Consultations undertaken during the audit, including their nature, scope and conclusions It also states that engagement quality control reviewers should document: Performance of the procedures required for engagement quality control reviews by the firm's quality control policies The completion date of the engagement quality control review That the reviewer is not aware of any unresolved matters that would cause the review to believe that the engagement team's significant judgments and conclusions were not appropriate. AU-C Section 240, Consideration of Fraud in a Financial Statement Audit. AU-C Section 240 requires that the following specific fraud-related items be recorded in the audit documentation: The fraud risk discussion in the planning phase of the audit, including: - Significant decisions reached - How and when the discussion took place - Who participated - The subject matter of the discussion Overall responses to assessed risks of material misstatement due to fraud: - At the financial statement level - The nature, timing and extent of audit procedures - The linkage of those procedures with assessed risk at the assertion level - The results of audit procedures, including those designed to address override of controls Communications about fraud made to management, those charged with governance, regulators and others The reasons for a conclusion that the presumption of a risk of material misstatement due to fraud in revenue recognition is overcome As noted in the AOEM to AU-C Section 230, certain requirements apply generally throughout an audit, but there may be no single way to document them. Consideration of fraud is one of these. Illustration 1-2 provides an example of how auditors may cross-reference the various procedures performed in other parts of the audit that provide information about fraud into a single document, for ease of reference. ILLUSTRATION 1-2 FRAUD RISK - EVALUATION OF AUDIT TEST RESULTS By: em Date: 2/1/15 CLIENT: CalMac Ltd DATE: 12/31/14 Certain of the procedures in the audit have the potential to discover fraud risk. In the performance of these procedures, have any of the above indicators or any other indicators come to our attention? 38

40 Explain any "yes" answers Procedure yes no wp ref Review of minutes X B-7 Attorney correspondence X B-9 Review of legal expense X B-9 Representation letter X B-18 Correspondence with funding sources X Cash receipts tests X Cash disbursements tests X Related party procedures X B-12 Review of regulatory correspondence None Analytical procedures X B-6, B-20 * Understanding, and (if applicable) tests of internal control X B-5 Management override of internal control X B-5 Tests of revenue recognition x D & R-series * * * Conclusions: 1. Based on the audit findings, is the original fraud risk assessment still valid? 2. Have the audit procedures adequately addressed the assessed fraud risks? 3. Based on the audit findings, is there reason to suspect that material misstatement to the F/S has occurred due to fraud? If yes, see AU-C Section 240 for further action. X X x * =see specific accounts w/p's. AU-C Section 250, Consideration of Laws and Regulations in an Audit of Financial Statements. AU-C Section 250 requires auditors to document: A description of identified or suspected noncompliance with laws and regulations The results of discussions with: - Management - Those charged with governance, if applicable - Other parties inside or outside the entity AU-C Section 260, The Auditor's Communication With Those Charged With Governance. AU-C Section 260 does not require written communication of any matters. It does, however, state that: Copies of written communications, if any, should be retained Oral communications, including when and to whom made should be documented OBSERVATION Many auditors feel that written communication represents a "best practice" under most circumstances. Oral communication is still appropriate, however, especially in the case of very small, owner-managed clients, as long as it is well-documented. AU-C Section 265, Communicating Internal Control Related Matters Identified in an Audit. AU-C Section 265 requires the auditor to: 39

41 Make written communication of significant deficiencies and material weaknesses in internal control within 60 days of the report release date. Make either written communication, or document the content of oral communications regarding other deficiencies in internal control. AU-C Section 300, Planning an Audit. AU-C Section 300 states that auditors should document: The overall audit strategy The audit plan Significant revisions to the overall audit strategy or audit plan, and the reasons for those changes. AU-C Section 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement. AU-C Section 315 requires that the following should be included in the audit documentation: The discussion between the engagement team concerning the susceptibility of the financial statements to material misstatements, and the applicable financial reporting framework, including: - The significant decisions reached - How and when the discussion took place - Who participated Key elements of the understanding regarding the entity and its environment, and its internal control, including the: - Sources of the information - Risk assessment procedures performed Identified and assessed risks of material misstatement at the: - Financial statement level - Relevant assertion level Risks identified and related controls about which the auditor has obtained an understanding AU-C Section 320, Materiality in Planning and Performing an Audit. AU-C Section 320 states that auditors should include the following amounts, and the factors considered in their determination, in the audit documentation: Materiality for the financial statements as a whole Materiality levels for particular transaction classes, account balances or disclosures, if applicable Performance materiality Any revisions of the above made during the audit OBSERVATION AU-C Section 320 defines performance materiality as an amount or amounts less than materiality for the statements as a whole to reduce the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the statements as a whole. When the auditor has determined materiality levels for particular transaction classes, account balances or disclosures, it also refers to amounts set at less than those levels. STUDY QUESTION 5. Which of the following statements best applies to the documentation requirements of AU-C Section 320? a. Auditors should document the factors considered in determining materiality. b. Auditors should not document materiality at levels below the financial statements taken as 40

42 a whole. c. Auditors should avoid documenting changes made to materiality levels during the audit. d. Audit documentation should include uncorrected misstatements from prior periods. AU-C Section 330, Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained. AU-C Section 330 states that auditors should document: The overall responses to address risks of material misstatement at the financial statement level The nature, timing, and extent of further audit procedures performed The linkage of further audit procedures with assessed risks at the relevant assertion level The results of the audit procedures, including conclusions, when not otherwise clear Conclusions about relying on controls that were tested in a prior audit, when planning to use evidence about their operating effectiveness in the current audit The basis for any decision not to confirm material accounts receivable That the financial statements agree or reconcile with the underlying accounting records OBSERVATION The AICPA Peer Review Program notes that further audit procedures performed are sometimes poorly correlated to the assessed risks at the assertion level. Some firms may, for example, assess the risk of material misstatement as high for a particular assertion, such as revenue cutoff, but limit their further audit procedures to analytical procedures, which would ordinarily be appropriate only for lower risk areas. Conversely, substantive tests may be extensive in areas of lower risk. OBSERVATION GAAS does not require auditors to perform procedures that are not likely to be effective. Consequently, when an auditor's experience indicates that accounts receivable confirmations have historically received a low response rate, and that subsequent collections testing provides the audit evidence that confirmations would have given, this should be documented as a basis for not confirming receivables. AU-C Section 450, Evaluation of Misstatements Identified During the Audit. AU-C Section 450 states that auditors should include in the audit documentation: The amount below which a misstatement would be regarded as clearly trivial. All misstatements accumulated during the audit Whether the misstatements have been corrected A conclusion about whether uncorrected misstatements are material individually or in the aggregate, and the basis for that conclusion. OBSERVATION The AOEM to AU-C Section 450 is explicit in stating that "clearly trivial" is not synonymous with "not material." Clearly trivial matters will be of a smaller and wholly different order of magnitude than materiality determined under AU-C Section 320. They will be clearly inconsequential, either individually or in the aggregate, whether judged by any criteria of size, nature or circumstance. A matter is not clearly trivial if there is any doubt about whether it is. The AICPA Peer Review Program has noted that a significant number of firms are not 41

43 documenting the threshold amount for clearly trivial misstatements. AU-C Section 501, Audit Evidence Specific Considerations for Selected Items. AU-C Section 501 states that auditors should document the basis for a determination not to seek direct communication with an entity's legal counsel. AU-C Section 520, Analytical Procedures. AU-C Section 520 requires auditors to document: The expectations used in analytical procedures, where not otherwise readily ascertainable from the documentation of the work performed The factors considered in developing expectations The results of comparisons of the expectations to recorded amounts or to ratios developed from recorded amounts Any additional auditing procedures performed in response to significant unexpected differences arising from the analytical procedures The results of those additional procedures OBSERVATION One of the most commonly-used analytical procedures is trend analysis, in which comparative trial balances or financial statements are analyzed for consistency over two or more periods. Simply placing a set of computer-prepared comparative financial statements in the audit documentation does not satisfy the requirements of AU-C Section 520 because it does not really indicate the auditor's expectations, nor does it indicate the results of the comparison, i.e., whether or not it is consistent with prior periods, or with some other expectation. In this case, however, most experienced auditors would probably agree that notations in the margins of such a workpaper to the effect that current period amounts are or are not consistent with prior periods would be sufficient. AU-C Section 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures. AU-C Section 540 states that auditors should include in the audit documentation: The basis for a conclusion of the reasonableness and disclosure of accounting estimates that give rise to significant risk Indications, if any, of management bias AU-C Section 550, Related Parties. AU-C Section 550 states that auditors should document the names of identified related parties and the nature of the relationship. AU-C Section 570, The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern. AU-C Section 570 requires the auditor to document: The conditions or events leading to the belief that there is substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time. The elements of management's plans that the auditor considered significant in overcoming the adverse conditions or events. The audit procedures performed to evaluate management's plans. The evidence obtained from those procedures. The auditor's conclusion about whether substantial doubt as to the entity's ability to continue as a going concern for a reasonable period of time remains or is alleviated. - If substantial doubt remains, the possible effects of the conditions or events on the financial statements and disclosures. - If substantial doubt is alleviated, the auditor's conclusion about the need for or adequacy of 42

44 disclosures of the conditions or events that initially led to substantial doubt. The conclusion about the effects on the auditor's report. AU-C Section 580, Written Representations. AU-C Section 580 requires written representations from management in all financial statement audits. AU-C Section 600, Special Considerations Audits of Group Financial Statements (Including the Work of Component Auditors). AU-C Section 600 states that the group engagement team should include in the audit documentation: An analysis of components indicating: - Significant components - The type of work performed on the components' financial information Those components for which the auditor's report on the group financial statements refers to the reports of component auditors. For those components, the group auditor's documentation should contain: - The financial statements of the component - The component auditor's report - The basis for the group engagement partner's determination that the component auditor's report met relevant GAAS requirements, when the component auditor's report does not state that the audit was performed in accordance with GAAS or PCAOB standards. Written communication of the group engagement team's requirements to the component auditors. When the group auditor is assuming responsibility for the work of a component auditor, the audit documentation should also include the nature, timing and extent of the group engagement team's involvement in the work of the component auditor, including, when applicable: The group engagement team's review of relevant parts of the component auditor's documentation. Its conclusions thereon STUDY QUESTION 6. AU-C Section 600 requires auditors to document all of the following except: a. Communication of the group engagement team's requirements to the component auditors b. The basis for the determination that the component auditor's report meets GAAS requirements, when the component auditor's report states that the audit was performed in accordance with PCAOB standards c. An indication of significant components d. The nature, timing and extent of the group engagement team's involvement in the component auditor's work, when the group auditor is assuming responsibility for that work AU-C Section 915, Reports on Application of Requirements of an Applicable Financial Reporting Framework. AU-C Section 915 states that the reporting accountant should document the rationale for not consulting with the continuing accountant, if the reporting accountant determines that consultation is not necessary. AU-C Section 930, Interim Financial Information. AU-C Section 930 requires auditors to prepare documentation in connection with a review of interim financial information that will enable an experienced auditor with no previous connection to the review to understand: The nature, timing and extent of the review procedures performed The results of those procedures 43

45 The evidence obtained Significant findings or issues arising in the review Conclusions on those findings or issues, and significant professional judgments made in reaching them The documentation should also include any communications required by this section, either oral or written. AU-C Section 935, Compliance Audits. AU-C Section 935 states that auditors should document: Risk assessment procedures performed, including those related to obtaining and understanding of internal control over compliance Responses to assessed risks of material noncompliance Procedures performed to test compliance with applicable compliance requirements, including any tests of controls over compliance Results of those procedures Materiality levels and the basis on which they were determined Compliance with the specific governmental audit requirements that are supplementary to GAAS and Government Auditing Standards CPE NOTE: When you have completed your study and review of chapters 1-2, which comprise Module 1, you may wish to take the Quizzer for this Module. Go to CCHGroup.com/PrintCPE to take this Quizzer online. 44

46 CHAPTER 3: FRF for SMEs An Alternative to GAAP Introduction 301 WELCOME The Financial Reporting Framework for Small- and Medium-Sized Entities (FRF for SMEs) is an alternative to GAAP for small entities who desire a simpler financial reporting framework to present their financial statements. This chapter introduces FRF for SMEs and provides an overview of the accounting model. 302 LEARNING OBJECTIVES Upon completion of this chapter, the reader should be able to: Describe where the Financial Reporting Framework for Small- and Medium-Sized Entities. (FRF for SMEs) stands as a financial reporting framework within the other comprehensive bases of accounting Describe the type of entities for which FRF for SMEs is most appropriate Describe the basic elements of financial statements Describe the recognition criteria and primary measurement approach used in FRF for SMEs Describe the basic approach for disclosures in the framework Describe the method of transitioning to a first time presentation of financial statements prepared on the basis of FRF for SMEs 303 INTRODUCTION For a generation or more of accountants, there has been a longing for "small GAAP." What that phrase refers to is the desire to have a simple and easy way to present financial information for a small and simple organization without some of the extremely complicated accounting treatments and disclosure requirements of "regular" GAAP. There is a perception among practitioners that the proper accounting for sophisticated transactions and comprehensive disclosures create a burden for smaller organizations. This chapter will introduce the Financial Reporting Framework for Small- and Medium-Sized Entities (FRF for SMEs). Subsequent chapters will provide detail in the framework with discussion on how it compares to GAAP. This new reporting methodology will be referred to as either the "framework" or "FRF for SMEs" in this chapter. A critical distinction is necessary FRF for SMEs is not generally an accepted accounting principle. It is neither "small GAAP" nor GAAP light nor GAAP without some of the detailed rules. This new framework is not GAAP. In one sentence, FRF for SMEs is one more in a collection of other comprehensive basis of accounting frameworks that might be an acceptable alternative to GAAP for some companies in some circumstances. Just as modified cash basis or tax basis might be appropriate for some entities, FRF for SMEs might be an appropriate alternative for others. 304 WHAT IS FRF FOR SMES, WHERE DID IT COME FROM, AND WHERE DOES IT FIT IN THE WORLD OF ACCOUNTING RULES? The FRF for SMEs was drafted and published by the American Institute of Certified Public Accountants (AICPA) with assistance from a task force appointed for the project. 45

47 FRF for SMEs are a self-contained body of knowledge describing one approach on how financial statements can be prepared to communicate financial position and results of operations of an organization (i.e. what constitutes a financial reporting framework). In printed format the text of the framework is 172 pages long with a 16 page glossary. It is designed to be an alternative for businesses in the small and medium size range. Many of these organizations (mostly owner-managed) do not have a requirement from a lender to prepare financial statements in accordance with GAAP. Often times these owner-managers need to relay financial information to a lender with whom they already have frequent communication. In such circumstances, financial reports prepared on a modified cash basis or income tax basis may be sufficient for management/owners and for lenders. Now there is another option FRF for SMEs. This new framework relies primarily on historical cost for measurement of transactions. It includes a variety of options, giving management flexibility in preparing financial statements while still maintaining a relatively consistent and standard structure. GAAP and Other Frameworks of Accounting AICPA ethics rule 203 says that a member of the Institute may not express an opinion that financial statements are in accordance with GAAP if those statements contain a departure from the rules established by organizations designated by the AICPA Council. That means we look to the AICPA for a list of the organizations that are allowed to establish GAAP. The AICPA Council has defined the following organizations as appropriate standard setters: Financial Accounting Standards Advisory Board (FASAB) for reporting by organizations in the federal government Financial Accounting Standards Board (FASB) for reporting by commercial entities and nonprofit organizations that are not subject to regulation by PCAOB Governmental Accounting Standards Board (GASB) for reporting by other governmental entities Public Company Accounted Oversight Board (PCAOB) for reporting by organizations that are publicly traded International Accounting Standards Board (IASB) for international reporting Rule indicates however that financial statements can be prepared using a financial reporting framework other than GAAP. This could be a framework prescribed by contract or other comprehensive basis of accounting, which is usually referred to as OCBOA. Common OCBOA financial reporting frameworks include cash, modified cash, or income tax. In some situations there is a framework specified by a regulatory agency, which is common in the insurance industry. FRF for SMEs is in the other comprehensive basis of accounting category. As such, an organization would have the option of preparing their financial statements in accordance with GAAP or they could prepare them in accordance with one of the OCBOAs, including FRF for SMEs. What Type of Companies Can Use FRF for SMEs? The framework does not contain specific criteria to describe what organizations may use it. In the United States there is not a consensus as to what size or type of organizations are included in the characterization of smalland medium-sized organizations. Instead the framework provides general characteristics: Entities using this framework tend to be closely held companies where the managers are substantially the same as the owners. The entity has no plans for going public. Entities tend to be for-profit businesses. 46

48 There is not a regulatory requirement to prepare financial statements in accordance with GAAP. The entity does not operate in an industry with highly specialized accounting guidance. The entity has little or no foreign operations and does not have highly complicated transactions. Lenders and other key users of the financial statements have access to management. The level of contact between management and the lender is such that if the lender didn't quite understand the implications of something in the financial statements, the lender could just pick up the phone, call a key contact, and ask the question directly. Managers/owners rely on financial statements to confirm what they already think is happening in terms of performance, cash flow, and what they own and owe. It is ultimately up to the management of an organization to decide if FRF for SMEs is an appropriate financial reporting framework for the organization. When might FRF for SMEs not be appropriate? Two industries illustrate when FRF for SMEs would likely not be an appropriate reporting framework. Financial institutions have complicated transactions. The industry in general has developed very specialized accounting and disclosure presentations. It would not take very many transactions before the information needs of users of the financial statements would outstrip the framework of FRF for SMEs. OBSERVATION Just two areas of GAAP show why this new framework would not be appropriate for financial institutions. First, significant information is needed about loan portfolios to understand risks and future cash flows. GAAP provides detail guidance on how to disclose loans and accounting for troubled debt. Second, even a minimal amount of hedging and derivative activity by a financial institution goes beyond the guidance found in FRF for SMEs. Nonprofit organizations have very distinctive activities and accounting issues that are not addressed in FRF for SMEs. Nonreciprocal transactions, reporting on donor contributions for specific purposes, reporting restricted contributions that have not yet been spent, reporting expenses by functional category, and deferred giving programs are just a few examples of specialized transactions that GAAP covers in depth but are unaddressed in FRF for SMEs. OBSERVATION Accounting for the specialized activity in a nonprofit organization would push the preparer to rely on GAAP for guidance on how to present a variety of transactions. This would leave the preparer and the CPA in the awkward situation of inappropriately blending GAAP and OCBOA. By the time the financial statements of even a very small nonprofit were prepared it would be unclear what financial reporting framework was actually in use. STUDY QUESTION 1. Which of the following factors suggests that FRF for SMEs might be appropriate for an entity? a. Owners of the entity hire managers to run the organization. b. Lenders to the organization have access to managers of the entity. c. The entity operates in an industry with specialized accounting principles that are widely known. d. The entity meets substantially all of the specific requirements to use the framework. 47

49 Effective Date and Frequency of Updates Use of the FRF for SMEs framework is completely optional since the AICPA has no authority to require an entity to use it. Since it is optional, there is no effective date. It may be used at any point after it was officially released (June 2013). The framework is intended to be simpler than GAAP. One implication of that idea is the framework will not need to be updated to deal with cutting-edge or highly sophisticated developments in the business world. That means it will not require significant ongoing revisions/updates as is the case with GAAP. The announced goal is for the AICPA staff and the task force to monitor implementation of the framework and then propose modifications if necessary. After that initial round of modifications, the goal is to amend the framework every three or four years. The overall goal is for the framework to be a very stable financial reporting platform. Financial Statement Concepts Since FRF for SMEs is a self-contained body of knowledge, the first chapter of the framework outlines a number of the basic concepts for general-purpose financial statements. Financial statements are available to be issued when: A complete set of financial statements has been prepared which includes all final adjusting journal entries, No additional changes are expected, and The financial statements have been approved by the entity. OBSERVATION The date that all of those conditions are met would then be the date used in the accountant's report. Materiality The objective of financial statements is to provide management, creditors, and any other users of the financial statements information useful to them in making resource allocation decisions or evaluating management's results. Materiality in this framework is a description of the significance of that information to those using the financial statements. Information is material if it is probable that misstatements of information or missing information would change a user's decision. Qualitative Characteristics Four primary qualitative characteristics make financial statement information useful to users: understandability, relevance, reliability, and comparability. Understandability the information needs to be understandable. This assumes users have a reasonable level of understanding of business and are willing to study the information. Relevance information that can help users evaluate financial transactions and revisit their previous assessments is relevant. Relevant information has predictive value for helping the user assess future cash flow and feedback value to evaluate past predictions. Information also needs to be timely in order to be relevant. Reliability information is reliable when it accurately reflects the actual underlying transactions. This is called representational faithfulness. This leads into emphasizing the importance of reflecting substance rather than form. Reliable information is also verifiable, which means an independent observer such as an outside accountant could agree the information accurately reflects the transaction. 48

50 Comparability using the same accounting policies consistently from period to period provides comparability of data over time. Changes in policies and the impact of those changes need to be disclosed. There are trade-offs between the qualitative characteristics. For example, taking substantially more time to gather additional information and prepare better estimates could increase the reliability of information. However, that would come at the cost of a drop in relevance because of the delay in providing the information. Elements of Financial Statements The basic elements of items needed to meet the objective of financial statements can be grouped into two categories: Elements that describe economic resources and obligations of the entity along with its equity, all as of a point in time; this is referred to several times in the framework as what is owned and owed. Elements that describe the changes in those resources, obligations, and equity during a period of time. Assets are defined as economic resources from past transactions or events that provide future economic benefits. These are controlled by an entity. It is not necessary to have legally enforceable control over a resource because control can be maintained by other means. Liabilities are obligations (financial or nonfinancial) of an entity. These also arise from past transactions or events. Liabilities may be settled in the future by transferring assets, using up assets, providing services, or providing some other economic benefit. Liabilities may be legally enforceable or they could be constructive obligations. A liability that is inferred from the circumstances of a particular situation would be a constructive obligation. Equity is the ownership interest representing the difference between assets and liabilities. Revenues are increases in economic resources generated from the ordinary activities of the organization. Expenses are decreases of economic resources generated from the organizations ordinary delivery of services or generation of revenue. Gains are increases in equity arising from peripheral or incidental events and transactions. This would not include revenue or additions to equity by owners. Losses are decreases in equity arising from peripheral or incidental events and transactions. This would exclude expenses or distributions of equity to owners. Recognition Criteria The framework provides foundational concepts for determining when a transaction or item should be reflected in the financial statements. Recognition means the amount is included in the financial statements along with a description of what the item is. There are two criteria for recognition: There is an appropriate basis of measurement for the item and a reasonable estimate can be made. If an item involves obtaining economic benefits in the future, it is probable those benefits will be obtained. Likewise for an item that involves giving up future economic benefits; it is probable those benefits will be given up. Sometimes an item will not be recognized in the financial statements because either a) a reasonable estimate cannot be made of the amount or b) the likelihood is below probable that the future benefits will be received or given up. In such cases, it may be appropriate to describe such items in the notes. It is important to note that, as is also required by GAAP, accrual accounting is used in FRF for SMEs. OBSERVATION 49

51 This comment on accrual accounting means that cash basis and modified cash basis are not allowed in this new framework. Revenue is recognized in the framework when: Performance is achieved There is reasonable assurance regarding measurement There is reasonable assurance of collectability For construction in process, partial recognition is allowed. Expenses and losses are generally recognized when an expenditure does not have a future economic benefit. If assets are determined to no longer have future economic benefit, they would be recognized as an expense or loss. The concept of matching cost with revenues is used in the framework. Revenue and expense would recognize simultaneously when both occur as part of the same transactions or events. An example would be recognizing revenue from product sales and cost of goods sold at the same time. Expenditures which will produce economic benefits over several years but which are unrelated to specific revenue transactions are recognized in the statement of operations on a systematic and rational allocation basis. Examples of such expenditures would be buildings, equipment, patents, and trademarks. Those items are recognized as expenses when the economic benefits are consumed or expire. Measurement Determining the amount to recognize for an item is called measurement. The framework uses historical cost basis as the primary measurement. Other measurement bases used in certain circumstances include: Replacement cost Realizable value Present value Market value Market value is described in one sentence. Summarized, it is the amount that knowledgeable, willing parties with no compulsion to act would agree upon in an arm's length transaction. The framework assumes entities are a going concern. FRF for SMEs should not be used by entities that are not a going concern. General Principles Chapter 2 of the framework describes general principles for financial statement presentation and accounting policies. Fair Presentation Financial statements should present fairly the financial position, results of operations, and cash flows of an entity. The presentation should be in accordance with the FRF for SMEs framework. A parenthetical comment in the framework document indicates fair presentation includes the following items discussed in the previous sections: Faithfully represent the substance of transactions Include the elements of financial statements (assets, liabilities, equity, revenue, expense, gain, loss) Apply the recognition criteria Apply the measurement criteria 50

52 Going Concern Responsibility for assessing whether an entity is a going concern belongs to management as they prepare financial statements. The going concern assumption indicates that an entity has the ability to realize its assets and fulfill its liabilities in the ordinary course of business. If an entity is not a going concern entity the FRF for SMEs framework should not be used. The framework indicates if that is the case, that liquidation basis accounting would be appropriate, which would obviously have to be applied outside of the framework. Management should take into consideration all known and available information when evaluating whether the entity is a going concern. The framework specifically mentions the time horizon is 12 months out from the statement of financial position date. Management may become aware of circumstances or material uncertainties or events that do not impair the going concern assumption yet are still so significant that they create a likelihood that there could be a severe impact on the entity's ability to realize its assets and fulfill its liabilities. Severe impact is described in the glossary as something that could have a disruptive effect on normal functioning. The level of impact is described as a significant financially disruptive effect. A severe impact is more significant than material yet less than catastrophic. If management is aware of issues that are probable of having a severe impact, then management should disclose the issue or uncertainty along with the entity's plans to deal with the adverse effects. The extent of management's assessment of going concern varies depending on the situation the entity finds itself in economically. That assessment would not require much analysis if there were a history of profitable operations and sufficient capital resources are available. In some circumstances, management would need to do a much more detailed analysis of expected profitability, debt payment maturities, and availability of other financing sources before it could conclude the entity is in fact a going concern. STUDY QUESTION 2. Which of the following statements is correct with respect to going concern issues within the framework? a. The time frame for assessing whether an organization as a going concern is 12 months from the statement of financial position date. b. If an organization is not a going concern, the FRF for SMEs framework is still appropriate if the circumstances and management's plans to address the situation are appropriately disclosed in the notes to the financial statements. c. Management needs to prepare a detailed analysis each year to assess whether the entity is a going concern. d. The external accountant is responsible for assessing whether the entity as a going concern or not. Financial Statements A complete set of financial statements includes a statement of financial position, a statement of operations, a statement of changes in equity, and a statement of cash flows. The changes in equity could be included in one of the other statements. Disclosures in notes that are necessary for any items presented in the body of the statements are an integral part of the statements. A single financial statement is allowed, such as preparing a statement of financial position only. If a statement of financial position and statement of operations are presented, then a statement of cash flows should also be presented. 51

53 OBSERVATION There are no references in the framework to a balance sheet or income statement as is often used in GAAP financial statements. Instead, all references are to the statement of financial position and statement of operations. There is no explicit comment in the framework on the reason for this different phrasing. The author's inference is that since this framework is an OCBOA, the basic financial statements should not be phrased in the same way as under GAAP reporting. Using the title balance sheet could imply to readers the statement is prepared in accordance with GAAP. Preparers should ensure the basic financial statements are titled appropriately. External accountants should verify the titles clearly communicate they are for OCBOA reporting. Presentation of transactions that are not in accordance with the framework cannot be corrected by either disclosure as an accounting policy or by information provided in the notes. There are many places in the framework where management has an option as to the accounting policy used to prepare financial statements. Management should select one of the options. Changes to accounting policies need to follow guidance prescribed within the framework. Comparative Information Comparative financial statements are allowed under the framework and usually are meaningful. Occasionally the grouping of items for presentation may change from one year to the next because there is an allocation change or a different grouping used. Changes due to such grouping or reclassifications are not a change in accounting principle. However, if items are classified differently in the current year presentation, the same classification changes should be made to the prior year financial statements so the information will be comparative. Disclosures Notes to the financial statements should prominently state the basis for presentation is FRF for SMEs. The framework does not require a description of principal differences between FRF for SMEs and GAAP. However, auditing standards found at AU-C Section 800, Special Considerations Audits of Financial Statements Prepared in Accordance With Special Purpose Frameworks, require an auditor to evaluate whether the financial statements are titled appropriately and contain a summary of significant accounting policies. Those standards also require the auditor to assess whether the differences between the special purpose framework and GAAP are described in sufficient detail. The differences don't need to be quantified. OBSERVATION Whether required or not, it might be wise for the entity to describe the principal differences between the framework and GAAP in order to assist users of the financial statements understand what they are reviewing. The notes to the financial statements should disclose the significant accounting policies. Specific mention should be made when management has chosen between several alternative principles that are acceptable under the framework. Accounting principles and methods unique to a specific industry should be described even if they are normal for all entities in that industry. It cannot be assumed that readers of a financial statement will be familiar with the distinctive policies used within an industry. The disclosure of policies should be gathered together and generally be presented as the first note to the financial statements instead of addressing the policies across individual notes. STUDY QUESTION 52

54 3. Which of the following statements about FRF for SMEs is correct? a. An entity is not required to prominently state in the notes that the financial statements are prepared on the basis of FRF for SMEs if the titles to the financial statements make it clear that is the financial reporting framework in use. b. A single financial statement, such as a statement of financial position only, is not allowed under FRF for SMEs. c. The framework requires a description of the principal differences between FRF for SMEs and accounting principles generally accepted in the United States of America. d. Notes to the financial statements need to disclose management's choice of accounting principle when there are options available within the framework. Transition The framework contains specific guidelines for making the transition from another financial reporting framework to the FRF for SMEs. Opening Statement of Financial Position When transitioning to the framework, an entity should prepare an opening statement of financial position as of the first day of the year. For a single year presentation this would be the first day of the current year. If comparative financial statements from one or more previous years are being presented in addition to the current year, then the opening statement of financial position would be the first day of the earliest year. The opening statement of financial position would be prepared with the following guidelines: Record as assets and liabilities those items which should be recognized as such under the FRF for SMEs framework. Do not record those assets and liabilities for which the framework does not permit recognition. If assets, liabilities, or components of equity were previously recognized differently under a different financial reporting framework, reclassify those items as assets, liabilities, or components of equity as required under the framework. Measurement of all assets and liabilities should be performed using guidance within the framework. When making the initial transition to the framework, the same accounting policies should be used in the opening statement of financial position and throughout all years presented. There may be changes in accounting policy from the previous presentation to what is used in the opening statement of financial position. These changes could arise because the previous accounting policy is not allowed under the framework or a different recognition or measurement is required. Regardless of the cause, the adjustments due to the change are attributed to the time before the date of transition. Therefore any adjustments from the change are reflected in equity as of the date of transition to the framework. Exemptions are allowed to the general concept that all assets and liabilities on the opening statement of financial position should comply with the requirements of the framework. Exemptions are allowed for certain items addressing: Business combinations Accounting for financial instruments contain both liability and equity component Recognition of asset retirement obligations Estimates used for the opening statement of financial position should reflect information that was available when the estimates were initially determined for the previous financial presentation. If estimates are necessary for items in the opening statement of financial position for which estimates had not been made previously, then 53

55 those estimates should reflect conditions that existed at the date of the opening financial statement of financial position. In other words, estimates may not be revised to reflect developments or new information that arose in subsequent years. Disclosures For the first presentation of financial statements under the framework, all changes to equity as of the date of transition to the framework should be disclosed. The nature and amount of each adjustment to equity should be described OBSERVATION The impact of this requirement would be to present equity as previously reported under the preceding finance reporting framework with a reconciliation to the opening amount of equity under the FRF for SMEs framework. 54

56 CHAPTER 4: FRF for SMEs An Alternative to GAAP Basic Financial Statements 401 WELCOME The Financial Reporting Framework for Small- and Medium-Sized Entities (FRF for SMEs) is an alternative to GAAP for small entities who desire a simpler financial reporting framework to present their financial statements. This chapter describes the general principles for the statements of financial position, operations, and cash flow. It also describes the very brief guidance in the framework for derivatives and sales of financial assets. Treatment of changes in accounting principle and correction of errors is described. 402 LEARNING OBJECTIVES Upon completion of this chapter, the reader should be able to: Describe the categories of investment assets and investment income that should be reflected in the financial statements Describe the criteria for classifying loans as current or long-term Describe the general principles for recognizing and derecognition financial assets and liabilities Describe the limited accounting guidance provided for recognition, measurement and disclosure of derivatives Describe the criteria for recording an accounting changes and the proper accounting Describe the criteria for correction of a prior period error and the appropriate accounting Describe the impracticable exception for retrospective restatement of financial statements Describe the risk and uncertainty disclosures required under the framework 403 INTRODUCTION CPAs trying to help their clients find simpler and easier ways to present financial information have long suggested one of the other comprehensive basis of accounting (known as OCBOA), such as modified cash basis or income tax basis. A new alternative is available. In June 2013 the AICPA published the Financial Reporting Framework for Small- and Medium-Sized Entities. Known as FRF for SMEs, this framework is categorized as one of the OCBOAs. This chapter is one in a series describing FRF for SMEs. The first chapter is FRF for SMEs An Alternative to GAAP Introduction. It describes how FRF for SMEs fits into the various options for financial reporting, and describes the basic financial concepts in the framework. That chapter also describes the general principle for transitioning financial statements to the first presentation under FRF for SMEs. This chapter will summarize the general approach to the statement of financial position, statement of operations, and statement of cash flows. It will also address how to handle accounting changes, changes in estimates, correction of errors, along with risk and uncertainty disclosures under the framework. The focus will be areas where FRF for SMEs differs from GAAP along with the general approach under the framework. It is worth addressing the philosophical approach because the framework is intentionally less specific than GAAP and more principles-focused. 55

57 A key point needs to be repeated FRF for SMEs is not GAAP. It is neither "small GAAP" nor GAAP light nor GAAP without some of the detailed rules. In one sentence, FRF for SMEs is another in the group of OCBOA frameworks that might be an acceptable alternative to GAAP for some companies in some circumstances. Just as modified cash basis or tax basis might be appropriate for some entities, FRF for SMEs might be an appropriate alternative. 404 STATEMENT OF FINANCIAL POSITION Categories of assets for presentation would generally be the same as under GAAP: cash and cash equivalents, trade receivables, loans receivable, prepaid expenses, inventories, property/plant/equipment, intangible assets, and long-lived assets held for sale. Investments would be broken into several categories: Nonconsolidated subsidiaries and not proportionately consolidated joint ventures, Investments measured using cost method, Investments using equity method, and Investments using market value. Liabilities would be categorized generally the same as under GAAP. Assets and liabilities would be classified as current based on whether they will be realized or payable within one year or within normal operating cycle if the operating cycle is longer than a year. Cash surrender value of life insurance would be excluded from current assets unless it has been converted to cash prior to the date when financial statements are available to be issued. The portion of long-term debt payable within a year of the fiscal year-end would be classified as current. If a lender has the right unilaterally to demand repayment of a debt as of the date of the statement of financial position or within one year following, the obligation is categorized as current. If the lender has the right to demand repayment of a portion of a loan, that portion would be a current liability. A loan, or portion thereof, that would otherwise have to be categorized as current can be classified as long term in any of the following circumstances: The creditor has waived the right to demand payment for more than a year from the date of the statement of financial position. This waiver must be in writing. If the creditor has otherwise lost the right to demand repayment, the debt would be classified as long-term. The loan has already been refinanced on a long-term basis prior to the date the financial statements are available to be issued. Prior to the financial statements being available to be issued, the entity and creditor have a noncancelable agreement for refinancing the short-term debt on a long-term basis. There would need to be no impediment to actual completion of the refinancing. If there is a covenant violation on long-term debt, the debt would be classified as current unless one of two circumstances applies: The creditor has waived the right to demand repayment for more than one year from the date of the statement of financial position. This waiver would need to be in writing. The borrower would need to have received the waiver by the date the financial statements are available to be issued. The debt instrument has a grace period to allow curing a violation and contractual arrangements are in place so that the violation will be cured within that grace period. 405 GENERAL PRINCIPLES FOR CERTAIN FINANCIAL ASSETS AND LIABILITIES 56

58 Recognition Financial assets and liabilities should be recognized in the financial statements when the entity becomes a party to the contract. Measurement Except for derivatives which will be discussed momentarily, financial assets and liabilities should be measured at the transaction amount. Included in the amount recognized would be financing fees, which are additional amounts paid to the lender such as origination, commitment, refinancing or other comparable fees. In addition, transaction costs directly attributable to the financial asset or financial liability would be added to the transaction amount. Those would be the incremental costs for the transaction such as legal fees, reimbursing the lender for their costs, or appraisals. Financial assets and financial liability should only be offset with the net amount reported in a statement of financial position if: The entity has a legally enforceable right to set off the items, and The entity intends to settle the items on a net basis or intends to realize the asset and settle the liability at the same time. Derecognition Financial assets are derecognized (removed from the financial statements) when they are transferred and control of the financial asset has been surrendered to another entity. OBSERVATION This is an illustration of one area where an entity's activities might make it inappropriate to use FRF for SMEs. Other than the disclosures discussed below, this comment is the extent of accounting guidance in the framework related to sales of financial assets, such as receivables or loans. There is a substantial of volume of guidance on this issue in GAAP, which is in sharp contrast to the one paragraph comment found above. The general concept in the framework is that if an entity operates in an industry where there is significant specialized guidance in GAAP, then FRF for SMEs probably might not be appropriate. Thus an entity that makes extensive use of financial asset sales should not use FRF for SMEs. In addition, an entity having significant volumes of financial asset sales would probably be engaged in other transactions requiring specialized guidance and also likely be subject to regulatory oversight. Such an entity might already have a requirement to present GAAP financial statements. In short, an entity needing substantially more guidance than the one paragraph comment above might not be using FRF for SMEs anyway. A financial liability is derecognized when it is extinguished. That would be when the obligation expires, is canceled, or discharged. The restructuring of a debt is treated as if it were an extinguishment of the old financial liability with recognition of a new financial liability. This could take place either as a new debt instrument with substantially different terms or it could be a modification of the existing financial liability. The difference between the carrying amount of the previous financial liability and the recognized amount of the new financial liability is recognized in the statement of activity for the year. Disclosures Accounts and notes receivable should be separated into different categories such as trade receivables, due from related parties, and other major categories. The amounts and maturity dates of financial assets maturing beyond one year should be disclosed separately. OBSERVATION Although the precise presentation of the disclosure is not specified in the framework, the author 57

59 views this as comparable to the five-year disclosure for loans payable or minimum noncancelable lease payments under GAAP. For transfers of financial assets recorded as a sale, an entity should disclose: Gain or loss from sales during the year, Accounting policy for initially measuring any retained interest in the financial assets and for subsequent measurement of those retained interest, and Description of the entity's continuing involvement such as servicing or recourse. For transfers of financial assets which were not derecognized, an entity should disclose: Nature and amount of financial asset transferred, Description of the risks and rewards that are retained, and Amount of liabilities assumed as a result of the transfer. For long-term debt such as bonds and mortgages, an entity should disclose the same type of items as under GAAP, such as interest rate, maturity, repayment terms, and other significant terms. The amount outstanding should include principal and accrued interest. In addition to disclosing what financial liabilities are secured, an entity should also disclose the carrying amount of any assets that are collateral. For all financial liabilities recognized in the financial statements, an entity should disclose whether any of those financial liabilities were in default or have a covenant violation that would allow a lender to demand accelerated payment. The entity should disclose whether the default or covenant violation was remedied or renegotiated by the date the financial statements are available to be issued. The face of the financial statements or the notes should disclose the following: Net gains or losses on financial assets and liabilities. Total interest income. Total interest expense. Transaction costs, financing fees, and amortization of premium and discounts should be separately identified. If an entity has a transaction that is indexed to equity, the entity should disclose sufficient information so users can understand the nature, terms and effects of the indexed transaction. Entities should also describe expected timing for payments and conditions when the payments will be made. STUDY QUESTION 1. Which of the following statements regarding accounting for restructuring of a debt under FRF for SMEs is correct? a. Any gain or loss on the restructuring is amortized over the term of the new debt instrument. b. The new debt instrument is recognized in accordance with its terms and any difference from the carrying value of the old debt is recognized in the statement of activity. c. Any gain or loss on the restructuring is presented as either an extraordinary item or a component of other comprehensive income, at the choice of management. Management's election should be disclosed in the notes. d. The gain or loss on modification of the loan terms is determined using present value concepts. 58

60 406 FINANCIAL INSTRUMENTS WITH LIABILITY AND EQUITY COMPONENTS OBSERVATION The framework covers the accounting for financial instruments with both a financial liability and equity component in one paragraph. An entity that issues a financial instrument with liability and equity components should classify the components as a liability or equity based on the substance of the contract. The FRF for SMEs framework indicates a financial liability is a contractual commitment to deliver cash or other financial instrument to another entity or to exchange financial instruments with another entity. An equity instrument is a contract showing the residual interest in an entity's assets less all liabilities. Disclosure If an entity has a financial liability that has an equity component along with the liability, the entity should disclose the following for the equity component: Exercise date of conversion options, Maturity dates of options, Strike price or conversion ratios Conditions necessary to allow exercising the options, and Other terms that affect exercising the option. Derivatives Derivatives are recognized in the financial statements based on the net cash paid or received at settlement. OBSERVATION Other than disclosures, which are discussed next, this is the extent of accounting guidance in the FRF for SMEs framework for derivatives. This obviously represents a dramatic departure from the extensive accounting guidance for derivatives found in GAAP. An entity should disclose the following for derivatives: Face or contract amount. If there is no face or contract amount, then the notional principal amount should be disclosed. Nature and terms of the derivative. This would include cash requirements and a discussion of credit risk and market risk. Description of the objectives for the derivatives. Net settlement amount as of the date of the statement of financial position. OBSERVATION Four specific items found in one paragraph is the extent of disclosure requirements for derivatives. There is no discussion of any particular types of derivatives. This is also a dramatic contrast to the extensive requirements in GAAP. OBSERVATION Keep in mind that even with the minimalist accounting requirements and disclosures for derivatives, it is still necessary to present material information to users of the financial statements. The author expects the extent of narrative descriptions would provide a robust 59

61 description of the derivatives and their potential impact on the entity to fulfill that objective. Statement of Operations Presentation of the statement of operations should include the appropriate categories to fairly present the results of operations. The necessary categories would depend upon the nature of the entity but should distinguish the following at a minimum: Income or loss before discontinued operations, Discontinued operations, and Net income or loss for the reporting period. The following items would typically be presented. These may be presented either on the face of the statement of operations or in notes or in attached schedules: Revenue recognized. Investment income with separate disclosure of the following: - Nonconsolidated subsidiaries and non-proportionally consolidated joint ventures - Investments valued using cost method - Investments valued under equity method - Investments using market value valuation Depreciation of property plant and equipment. Amortization of intangible assets. Exchange and loss from foreign currency translation. Revenue, gains, expenses, or losses arising from transactions the entity does not expect to occur frequently in several years. This could also include those transactions that are not typical of normal activities. Income tax expense or benefit, with separate presentation of income tax expense or benefit before discontinued operations OBSERVATION Since FRF for SMEs uses fair value less than GAAP, there may be investments included in the financial statements which are valued under different measurement criteria. Classification of assets and disclosure of the related investment income are aggregated based on the basis used to measure the asset or investment earnings. STUDY QUESTION 2. All of the following statements about accounting and disclosure under the FRF for SMEs framework are correct except: a. For financial assets, the amounts and maturity dates beyond one year should be disclosed separately. b. An entity that issues a financial instrument with liability and equity components should classify the components as a liability or equity based on the substance of the contract. c. Guidance for derivatives under FRF for SMEs is substantially less detailed than GAAP yet still provides extensive guidance for recognition and measurement for several types of derivatives. d. Disclosure of investments and investment income needs to be broken out into four 60

62 categories based on the accounting methodology used, if those types of investments are present. OBSERVATION Noticeably missing from the framework is any discussion of comprehensive income. The discussion of the statement of operations contains no reference to the concept and there are not requirements elsewhere to include an item in other comprehensive income. This is a significant difference between FRF for SMEs and GAAP. Statement of Cash Flows The goal of the statement of cash flows under FRF for SMEs is comparable to GAAP: provide information to readers of the financial statements about the entity's historical ability to generate cash and how it uses available cash. From this readers can make their own inferences about future cash needs. The presentation of a statement of cash flow under the framework will be very familiar: presenting cash flows in operating, investing, and financing categories which ties to cash and cash equivalents on the statement of financial position. The framework allows a single financial statement to be presented. However if a statement of financial position and statement of operations is presented, then a statement of cash flows is required. Cash would not include balances that are subject to restrictions which prevent use of the cash for current operations. Cash equivalents may include investments with a maturity of three months or less from the date they were acquired by the entity. As with GAAP, the framework allows an entity to define whether it wishes to categorize short term, highly liquid investments as a cash equivalent or an investment. As under GAAP, the operating activities section of a statement of cash flow under the framework may be prepared under either the direct method or indirect method. If the direct method is used, the statement should include a separate schedule to reconcile net income to cash flows from operating activities. Non-cash transactions should not be included in the statement of cash flow as operating, investing, or financing activities. They should instead be disclosed either separately on a statement of cash flows as "non-cash investing or financing activities" or in notes to the financial statements. 407 ACCOUNTING CHANGES AND CORRECTION OF ERRORS Accounting Changes Accounting policies should only be changed if: The change is required by the FRF for SMEs framework, or The financial statements will provide reliable and more relevant information on the entity's financial condition. If an entity changes an accounting principle at the time of initial application of the framework, the change should be accounted for as discussed in the earlier chapter in this module. Essentially that would require restating the opening statement of financial position, including the cumulative impact of the change in opening net assets, and disclosing the amount and nature of the change in opening net assets. A change in accounting policy should be applied retrospectively when: There is a change in accounting policy at the time of initial application of the framework but the framework does not include specific provisions for a transition, The entity makes a voluntary change in accounting policy, or 61

63 The framework requires a change in accounting policy. Retrospective application requires adjusting the opening balance of equity for the earliest period presented. Other items in the financial statement should be restated as if the new accounting policy had been applied for each of the years that are presented. Impracticability Exception A change in accounting principle does not need to be applied retroactively if it is impracticable to do so. There are specific criteria for assessing whether retroactive application of a change in accounting policy is impracticable. Those criteria are: The effects of the change in accounting principle are not determinable, Determining the impact would require making assumptions about management's intent at the time, or It is not possible to objectively identify the estimates that would have been made to apply the accounting principle. This third criterion requires additional discussion. The framework indicates it is not appropriate to use hindsight in applying a new accounting policy, or for that matter, retroactively restating financial statements for a material prior period error. Retrospectively applying a new accounting policy or retrospectively restating for an error requires identifying information that: Provides evidence of the situation or amounts or values that existed at the date of the transactions or events, and Would have been available when the previous financial statements were issued. The information needed to objectively support an estimate that feeds into a retrospective change needs to be distinguished from evidence that did not exist at that date or would not have been available. If the evidence to support an estimate didn't exist or wouldn't have been available, then the retrospective application or restatement would not be practicable. OBSERVATION A few examples may help illustrate the concept of not being able to objectively identify an estimate that is necessary to apply a retrospective change. If the accounting system did not accumulate the information that would have been necessary to inform an estimate needed to apply the appropriate accounting, then the evidence for that accounting treatment did not exist at the point the financial statements were issued. Another illustration of not being able to objectively support an estimate that is necessary to make a retrospective change would be a construction company which previously had been reporting on a completed contract basis. Assume the company concluded it would be reliable and more relevant to apply percentage of completion accounting. Since the entity was applying the completed contract method for previous periods, management likely did not review each project in terms of percent complete at each financial reporting date, which means there would be no contemporaneous evidence available to support an estimate. That means it is necessary to objectively determine what the percentages were at the time. To do so would require an estimate of the percent complete for each project as of each financial statement reporting date. It would be possible to determine those estimates to complete after the fact by reviewing final results for each project and backing into a percent completed. However, the final costs would not have been available when the financial statements were issued. That approach would use hindsight, and thus those estimates would not be objectively supportable. If the construction company was involved in relatively small projects, it might be possible for managers to estimate the percent complete by applying their experience with an eye-ball of each project or perhaps just by looking at the costs incurred in relation to scope of the project. There is no documentation to support what 62

64 management at the time would have thought and therefore no evidence of what the completion percentages were. In the scenario as just described it would be impracticable to retrospectively apply this change in accounting principle. OBSERVATION The author perceives this definition creates a relatively high threshold to allow concluding a retrospective application is impracticable. If it is impracticable to determine either the cumulative effect for all years presented or the period-specific effects for one or more years, then management should retrospectively apply the change in accounting principle at the earliest date for which retrospective application is practicable. Disclosures. When there is a change in accounting policy required by the framework or a voluntary change in accounting policy, an entity should disclose: Nature of the change, Amount of adjustment for each line of the financial statements in the current period, Amount of the adjustment for periods prior to those presented, and If retrospective application is impracticable, the circumstances make it impracticable and a description of when and how the change has been applied. If the change in accounting policy is voluntary, the entity should also disclose an explanation why the new accounting policy provides reliable and more relevant information, For a change in accounting policy required by the framework, those disclosures do not need to be repeated in a subsequent year when there is a single year presentation. If comparative (prior year) financial statements are presented, those the disclosures should be repeated. In contrast, for a voluntary change in accounting policy subsequent period financial statements do not need to repeat those disclosures. Change in Accounting Estimates Preparation of financial statements requires reasonable estimates which are based upon the most recent available, reliable information. New information, or more experience, or changes in circumstances could require revision to an estimate. The impact of changing an estimate should be recognized prospectively. The impact would flow into net income either in the year of the change if it affects only the current period or it could affect net income in the current period and subsequent years if the change affects multiple years. Disclosures. The financial statement should disclose the nature and amount of a change in estimate that has an impact in the current year. However, changes in estimates resulting from routine accounting for items such as inventory obsolescence or uncollectible accounts do not need to be disclosed. Correction of Errors Errors in financial statements, both material and immaterial ones, can occur. If they occur in the current period before the financial statements are issued, the error should be corrected. If material errors are not discovered until a subsequent year, then the prior period errors are corrected in the next set of financial statements after the error is identified. Material prior period errors should be corrected retrospectively. This is accomplished by: Restating the prior period or periods when the error occurred, or If the error is prior to the earliest period presented, the opening balances for the earliest period are restated. 63

65 It might be impracticable to restate all prior periods which contain a material error. The earlier discussion of impracticability applies to correction of errors. The financial statements should be retrospectively corrected for the earliest period for which it is practicable to do so. Disclosures. For correction of an error, the financial statement should disclose: Nature of the prior period error, The amount of the correction for each line of the financial statements that are affected for each of the prior years presented, and Amount of any correction at the start of the earliest year presented. STUDY QUESTION 3. Which of the following comments about treatment of accounting changes and corrections of errors is correct? a. An entity may voluntarily change in accounting principle if the new principal is clearly preferable in the circumstances. b. One part of retrospective application of a change in accounting principle is to adjust the opening balance of equity for the earliest period presented. c. Material accounting errors in prior period financial statements are corrected on a prospective basis. d. For a change in accounting principle, it is not necessary to restate the opening balance of equity for the earliest period presented if doing so would be significantly inefficient. Risks and Uncertainties The framework requires entities to disclose general types of risks and uncertainties they face. Readers familiar with GAAP requirements will recognize the following discussion. Disclosures are needed in four areas. Nature of operations. An entity should disclose the major products or services along with its principal markets with the locations mentioned. These disclosures do not need to be quantified but could describe relationships such as predominantly or about equally. Use of estimates. The notes should explain that financial statements prepared in accordance with the FRF for SMEs framework require estimates by management. Significant estimates. An entity should describe significant estimates for which it is reasonably possible that: The estimate will change in the near term (defined as one year from the date of the statement of financial position), and The impact of the change will be material. Three of the illustrations provided by the framework of possible significant estimates are litigation liabilities, inventory with rapid technological obsolescence, and real estate loan valuation allowances. Concentrations. An entity should disclose certain concentrations if: A concentration exists as of the financial statement date, The entity is vulnerable to a near-term severe impact from the risk from the concentration (near-term is one year from the financial statement date), and The possibility that events could cause a severe impact in the near-term is at least reasonably possible. 64

66 OBSERVATION As can be seen from the above descriptions, the FRF for SMEs framework requires roughly the same type of disclosures for risks and uncertainties as the GAAP framework. 65

67 CHAPTER 5: FRF for SMEs An Alternative to GAAP General Issues 501 WELCOME The Financial Reporting Framework for Small- and Medium-Sized Entities (FRF for SMEs) is an alternative to GAAP for small entities who desire a simpler financial reporting framework to present their financial statements. This chapter describes the requirements in the framework for inventory, PP&E, discontinued operations, and equity. It also covers the broader, general topics of commitments, contingencies, related party transactions, and subsequent events. 502 LEARNING OBJECTIVES Upon completion of this chapter, the reader should be able to: Describe the measurement and disclosure requirements for inventory Understand the lack of requirements for assessment of impairment for long-lived assets Describe the presentation and disclosure requirements for long-lived assets held for sale and discontinued operations Describe the presentation of stock acquisition under the cost and constructive retirement methods Describe the disclosure requirements for stock-based compensation and understand that there are no recognition requirements for options granted Define the three levels of probability used to describe the likelihood of a future event Describe the recognition and disclosure requirements for contingent losses and contingent gains Describe the recognition and measurement requirements for asset retirement obligations Define the term related party Describe the disclosure requirements for related party transactions Describe the two types of subsequent events and identify which one requires recognition in the financial statements 503 INTRODUCTION CPAs trying to help their clients find simpler and easier ways to present financial information have long suggested an other comprehensive basis of accounting (known as OCBOA), such as modified cash basis or income tax basis. A new alternative is available. In June 2013 the AICPA published the Financial Reporting Framework for Small- and Medium-Sized Entities. Known as FRF for SMEs, this framework is categorized as one of the OCBOAs. This chapter is one in a series describing FRF for SMEs. The first chapter is FRF for SMEs An Alternative to GAAP Introduction. It describes how FRF for SMEs fits into the various options for financial reporting, and describes the basic financial concepts in the framework. That chapter also describes the general principle for transitioning financial statements to the first presentation under FRF for SMEs. This chapter will describe several areas of the statement of financial position, including inventory, PP&E, and equity. It will also address general areas such as commitments, contingencies, related parties, and subsequent 66

68 events. Several major differences from GAAP will be highlighted in this chapter, including issues such as not needing to assess long-lived assets or impairments and the lack of recognition of stock-based compensation prior to issuing the stock. A key point needs to be repeated FRF for SMEs is not some variation or subset of GAAP. It is neither "small GAAP" nor GAAP light nor GAAP without some of the detailed rules. In one sentence, FRF for SMEs is another in the group of OCBOA frameworks that might be an acceptable alternative to GAAP for some companies in some circumstances. Just as modified cash basis or tax basis might be appropriate for some entities, FRF for SMEs might be an appropriate alternative to GAAP in some situations. 504 INVENTORIES Inventories are measured at the lower of cost or net realizable value. Much of the discussion in the framework for inventories, such as including cost of conversion and other costs necessary to get inventory to the present location and condition, and allocating overhead to production runs, will be familiar to anyone who already understands GAAP. The framework specifically mentions standard cost and retail method as allowable along with FIFO, LIFO, and weighted average cost formulas. Specialized industries, such as agriculture, have unique inventory accounting policies. Those policies are allowed by FRF for SMEs even though they are not specifically mentioned, as long as those policies are an accepted industry practice and the policies are adequately disclosed. Financial statement should disclose: Accounting policies used to measure inventories including the cost formula in place. Total carrying amount of inventories. Amount of inventory in different classifications, depending on the nature of the inventory, such as merchandise, material, work in progress, or finished goods. Cost of goods sold for the period. A write-down to lower of cost or net realizable value should be presented in the statement of operations separate from cost of goods sold. The practice of writing inventories down below cost to net realizable value is consistent with the view that assets are not carried in excess of amounts expected to be realized from their sale or use. 505 PP&E Measurement of PP&E is at cost. In addition to purchase price of the asset, this would include, but is not limited to, expenditures necessary to place the item in service such as broker commissions, installation costs, legal fees, site preparation costs, and freight. If an item is constructed or developed over time, the cost would include direct construction and also development costs along with overhead costs that are directly attributable to the item. This would include interest cost if it is the entity's accounting policy to capitalize those costs. However, it should be noted that capitalization of carrying costs should cease when an item is substantially complete and ready for productive use. The framework does not contain any comment indicating an entity should assess long-lived assets for impairment. OBSERVATION This is a significant difference between FRF for SMEs and GAAP. PP&E does not need to be assessed periodically for impairment as is required by GAAP. Accordingly, there is no need to go through the process of assessing future cash flows in comparison to carrying value. 67

69 Improvement Versus Repair Costs that increase an item's physical output or service capacity or extend its useful life would be considered an improvement. Expenditures for improvement are included in the cost of an asset. In contrast, expenditures for maintaining the service potential of an item are considered repairs and thus should be expensed. Consistent with GAAP, depreciation is recognized over the asset's useful life in a rational and systematic manner considering the nature of the item. The framework mentions the nature of the item may suggest that straight line or accelerated or increasing methods may be appropriate. The framework indicates that when an item has significant separable component parts, the cost of the item should be allocated to the component parts if practicable and if lives of the separate components can be estimated. The depreciation and useful lives of items need to be reviewed on a regular basis. A variety of items could suggest there is a need to revise either the method or remaining useful life, such as: A change in a manner or extent the asset is used Removal of the asset from service for an extended period of time Physical damage Significant technological advancements or A change in the law, environment, or consumer styles and tastes that affects the period of time for which the asset will be productively used Disclosure requirements for PP&E are very similar to those requirements prescribed by GAAP. 506 DISPOSAL OF LONG-LIVED ASSETS AND DISCONTINUED OPERATIONS Long-lived assets include nonmonetary items such as property, plant and equipment, intangibles, and long-term prepaid assets. This would not include the following: Goodwill (except in the case of a disposal group that constitutes a business) Financial assets Financial liabilities Equity method investments Disposal of Long-Lived Assets A long-lived asset to be sold is classified as held for sale when the following criteria are met: Management commits to a plan to sell the asset The asset is available for immediate sale in its current condition A plan to find a buyer is active and other efforts necessary to sell the asset have been initiated The sale is probable The sale is expected to be completed within one year The asset is been actively marketed at a reasonable price; and It is probable that no significant changes will be made to the plan. A long-lived asset held for sale should be presented separately in the statement of financial position. If there is a group of assets and liabilities that will be sold in one transaction (called a disposal group), those assets and liabilities should be presented separately. Any financial assets and liabilities of the disposal group should not be 68

70 netted because they do not meet the criteria for netting discussed in the earlier chapter. Depreciation or amortization of the long-lived asset would be placed on hold when the item is categorized as held for sale. If the item stops meeting the criteria to be classified as held for sale, it should be reclassified back to the presentation previously in use. Depreciation and amortization that would have been recognized while it was classified as held for sale should be recorded as expense when it is moved out of the held for sale category. Discontinued Operations A component of an entity consists of the operations and cash flows that can be clearly distinguished from the rest of the entity, both operationally and for purposes of financial reporting. Discontinued operation treatment should be applied to a component of an entity that has been disposed of by sale or spin-off, or that is classified as held for sale, only if both of the following conditions are met: The component's operations and cash flows have been eliminated from ongoing activity of the entity (or will be eliminated in the case of a held for sale component); and There won't be any significant continuing involvement by the entity in the operations of the component. The results of discontinued operations, net of any income taxes, should be presented as a separate component in the statement of activities for the current and prior periods. It is possible there could be adjustments to the amount of the discontinued operations in a period after the disposal is complete. Any such adjustment would also be presented as a discontinued operation in the statement of operations. During a period in which a long-lived asset or disposal group has been disposed of, or is classified as held for sale, the following items should be disclosed: A description of the disposal and the circumstances leading to the actual or expected disposal Amount of the gain or loss on disposal, if not separately presented in the statement of operations, and the caption where the gain or loss is presented; and Amount of revenue and pretax profit or loss included in discontinued operations. Additionally, in a period where a decision is made not to sell an asset previously classified as held for sale, the change in accounting treatment should be disclosed. 507 EQUITY Acquisition or Redemption of Shares When an entity acquires its own previously issued shares there are two alternatives for accounting: the cost method and constructive retirement. State law may have provisions that prescribe a specific accounting treatment of treasury stock. Cost method. With the cost method, the acquired shares are measured at cost and presented as a deduction from stockholders' equity until cancelled, retired, or resold. When acquired shares are subsequently resold, the treasury stock account is credited and the excess of proceeds over cost would be credited to additional paid-in capital. If proceeds are less than what the shares were acquired for, the deficit would be charged to additional paid-in capital. For retirement of stock under the cost method, the treasury stock account is credited with the offset allocated to the capital stock (again at par or stated value) and additional paid-in capital. Constructive retirement method. With the constructive retirement method, the par value or stated value is debited to the capital stock account. The difference between reacquisition price and par or stated value is allocated between additional paid-in capital and retained earnings. The resale of shares should be handled as if it was an original issue. Capital stock should be credited for par or fair value with the remainder credited to additional paid-in capital. 69

71 Retirement of stock under the constructive retirement method would not require any further entries. Presentation Components of equity, such as common stock, additional paid-in capital, and retained earnings, should be presented either in the body of the financial statements or in notes. Changes in each component should be separately disclosed. Components of equity and changes therein should also be presented for unincorporated businesses and partnerships. Disclosures An entity with stock-based compensation plan(s) should provide the following disclosures: Description of the plan(s) General terms of awards, such as vesting requirements Maximum term of options If there are options granted under several stock-based employee compensation plans, an entity should provide separate information for different types of awards to the extent that separate disclosure of groups of awards is important to understanding how the entity is using stock-based compensation. OBSERVATION Half a moment of reflection will reveal the first mention of stock-based compensation in this discussion of equity is when describing disclosures. There was no discussion of presentation or measurement for stock-based compensation. The reason is simple: FRF for SMEs has no requirements other than disclosure. This is a significant difference between FRF for SMEs and GAAP. There are extensive recognition and measurement requirements under GAAP for stock-based compensation. Under the FRF for SMEs, stock-based compensation is not recognized in the financial statements until shares are issued. The extent of disclosure requirements is described above. STUDY QUESTION 1. Which of the following statements about equity is correct? a. When the constructive retirement method is applied to shares which are acquired, the amount paid for the shares is recorded as a contra account to equity. b. When shares are acquired, the framework indicates entities should look to state law to determine the appropriate accounting treatment and therefore the framework does not provide accounting guidance for such acquisition. c. If an entity issues stock options under a stock-based compensation plan, the options are not recognized in the statement of financial position but only reflected as disclosures in the notes. d. The accounting for stock-based compensation plans under FRF for SMEs is identical to the requirements of GAAP. Equity disclosures under the framework, other than stock-based compensation, will be familiar to those who are aware of the GAAP financial reporting framework. An entity that is unincorporated should clearly describe the name under which it does business. In addition, the notes should disclose that the financial statements do not include all of the financial resources, revenues, and 70

72 expenses of the owners. EPS and Other Comprehensive Income The framework does not address earnings-per-share (EPS). In addition it does not address other comprehensive income (OCI). Those concepts are not a factor in FRF for SMEs. OBSERVATION Here are two more issues not included in the framework: EPS and OCI. When combined with the lack of accounting and limited disclosures for stock-based compensation mentioned earlier, these issues represent a very significant difference between GAAP and FRF for SMEs. 508 COMMITMENTS Commitments for items such as construction projects, agreements to reduce debt or maintain working capital, or purchase obligations should be disclosed if they provide material information for current financial position or operations in the future. 509 CONTINGENCIES Definitions The framework defines three levels of probability to assess the likelihood of a future event taking place. Those levels are: Probable the future event is likely to occur. This does not mean virtually certain. Remote the chance for the future event is slight. Reasonably possible the chance for the future event is more than remote but less than likely. These terms are used in a variety of places throughout the FRF for SMEs framework. OBSERVATION These definitions will be familiar to readers. The wording is not identical to GAAP, but the meanings are the same. The key phrases likely to occur and slight are identical. When assessing the likelihood of an event, all information should be taken into consideration that is available through the date the financial statements are available to be issued. Contingent Gains and Losses Contingent losses. A contingent loss should be accrued when both of the following conditions are met: The likelihood is probable that a future event will verify an asset value has diminished or a liability exists as of the date of the financial statement, and The loss amount can be reasonably estimated. Sometimes the amount of a contingent loss can be mitigated with a counterclaim against the party or a claim against another party, such as an insurance company. The likelihood of a successful recovery needs to be virtually certain in order to include a potential recovery in determining the amount of a contingent loss. If the likelihood such recovery is virtually certain, it would be presented gross on the statement of financial position, not netted against the liability. The process of estimating the amount of a contingent loss may generate a range of possible losses. If a particular amount within that range is a better estimate than others, that amount should be accrued. If a particular amount is a better estimate than the others, the minimum of the range should be accrued. See the following disclosures for a requirement to disclose such a range. 71

73 Contingent gains. Because accruing a contingent gain could result in recognizing a gain that might never be realized, such items should not be accrued. Disclosures. The existence of a contingent loss should be disclosed if at the financial statement date: The likelihood of a loss is probable but the amount cannot be reasonably estimated, The likelihood is probable and the loss has been accrued, but there is exposure to possible loss in excess of the amount accrued, or The likelihood is reasonably possible. Such disclosure should include: Nature of the contingency, An estimate of the amount or stating an estimate cannot be made, and Exposure to loss in excess of what was accrued. The financial statements should also describe the conditions or situations that exist as of the financial statement date when the probability of a loss is either probable or reasonably possible. OBSERVATION This is a subtle difference from GAAP, which states disclosure of already accrued contingent losses is only necessary if such disclosure is needed to keep the financial statements from being misleading. Disclosure would be made depending on the circumstances of the entity. The FRF for SMEs framework indicates all loss contingencies with likelihood of probable or reasonably possible should be described to users of the financial statements. A gain contingency with likelihood of probable should be disclosed in the notes. It is not appropriate to disclose gain contingencies with a likelihood of either reasonably possible or remote. If a gain contingency with a probable likelihood is disclosed, the notes should include: Nature of the contingency and An estimate of the amount or stating an estimate cannot be made. Asset Retirement Obligations When an entity has a legal obligation to cover the costs needed to retire a long-life asset, such obligation should be accrued as a liability on the statement of financial position. The liability should be recognized when a reasonable estimate of the amount can be made. OBSERVATION It should be noted that like GAAP, only a legal obligation associated with the requirement of a tangible long-lived asset, including an obligation created by promissory estoppel, establishes a clear duty or responsibility to another party that justifies recognition of the liability. When an asset retirement obligation is initially recognized, the carrying amount of the related asset should be increased by the amount of the liability. That increasing cost should be allocated to expense over the useful life on a systematic and rational basis. Measurement of the liability should be based on the best estimate of the cost to settle the obligation at the date of the statement of financial position. In many cases it is impossible or prohibitively expensive to settle the obligation or transfer the liability to a third-party. In such cases the entity should estimate the amount it would rationally pay to settle or transfer the asset retirement obligation. It is possible the best estimate of the cost to settle the obligation is to determine future cash flows when applying appropriate technology at the end of the asset's life and use present value techniques to discount those future cash flows. Changes to the asset retirement obligation can occur because of the passage of time, revisions to 72

74 the timing or amount of future cash flows, and revisions of discount rate. When revising the estimate of the liability at each financial statement date, the impact of passage of time is considered first. With a shorter period of time to discount, the liability will increase. This incremental cost could be considered something comparable to interest expense, which is the approach used for pension liabilities in GAAP. However, the framework specifies this increase in cost due to passage of time should be reflected as an operating item in the statement of operations. It should not be presented as interest expense. Changes in the obligation due to revision of the projected amount of future cash flows and any revisions to discount rate would then be determined. Those changes would increase the obligation and would be added to the carrying amount of the related asset. This increase in the long-life asset should be allocated to expense over the useful life. Disclosures for asset retirement obligations should include: Description of the obligation and the related long-lived assets, Amount of the obligation as of the financial statement date, Amount paid during the year to resolve the obligation, and Amount of any assets legally restricted for settling the obligation. Additionally, when a reasonable estimate of the amount of an asset retirement obligation cannot be made, this fact along with the substantive reasons should be disclosed. Guarantees Any guarantees by an entity are recognized and measured in accordance with the provisions described above for a contingent loss. OBSERVATION This is a subtle departure from GAAP. There is no mention of the fair value of a guarantee, only an assessment of likelihood and estimated loss, as with contingent losses. Even if the likelihood of a guarantor having to make any payment is remote, the guarantor should disclose the following: Nature of the guarantee, terms of the guarantee, how the guarantee arose, and conditions which would require the guarantor to perform. Maximum potential amount of future payments. The amount should not be discounted to present value. If there is no upper limit, that should be disclosed. If the entity is unable to estimate the possible amount of future payments, that fact should be disclosed. Carrying amount of the guarantor's liability reflected in the statement of financial position. Nature of any recourse the guarantor may have against third parties for any amounts paid under guarantee. Nature of any assets held by the guarantor which could be obtained and liquidated to recover amounts paid. STUDY QUESTION 2. Which of the following statements with respect to contingencies is correct? a. Guarantees by an entity are measured using the fair value of the guarantee, which is approximated by the expenditure that would be necessary to transfer the guarantee to another party. 73

75 b. The increase in the amount of an asset retirement obligation caused by the passage of time is classified as an operating expense on a statement of operations. c. Gain contingencies are recognized in a statement of financial position if the likelihood of realization is probable and the amount can be reasonably estimated. d. If the amount of a loss contingency an entity is exposed to is greater than the amount accrued, it is not necessary to disclose the larger exposure amount because an amount is already accrued. 510 RELATED PARTY TRANSACTIONS Related parties are defined in the framework's glossary as a party that has a direct or indirect ability to exercise control, joint control, or significant influence over another party. If entities are subject to common control, joint control, or, significant influence then those entities would be related. Management and their immediate family members are also related parties. Immediate family members would include a person's spouse and those individuals dependent upon either the individual or the individual's spouse. The expansion to include immediate family members as related party includes individuals who control the reporting entity or who have an ownership interest large enough to provide significant influence. It is management's responsibility to make reasonable efforts to identify all related parties. If management obtains information suggesting another party might be related, management has a responsibility to determine whether the party is actually related. Measurement Transactions occurring with a related party in the ordinary course of business should be measured as if the transaction took place with an unrelated party. A transaction with related party not in the ordinary course of business is measured at market value if there is any objective third-party evidence supporting that valuation. If not, the transaction would be valued at the carrying amount. Disclosure For related party transactions, an entity should disclose the following: Description of the relationship. Description of the transaction, to include transactions for which no amount is recognized. Recognized amount of the transaction including the category in the financial statements where the transactions are classified. Measurement basis used. Amounts due to or due from related parties and the terms of those balances. Commitments with related parties separate from other commitments. Contingencies with related parties separate from other contingencies. OBSERVATION As an indicator of the significance of this disclosure information, the framework points out that users of the financial statements may find information about related party transactions to be more significant than unrelated transactions, no matter the size of those related party transactions. The description of relationships should be sufficient so a user the financial statements will understand the nature of the relationship. Terms such as affiliate or related company are insufficient. More helpful would be terms such 74

76 as controlled investee, common control entity, or member of the immediate family of the shareholder. The framework specifically says quantifying the aggregate amount of related party transactions by category in the financial statement is useful information. 511 SUBSEQUENT EVENTS In general there are two types of subsequent events, including those that: Provide evidence of conditions that existed as of the date of the financial statements. Indicate conditions that arose after the financial statement date. A subsequent event may have effects that are so significant that the viability of the entity may be brought into question. If the impact is severe enough, it could become necessary to assess whether the going concern assumption is still valid. As mentioned earlier in this module, if the going concern assumption is not valid then the FRF for SMEs framework is not appropriate. OBSERVATION The framework does not use a label for the two different types of subsequent events, which accountants are accustomed to seeing in GAAP. There are no comments about type 1 or type 2, recognized or nonrecognized subsequent events. When subsequent events provide evidence regarding conditions that existed on the financial statement date, then the financial statements should be adjusted based on that information. All information available through the date the financial statements are available to be issued should be reflected in the financial statements. Subsequent events that indicate development of conditions arising after the financial statement date should not be used to adjust the financial statements. Those events may be significant enough that disclosure is necessary so the financial statements are not misleading. At minimum, a description of the nature of the event and an estimate of the financial effect (or statement that it cannot be estimated) should be disclosed STUDY QUESTION 3. All of the following accounting treatments under FRF for SMEs are different from GAAP except: a. It is not necessary to assess long-lived assets for impairment. b. Stock-based compensation option grants are not recognized in the statement of financial position. c. The concept of other comprehensive income and presentation thereof in the statement of operations does not exist in the FRF for SMEs framework d. Presentation of discontinued operations as a separate caption on the statement of operations is an accounting choice by management depending on which approach is considered to be more informative for users. 75

77 CHAPTER 6: FRF for SMEs An Alternative to GAAP Investments and Consolidation 601 WELCOME The Financial Reporting Framework for Small- and Medium-Sized Entities (FRF for SMEs) is an alternative to GAAP for small entities who desire a simpler financial reporting framework to present their financial statements. This chapter describes the accounting for investments, with a focus on the simplicity in the FRF for SMEs framework. Consolidation and acquisition of another entity through business combination is explained. 602 LEARNING OBJECTIVES Upon completion of this chapter, you will be able to: Describe the accounting policy choice an entity may make for accounting for subsidiaries Describe the equity method and cost method of accounting for investments Describe the process for consolidating subsidiaries Describe the acquisition method of recording business combinations Described the general measurement principle for recognizing assets and liabilities at market value in a business combination Describe the accounting policy choice an entity may make for recognizing an intangible asset in a business combination Describe the method used to recognize and measure goodwill or gain from bargain purchase on a business combination Describe new basis (push-down) accounting 603 INTRODUCTION CPAs trying to help their clients find simpler and easier ways to present financial information have long suggested one of the other comprehensive basis of accounting (known as OCBOA), such as modified cash basis or income tax basis. A new alternative is available. In June 2013 the AICPA published the Financial Reporting Framework for Small- and Medium-Sized Entities. Known as FRF for SMEs, this framework is categorized as one of the OCBOAs. This chapter is one in a series describing FRF for SMEs. The first chapter is FRF for SMEs An Alternative to GAAP Introduction. It describes how FRF for SMEs fits into the various options for financial reporting, and describes the basic financial concepts in the framework. This chapter will summarize the accounting for investments. It will describe the option to either consolidate subsidiaries or account for them on the equity method. It will then explain the accounting for business combinations. A key point needs to be repeated FRF for SMEs is not generally accepted accounting principles. It is neither "small GAAP" nor GAAP light nor GAAP without some of the detailed rules. In one sentence, FRF for SMEs is another in the group of OCBOA frameworks that might be an acceptable alternative to GAAP for some companies in some circumstances. Just as modified cash basis or tax basis might 76

78 be appropriate for some entities, FRF for SMEs might be an appropriate alternative. 604 EQUITY, DEBT, AND OTHER INVESTMENTS Accounting Policy Choice for Subsidiary Accounting The framework allows entities to make an accounting policy choice between two options for handling subsidiaries. Entities may either: Consolidate subsidiaries, or Use the equity method to account for subsidiaries. All subsidiaries need to be accounted for with the same method, with that method properly disclosed. Subsidiaries are defined as an entity that is controlled by another. Control is defined as owning more than 50 percent of the outstanding equity interests, usually based on voting rights. If there is a material difference in the basis of accounting between a parent and its subsidiary, use of both consolidation and the equity method is precluded. OBSERVATION This option to choose between two approaches for subsidiaries is another significant difference from GAAP. Investors with significant influence over another entity that is not a subsidiary should account for the investment using the equity method. Significant influence can occur in two ways. First there's a rebuttable presumption that if an investor owns 20 percent or more of the voting interest, then the investor has significant influence. Second, an investor may have the ability to influence strategic direction or financing through other means, such as representation on the Board of Directors, material intercompany transactions, technological dependency, or sharing managerial personnel. In such cases, there would be significant influence. An investor that cannot exercise significant influence would account for an investment using the cost method. Investments in debt or equity securities held for sale are accounted for at market value. Changes in market value of those investments would be recognized in net income as they occur. Investments held for sale are those which management is currently attempting to sell. Market value is defined in the framework as the amount that would be agreed upon in an arm's length transaction between knowledgeable, willing parties. Neither party would be under compulsion to act. OBSERVATION That is the extent of the definition of market value. None of the additional comments encountered in GAAP are present. There is no concept of principal market, highest and best use, or other expansive explanations of what constitutes market value. There are two long paragraphs that discuss market value in the context of leases, but other than for leases, the definition of market value is covered in only 26 words. The phrase fair value is not used in the framework. To summarize, the framework provides the following approaches for investment accounting: Subsidiaries may be all consolidated or all accounted for on the equity method. Non-subsidiary investments for which the owner has significant influence are accounted for using the equity method. Investee's for which the owner does not have significant influence should be accounted for on the cost method. 77

79 Debt and equity securities which the owner is attempting to sell are accounted for on the basis of market value. Equity method. Investment income is the investor's proportionate share of the income or losses as recorded by the investee. The investor's proportionate share of discontinued operations, changes in accounting policy, correction of errors relating to prior period financial statements, and capital transactions should be presented in the investor's financial statements based on the nature of the underlying item. Investees accounted for under the equity method should apply the same accounting framework (specifically FRF for SMEs) as the investor. If the underlying accounting for the investee is a different framework, then the results of operations should be adjusted to conform to the framework. If that is impracticable to do and there is a material difference between accounting at the parent and investee level, then the equity method would be precluded. The investor would need to determine and monitor the difference between its cost and its proportionate share of the underlying equity in the investee. This difference is similar to goodwill and is amortized. If the investor loses the ability to exercise significant influence, then equity method accounting should cease. The carrying value at the time significant influence was lost becomes the new cost amount for the cost method. If the amount of the investor's recorded investment drops below zero, the investor should generally discontinue the equity method. Exceptions would be if the investor: Has guaranteed debts of the investee, Is committed to provide additional financial support, or Is assured investee will return to profitability imminently. Cost method. This method would be used for debt and equity investments when an investor does not exercise significant influence. This would also be the accounting used for other investments such as works of art or other tangible items held as investments OBSERVATION The inference of the rules addressing whether to use cost or equity method seems to be designed for the context of the typical small business situation where one person or a group of individuals own several related or closely controlled businesses. The framework does not explicitly address how to categorize investments in marketable debt or equity securities listed on an exchange where the owner of a share has no say other than at the annual election of directors, but the investor isn't attempting to sell the shares. The concepts of trading securities, available for sale, and held to maturity do not exist in the FRF for SMEs framework. What would be the appropriate accounting if a small business has some investable funds that are moved into the stock market or corporate bonds? The framework specifically says investments held for sale are valued at fair value. If the entity's plans were such that the intent were comparable to what would be a trading security or available for sale, then the investment would be accounted for at market value. How then to account for a security which would otherwise fall into the held to maturity category if GAAP were being applied? That would be accounted for under the cost method because the investor would not have significant influence. Presentation. The statement of financial position and statement of operations should present assets and investment income in the following categories: Investments accounted for under the equity method, which would be those investments where the investor has significant influence. Investments accounted for at cost. 78

80 Debt and equity investments held for sale. Those assets and income amounts can be presented either on the face of the pertinent financial statement or in the notes. The reason for the separate presentation is to allow readers of the financial statements to compare the relationship between income earned and the investments generating that income. Thus, investment should be aggregated the same way on a statement of financial position and statement of operations. STUDY QUESTION 1. All of the following statements about accounting for investments are correct except: a. Investments are presented using three categories in the financial statements and the same three corresponding categories are used for investment income so that the returns on investments under different accounting methods can be seen. b. Entities have the option of accounting for subsidiaries either using consolidation or using the equity method. c. If subsidiaries are being considered for consolidation, the level of control at which consolidation would be recorded is 50 percent of equity interests. d. Investments in debt or equity securities that are held for sale are accounted for at fair value. 605 SUBSIDIARIES Accounting Policy Choice As previously mentioned, an entity has a choice to consolidate or not consolidate its subsidiaries. An entity can choose between these two accounting policies: Consolidated subsidiaries, or Account for subsidiaries using the equity method. The choice of accounting policies must be applied to all subsidiaries. If an entity chooses the equity method, the accounting and disclosures are described in the preceding section titled Equity, debt, and other investments. If material differences in the basis of accounting exist between a parent and subsidiary, preparation of consolidated financial statements is precluded and the equity method would be used. Consolidated Financial Statements Financial statements should be described as being prepared on a consolidated basis when an entity chooses the consolidation accounting policy. Each of the basic financial statements should be labeled accordingly. The lender to a parent company may be more interested in the cash flows results of operations of the parent than the consolidated results. If a lender looks to the parent for repayment of the loan, unconsolidated financial statements may be more useful. Consolidation begins at the date the parent gains control and continues while the parent holds control. This means the parent does not retroactively consolidate for the period of time before gaining control. At the point that a parent ceases to have control of a subsidiary, consolidation ceases. Financial statements prior to cessation of consolidation are not restated retroactively on a nonconsolidated basis. 79

81 Nonconsolidated Financial Statements When an entity chooses the accounting policy of not consolidating its subsidiaries, the financial statements should be described as being prepared on a nonconsolidated basis. Each of the statements should be labeled accordingly. Disclosures For consolidated financial statements, management should disclose the following: A list and description of subsidiaries Names and income of each subsidiary Percentage ownership interest For nonconsolidated financial statements, management should provide the same information: list and description of each subsidiary, name, income from each, and percentage ownership interest. In addition management should disclose the carrying amount of each subsidiary. 606 CONSOLIDATED FINANCIAL STATEMENTS AND NONCONTROLLING INTERESTS The consolidation process specified in the framework will be familiar to those with a working knowledge of GAAP. A few items are worth noting however. Combined Financial Statements It may be useful to prepare combined financial statements when an individual or group of individuals owns a controlling interest in several different entities. Combined financial statements could also be prepared for a select group of subsidiaries. When combined financial statements are prepared, similar principles to those used when preparing consolidated financial statements apply. It should be noted that combined financial statements are not a substitute for consolidated financial statements though. Preparation of Consolidated Financial Statements Gains or losses on transactions that took place between a parent and newly-acquired subsidiary prior to acquisition do not need to be eliminated upon consolidation. Elimination of those transactions would only be needed if they were made in contemplation of the acquisition. Gains and losses between related parties would be eliminated upon consolidation. Consolidation is precluded if there is a material difference in the basis of accounting between a parent and subsidiary. If a foreign operation is consolidated, the financial statements would need to be adjusted to the FRF for SMEs framework during consolidation. It should also be noted that a difference in fiscal periods of a parent and subsidiary does not, of itself, justify the exclusion of the subsidiary from consolidation. Noncontrolling Interests An entity needs to identify the noncontrolling interests' share of net income and net assets of the subsidiaries. Such determinations are based on the ownership interest based on current voting rights and do not take into consideration the possible exercise or conversion of potential voting rights. A parent can increase or decrease its ownership interest in a consolidated subsidiary. Presuming any changes did not result in a loss of control (in which event consolidation would be terminated) such transactions would be treated as equity transactions. The carrying amount of the noncontrolling interest would be adjusted to reflect the change in relative interests. The difference between the change in noncontrolling interest and the market value of consideration received or paid would be determined. Any such difference is recognized in equity directly and would be attributed to the 80

82 parent. Loss of Control of a Consolidated Subsidiary A parent could lose control of a consolidated subsidiary through several transactions. If those arrangements are essentially a single transaction, the parent should take the terms and conditions of all transactions into consideration when accounting for the loss of control. A transfer of interest could be executed in several transactions in order to achieve an overall commercial effect. If a parent loses control of a consolidated subsidiary, the parent should: Derecognize the carrying amount of assets and liabilities of the subsidiary as of the date control is lost. This would include goodwill. Derecognize the carrying amount of the subsidiary's noncontrolling interests. Recognize the market value of consideration received, if any. Recognize distribution of shares from the subsidiary to the owners of the parent, if any. Recognize the carrying value of any retained investment in the former subsidiary. This would be the proportionate share of the carrying value of the subsidiary on the nonconsolidated financial statements of the parent. This becomes the new cost of the investment. Recognize any differences in the sum of above items as a gain or loss in net income attributed to the parent. Presentation of Consolidated Financial Statements and Noncontrolling Interests The only income from a subsidiary that is included in consolidated net income is that which occurs post acquisition and predisposal. If subsidiaries are consolidated (remember this is an accounting policy election), noncontrolling interests are presented within the equity section of the consolidated statement of financial position, separate from equity of the owners of the parent. Proportionate interest in income is attributed to the noncontrolling interests even if doing so brings the noncontrolling interests to a deficit balance. Disclosures The consolidation policy should be disclosed. When it is necessary to use different fiscal periods for a parent and subsidiary, the fact of doing so should be disclosed along with the period used. In such case, any events or transactions of the subsidiary that took place during the intervening period which have a significant impact on the financial position or result of operations should be considered. The events or transactions should be either recorded or disclosed as appropriate, based on the nature of the items. 607 BUSINESS COMBINATIONS Identify a Business Combination The first step in acquiring a business is to identify whether there is a business combination, which is the acquisition of assets and assumption of liabilities that constitute a business. If that definition is not met, then the entity has purchased assets, which should be recognized as a regular asset acquisition. Acquisition Method A business combination should be accounted for using the acquisition method, which requires the entity to: Identify the acquirer Determine the acquisition date 81

83 Recognize major identifiable assets acquired, including intangible assets, the liabilities assumed, and any noncontrolling interest Recognize and measure any resulting goodwill or gain from bargain purchase Usually an acquirer obtains control of the investee on the closing date. That would be when the entity legally transfers consideration and acquires the assets and assumes liabilities. Control could be obtained at a date earlier or later than closing, depending on the contract terms. Recognizing and Measuring Assets, Liabilities, and Noncontrolling Interest On the acquisition date, the acquirer should recognize the identifiable assets that were acquired, any liabilities assumed, and the noncontrolling interest, if any. Goodwill is recognized separately. Measurement principle. The assets acquired and liabilities assumed should be measured at their market values as of the acquisition date. Any noncontrolling interests should be measured at the proportionate share of the identifiable net assets held by those noncontrolling interests. There are several specific exceptions to those measurement principles. Intangible assets. An entity is allowed to make an accounting policy election on how to handle intangible assets. It may: Recognize identifiable intangible assets separately, or Not recognize intangible assets separately which would have the effect of rolling the value of those intangible assets into the goodwill amount. The framework allows the accounting policy choice to recognize intangible assets to be made on an asset by asset basis. The accounting policy election cannot be reversed once the decision has been made. Income taxes. If the acquirer uses the deferred income tax method for income tax accounting, it should recognize a deferred income tax asset or liability resulting from the assets acquired and liabilities assumed. This would be the approach outlined in the separate chapter in the framework that addresses income taxes, which is addressed in a later chapter of this module. Retirement and other postemployment benefits. Plan assets are valued at market value. The accrued benefit obligation is calculated using the best estimates for the assumptions involved in calculating such liability. All previous unamortized actuarial gain/loss, unamortized prior service cost, and unamortized transition obligation/asset are all removed from the calculation of accrued benefit obligation. This means the accrued benefit asset or accrued benefit liability will simply be the difference between the market value of plan assets and the accrued benefit obligation. As explained in a later chapter in the module, an accrued benefit asset exists when plan assets exceed the accrued benefit liability. The accrued benefit asset is limited to the amount that can be recovered either through reducing future contributions or accessing the plan assets. Regulatory limits may limit the amount of future contribution reduction or the acquirer's ability to access plan assets which in turn could possibly create an upper limit on the amount of accrued benefit asset that may be recorded. Recognizing and Measuring Goodwill or Gain from Bargain Purchase Goodwill is measured as of the acquisition date by comparing the following two amounts: The sum of: - Consideration transferred. Any consideration that is not cash is remeasured at market value as of the acquisition date. Any difference between market value and carrying value would result in a gain or loss recognized in net income. - Amount the noncontrolling interest has in the acquiree. - If a business combination is achieved in stages, the value of the previously held equity 82

84 interest in the acquiree measured at market value as of the acquisition date. This would require adjusting the valuation of previously held equity interest from the carrying value to the market value determined on the acquisition date. Any adjustment from revaluation would be recognized in income. The amount of identifiable assets acquired less the amount of liabilities assumed, both measured at market value as of the acquisition date. Occasionally an acquiree may get a bargain purchase. This could happen when the consideration paid plus noncontrolling interest plus previous equity position (after adjusted to market value) is less than the net amount of identifiable assets acquired less liabilities assumed. An example of how this could occur is if the seller is in the situation of a forced sale. If there is a bargain purchase, the acquirer should recognize the gain in net income as of the acquisition date. The framework indicates that if a bargain purchase is recognized, the acquirer should reassess all the components of the calculation leading to determining there was a bargain purchase. The entity should reassess that it has correctly identified all the assets acquired and all the liabilities assumed. The acquirer should also review the methodology used to measure the assets acquired, the liabilities assumed, the noncontrolling interest, the previously held equity interest, and consideration transferred. OBSERVATION The explicit comment requiring the acquirer to revisit the methodology to make sure all assets and liabilities were picked up and all calculations are correct seems peculiar. It is as if the framework is dropping a hint if there appears to be a bargain purchase, it is a good chance there could be an error in the calculation. As a part of revisiting all the methodology that goes into calculating the gain from a bargain purchase, it might be wise to document an explanation of how it is that the acquirer was able to achieve a bargain purchase. STUDY QUESTION 2. All of the following statements about accounting for business combinations are correct except: a. The general concept is that all assets acquired and liabilities assumed should be measured at their market value as of the date of acquisition. b. An entity can make an accounting policy choice to either recognize identifiable intangible assets or not recognize them. c. Retirement and other postemployment benefits are recognized using only the plan assets and accrued benefit obligation; previously deferred items such as unamortized actuarial gain or loss and unamortized prior service cost are not recognized. d. After recognizing acquired assets and assumed liabilities it is possible an entity may have a bargain purchase from a business combination. In such a case the amount of bargain purchase is used to reduce intangible assets to zero with any remaining amount of bargain purchase deferred and amortized. Measurement Period It may sometimes take longer than the end of the reporting period to accumulate all of the information to prepare all the necessary calculations for a business combination. While the entity gathers all needed information, the entity should report provisional amounts in the financial statements. During a measurement period, the acquirer should retrospectively adjust any of those provisional amounts for which new information is obtained regarding 83

85 the facts and circumstances that existed as of the acquisition date. The measurement period ends when the acquirer gathers the information that was needed about the facts and circumstances needed to correctly record the combination. The measurement period may not last longer than one year from the acquisition date. The measurement period allows a reasonable time to obtain all the information necessary to identify and measure all of the following as of the acquisition date: Identifiable assets acquired, liabilities assumed, and noncontrolling interests Consideration transferred Fair value as of the acquisition date for equity interest held prior to acquisition date Goodwill or gain on a bargain purchase The acquirer will need to distinguish whether information obtained during the measurement period reflects facts and circumstances that existed as of the acquisition date or it reflects events that occurred after the acquisition date. Any changes to provisional amounts during the measurement period will result in an offsetting revision in the amount of goodwill or gain on bargain purchase. Because any changes during the measurement period are made on a retrospective basis, it would be necessary to adjust comparative information from prior years. In addition, adjustments to prospective amounts could in turn have an impact on depreciation, amortization, or other components of income. Any such ripple effects should also be adjusted on a retrospective basis. Acquisition-Related Costs Costs incurred to effect a business combination, such as finder's fees, advisory, legal, accounting, valuation, or similar costs are called acquisition-related costs. Any acquisition-related costs should be expensed as incurred. Disclosures Users of the financial statements need to understand the nature and financial effect of business combinations that take place: During the reporting period, or After the date of the financial statements but before those statements are available to be issued. To provide this information to users, the financial statements should show the following for each material business combination: Name and description of the acquiree Acquisition date Percent of voting interest acquired Market value of the total consideration transferred as of the acquisition date Market value of each major class of consideration as of the acquisition date in categories such as: - Cash - Liabilities incurred, and - Equity interests of the acquirer issued Condensed statement of financial position which describes the amount recognized for each major class of acquired assets and assumed liabilities Amount of any gain from a bargain purchase and description of the line item in the statement of operations where the gain is recognized 84

86 Amount of noncontrolling interest in acquiree recognized as of the acquisition date Accounting policy regarding intangible assets acquired. Amount and useful life of any intangible assets recognized For a business combination that was achieved in stages: - For the equity interest in the acquiree held immediately before the acquisition date, the market value of that equity interest as of the acquisition date, and, - Amount of any gain or loss recognized due to remeasuring the carrying value of the previously held position to market value on the date of acquisition along with the line item in a statement of operations where the gain or loss is recognized. For business combinations that are individually immaterial but for which the collective amount is material, the acquirer should disclose: Number of entities acquired. Brief description of entities acquired. Market value the total consideration transferred as of the acquisition dates. Number of equity instruments or interests issued. If a business combination has an acquisition date after the financial statement date but before the financial statements are available to be issued, the information described above should be disclosed. If the initial accounting for those business combinations is incomplete when the financial statements are available to be issued, the acquirer should describe which disclosures could not be made and the reasons why. STUDY QUESTION 3. All of the following statements about accounting for a business combination are correct except: a. Any changes made to provisional amounts during the measurement period are recognized as a gain or loss in the statement of operations at the close of the measurement period. b. During the measurement period after a combination, the acquirer should retrospectively adjust any amounts recorded on a provisional basis. c. The measurement period after a business combination ends at the earlier of one year after the acquisition date or when the acquirer gathers all information that was needed to correctly record the combination. d. Acquisition-related costs for a business combination are expensed as incurred. 608 NEW BASIS (PUSH-DOWN) ACCOUNTING There may be circumstances in which an acquirer or acquiree in a business combination might find it convenient to adjust the accounting records of the acquiree to reflect the revised valuations to market value. In essence, this would push-down the recognition of intangible assets and adjustment of assets and liabilities to market value from the acquirer into the financial statements of the acquiree on a standalone basis. This could be helpful if it improved the ability to monitor the results of operations and investment performance of the acquiree. Push-down accounting is an option; it is not required. Push-down accounting becomes an available option when the acquirer gains control, that is, it obtains more than 50 percent of the outstanding residual equity interests. The amount of adjustments applied to the acquiree are the same amounts used to recognize assets and 85

87 liabilities in the consolidated financial statements. This would provide symmetry between the carrying amounts on the acquiree's financial statements and the carrying amounts on the acquirer's financial statements. The adjustments to apply push-down accounting apply to the proportionate increase in ownership that took place as a result of the transaction that created control. For example, if an entity owned 20 percent of an acquiree before the acquisition date purchased the remaining 80 percent ownership from another owner, the revaluation from push-down accounting would only apply to the 80 percent increase in ownership. The reason for this is push-down accounting applies to transactions with unrelated parties. In the example of the purchase of 80 percent, the previously owned 20 percent is a related party and should not be revalued. The revaluations of assets and liabilities should be recognized as a capital transaction. It would be the option of the acquiree whether to record that as in addition to capital stock, additional paid-in-capital, or a separate account within shareholders' equity. Obviously if there is a noncontrolling interest that amount would be adjusted as well. Income Tax Benefit If the deferred income tax method is applied, deferred income tax assets would be recognized as a part of a push-down revaluation, but only to the extent they are more likely than not to be realized. Disclosure In the year push-down accounting is first applied, the following items should be disclosed: Date that push-down accounting was applied Date of the transaction that led to application of push-down accounting Explanation of the circumstances resulting in application of push-down accounting, and Change in each major class of assets, liabilities and shareholders' equity resulting from applying pushdown accounting The following items should be disclosed in the fiscal year that push-down accounting is applied and in the following fiscal year: Date that push-down accounting was applied Amount of revaluation adjustment and account within the shareholders equity section where the revaluation adjustment was recorded 86

88 CHAPTER 7: FRF for SMEs An alternative to GAAP Revenue, Intangibles, Leases 701 WELCOME The Financial Reporting Framework for Small- and Medium-Sized Entities (FRF for SMEs) is an alternative to GAAP for small entities who desire a simpler financial reporting framework to present their financial statements. This chapter describes the general principles used to guide revenue recognition. It also describes the accounting for intangible assets and leases. 702 LEARNING OBJECTIVES Upon completion of this chapter, the reader should be able to: Describe the criteria for recognizing an intangible asset Define the research phase and development phase of developing and internally-generated intangible asset Describe the recognition and measurement of intangible assets Describe the amortization methodology for goodwill Describe the general principles for revenue recognition List the criteria for capitalizing lease Describe the accounting for operating or capital leases 703 INTRODUCTION CPAs trying to help their clients find simpler and easier ways to present financial information have long suggested one of the other comprehensive basis of accounting (known as OCBOA), such as modified cash basis or income tax basis. A new alternative is available. In June 2013 the AICPA published the Financial Reporting Framework for Small- and Medium-Sized Entities. Known as FRF for SMEs, this framework is categorized as one of the OCBOAs. This chapter is one in a series describing FRF for SMEs. The first chapter is FRF for SMEs An Alternative to GAAP Introduction. It describes how FRF for SMEs fits into the various options for financial reporting, and describes the basic financial concepts in the framework. That chapter also describes the general principle for transitioning financial statements to the first presentation under FRF for SMEs. This chapter will describe the accounting for intangible assets, including goodwill. Revenue recognition is covered by spelling out basic general principals. Finally, accounting for leases and nonmonetary transactions will be described. A key point needs to be repeated often FRF for SMEs is not generally accepted accounting principles. It is neither "small GAAP" nor GAAP light nor GAAP without some of the detailed rules. In one sentence, FRF for SMEs is another in the group of OCBOA frameworks that might be an acceptable alternative to GAAP for some companies in some circumstances. Just as modified cash basis or tax basis might be appropriate for some entities, FRF for SMEs might be an appropriate alternative. 87

89 704 INTANGIBLE ASSETS This chapter of the framework applies to goodwill after initial recognition. It also applies to a wide variety of other intangible assets, which are identifiable, under control by the entity, and have future economic benefits. These include licensing rights such as films, video recordings, manuscripts, patents, copyrights, and also advertising, startup, and research and development. This would also include computer software, patents, trademarks, mortgage servicing rights, franchises, customer lists, and other intellectual property. The three criteria for recognizing an intangible asset, specifically identifiable, control, and future economic benefits, get further discussion in the framework. Identifiable. Unlike goodwill, which represents future economic benefits which can't be related to specific assets, an intangible asset needs to be specifically identifiable. This requirement can be met in one of two ways: It is separable, which means it could be removed from the entity and sold, licensed, or exchanged It arises from legal rights or by contract Control. If an entity has the ability to obtain the future economic benefits from an item and can restrict others from accessing those benefits, an entity has control. Usually this would be demonstrated by enforceable legal rights, but enforceability is not required in all circumstances as an entity may be able to control the future economic benefits in some other way. Although there would be no legal enforceability for such an intangible asset, it is possible that an entity could have a portfolio of customers or a market share that meets the criteria for recognition as an intangible asset. Future Economic Benefits. These could be revenues from the sale of goods or services. The benefits could also be cost savings in future production or the intellectual property to facilitate a production process. Recognition and Measurement Typically when an intangible asset is in place it would be difficult to identify any expenditures that specifically increase its future economic benefits. Costs incurred later would typically be indistinguishable from the cost to maintain the intangible item or merely to operate the entity. As a result it would be rare that any subsequent expenditures would increase the carrying amount of an internally-generated intangible asset. The framework specifically mentions subsequent costs on brands, publishing titles, customer lists, or similar items are always recognized as an expense as incurred. An intangible asset should be recognized if all of the following criteria are met: Is probable that a future economic benefits would flow to the entity Cost can be measured reliably Useful life can be estimated Separate Acquisition An asset acquired in a specific transaction illustrates the criteria to recognize an intangible asset. Implicit in the purchase price is a likelihood of probable that there will be future economic benefits. The cost is readily measured. Useful life on a specific purchase could be estimated. Cost would include the purchase price, taxes, and costs directly attributable to getting the asset prepared. Attributable costs could include salaries, wages, and benefits along with professional fees to get the asset into working condition. Internally-Generated Goodwill Internally-generated goodwill is not recognized as an asset because such expenditures would not be an identifiable resource. Internally-Generated Intangible Assets 88

90 Additional guidance applies for internally-generated intangible assets since it is difficult to ascertain what expenditures qualify for recognition. To evaluate an internally-generated intangible, the entity needs to distinguish between the research phase and the development phase. Research phase. This is the original or planned investigation that has the goal of gaining new scientific or technical knowledge. Expenditures during the research phase should be recognized as an expense when incurred. In this phase, an entity cannot demonstrate probable future economic benefits and as such, an intangible asset should not be recorded Efforts during the research phase could include gaining new knowledge, searching for application of research, searching for alternatives, or developing possible alternatives for materials, products, or services. Development phase. This is the application of research or knowledge to develop new or substantially improved materials, processes, products, systems, or services before commercial production or use begins. Management can choose between two accounting policies: Expense development expenditures, or Capitalize those expenditures as an intangible asset The choice of accounting policy should be applied to all internal projects with expenditures incurred during the development phase. Expenditures incurred during the development phase can be capitalized only if management can show all of the following: Technical feasibility of completing the intangible asset so it can be sold or used The entity has the intention to complete the intangible asset Entity is able to use or sell the intangible asset There are adequate technical, financial, and other resources available to complete the project The entity can reliably measure the expenditures attributed to the intangible asset during the development phase How the intangible asset will be generating probable future economic benefits Some of the activities that can take place during the development phase could be: Design or construction of preproduction prototypes and models Design of tools, jigs, or dies using the new technology, or Design, construction, and testing of new or improved materials, products, systems, or services Costs of an internally-generated intangible asset. Total cost would include only expenditures incurred after an intangible asset first met recognition criteria. This could include items such as: Cost of materials and services used to generate the intangible asset Employee salaries, wages and benefits Fees to register the intangible asset if such items are legally registered Expenditures that should not be included in the capitalized cost are: Selling, general, and general overhead expenditures Inefficiencies and initial losses before the asset achieves its planned performance levels Training staff on using the new asset 89

91 Start-up costs Management can make an accounting policy choice for start-up costs. The options are: Expense start-up costs as incurred Capitalize start-up costs with amortization of the amount over 15 years OBSERVATION Here again the significant flexibility of the FRF for SMEs framework is quite visible. Management has a choice to expense or capitalize start-up costs. Management can choose whether to expense or capitalize the development phase expenditures of internallygenerated intangible asset. Subsequent Measurement Intangible assets should be amortized over the useful life. The framework indicates all intangible assets should have a finite useful life. If the entity does not know the precise length of an intangible assets useful life, management should make its best estimate. The entity should regularly review the amortization method and estimated useful life of intangible assets. OBSERVATION One concept from GAAP that is quite noticeably missing from the FRF for SMEs framework is any indication that an entity should assess intangible assets for impairment. Keep an eye on the following discussion to see the similar lack of any such comment for goodwill. STUDY QUESTIONS 1. All of the following are criteria to recognize intangible assets except: a. Identifiable b. Indefinite life c. Control d. Future economic benefits 2. For an internally-generated intangible asset that is being capitalized, all of the following costs are eligible for capitalization except: a. Training staff on using the new asset b. Employee salaries, wages, and benefits to develop the item c. Cost of materials and services to generate the item d. Fees to register intangible asset if the item needs to be registered Goodwill Goodwill is recognized in a statement of financial position at the initial amount less accumulated amortization. Amortization term for goodwill is the same period as used for federal income tax purposes. If the goodwill is not amortized for federal income tax, then the amortization term is 15 years. 90

92 Equity method investments may have a difference between the entity's cost and the amount of underlying equity in the investee. This is analogous to goodwill and is also amortized. OBSERVATION That is the extent of the discussion in the FRF for SMEs framework on subsequent measurement for goodwill three sentences taking up nine lines of text. The rather dramatic component of the discussion is the complete lack of any comment to assess goodwill for impairment. This is a significant difference from the GAAP framework. Presentation The aggregate amount of goodwill and intangible assets should be presented on separate lines in the statement of financial position. Disclosures The following items should be disclosed in the financial statements: Carrying amount in total for intangible assets Carrying amount of major intangible asset classes, which are groups of intangible assets that are similar, based on their nature or how they are used in operations For major intangible asset classes, the amortization method used and amortization period or rate For internally-generated intangible assets, the accounting policy used, including whether development costs are expensed or capitalized Accounting policy for startup costs, if such expenditures have been incurred 705 REVENUE The brief guidance in the framework covers revenue from: Sales of goods Services Interest, dividends, and royalties Revenue from leasing arrangements will be covered later in this chapter. Revenue from investments handled under the equity and cost methods are covered in the previous chapter in this module. Recognition For sales of goods, revenue is recognized upon performance, which requires fulfilling two conditions: The seller has transferred significant risks and rewards of ownership to the buyer, all significant acts are completed, and the seller does not have continuing involvement or control over the goods that are usually associated with ownership. Consideration to be received can be measured with reasonable assurance. This would include the ability to determine extent for which goods may be returned. This assumes that the collection is reasonably assured. For service transactions and long-term contracts, revenue is also recognized upon performance which could be determined under either the percentage of completion method or completed contract method. Performance would be achieved when consideration can be measured with reasonable assurance. For both sales of goods and services, performance has been achieved when three criteria have all been met: Persuasive evidence of the arrangement is in existence 91

93 Goods have been delivered or services have been rendered Price of the transaction is fixed or determinable These three criteria are explained more detail. Management should consider the characteristics of a transaction in assessing whether persuasive evidence exists. A few items to consider would be: Customary business practices Consignment understandings Rights of return Delivery is generally considered to have occurred when the product has been delivered to the customer. Some factors for management's consideration when determining whether delivery has occurred or services have been rendered would be: Bill and hold arrangements Layaway arrangements Nonrefundable fees Licensing and similar fee arrangements Whether risk of loss has transferred to buyer When significant risks of ownership are retained, it would usually be inappropriate to recognize revenue from a sale. Some examples of retaining significant risk of ownership would include when a normal warranty would not cover unsatisfactory performance or when the purchaser is allowed to rescind the transaction. In most cases delivery would take place upon transferring possession and legal title of the goods. This would especially be the case in retail. In other circumstances, legal title may transfer at a different time from taking possession or transferring the risks and rewards of ownership. Management should consider a variety of factors in determining whether the price is fixed or determinable, such as: Cancelable sales Right of return Price protections Refundable service fees Usually recognition criteria discussed here would be applied to each transaction. There may be circumstances in which components of a transaction should be recognized separately or several transactions should be combined and handled as one. For example, if there are multiple deliverables, such as several products, multiple stages of services, or performance over several periods, then it would be necessary to recognize revenue for each identifiable component. On the other hand, if there were an understanding to sell goods with a separate agreement to either allow or require repurchase of the goods, then those two transactions would be addressed together. Revenue from interest, royalties, or dividends should be recognized when the transaction is measurable and collectible with reasonable assurance. Interest would be recognized on a time proportionate basis. Royalties are recognized in accordance with the terms of the agreement. Dividends are recognized when the stockholder has a right to receive payment. Percentage of completion method is appropriate when performance includes more than one act. Revenue would 92

94 then be recognized proportionally based on the performance of each act. Revenue recognized should be determined on a rational and consistent basis, which could include relative sales values, associated costs, or portion of progress. Completed contract method is used when management cannot reasonably estimate progress towards completion. It may be used if two conditions are met: Completed contract is used for purposes of income tax reporting There would not be a material difference in financial position and results of operations for the entity using the completed contract method when compared to using the percentage of completion method Presentation Revenue recognized should be presented separately in a statement of operations. Major categories of revenue should either be presented separately on the face of the statement of operations or in notes to the financial statements. Judgment is necessary to determine what categories are appropriate. Disclosure The entity's revenue recognition policy should be disclosed. If there are different policies for different types of transactions, disclosures include the policy for each major type of transaction. If there are multiple elements, such as products and services, the policy for each should be disclosed. If there are multiple deliverables, the accounting policy for determining and measuring them should be disclosed. If an entity uses the completed contract method instead of percentage of completion method, the reasons for doing so should be disclosed. An entity should disclose separately, either on the face of the financial statement of operations or in the notes to the financial statements, the major categories of revenue recognized during the period. 706 LEASES Accounting for leases under the FRF for SMEs framework will be quite familiar to those who have a working knowledge of the GAAP framework. The basic perspective in FRF for SMEs is that the transfer of substantially all the benefits and risks of ownership is in substance an acquisition of an asset in return for a future stream of payments. For a lessor, the transfer of substantially all the benefits and risks of an asset is a sale. From the perspective of a lessee, a lease would transfer substantially all the benefits and risks of ownership if any of the following conditions are present at the inception of the lease: The lease transfers ownership by the end of the lease term. The lease provides for a bargain purchase option. The length of the lease indicates that the leasee will receive substantially all of the economic benefits from the leased property during the lease term. This would be the case if the lease term is for 75 percent or more of the remaining economic life of the leased property. The lessor will recover the investment in the property. This would be the case if the present value of lease payments, exclusive of executory cost, is equal to 90 percent or more of the market value of the property at the start of the lease. The interest rate used to determine the present value of payments would be the lower of the lessee's incremental borrowing rate or the interest rate implicit in the lease if that is known. Since land has an indefinite useful life, the lease of land would be operating, unless the terms of the lease indicate there is a reasonable assurance that ownership will transfer by the end of the lease. From the perspective of a lessor, a lease transfers substantially all of the benefits and risks of ownership if all of the following conditions are met: 93

95 Any one of the above four conditions from the lessee's perspective are met. Credit risk from the lease is normal in comparison to the collection risk of similar receivables. Remaining nonreimbursable costs that are probable of being incurred can be reasonably estimated. For example, if the lessor is assuring the leasee the property will perform at a certain level or will not become obsolete, the amount of future costs could not be reasonably estimated. Leases that transfer substantially all of the benefits and risks of ownership are treated as a capital lease by the lessee and as a direct financing lease by the lessor. Leases that do not transfer substantially all of the risks and benefits are treated as an operating lease by both the lessee and lessor. Accounting Treatment by a Lessee The accounting treatment for a capital lease under FRF for SMEs will be quite familiar. An asset and liability are recorded equal to the present value of the minimum lease payments, excluding any executory costs. The asset is amortized over the term of the lease unless there is a transfer of ownership by the end of the lease, in which case the amortization term would be the economic life of the asset. The liability is amortized similar to a loan, with allocation of payments between principal and interest. Assets under a capital lease should be presented separately, whether that is on the face of the statement of financial position or in notes. Likewise, obligations for future payments should be presented separately from other long-term obligations, either on the face of the statement of financial position or in the notes. Lease concessions, such as a certain number of months at no rent, are a part of the whole lease agreement and should be reflected as a reduction of lease expense over the full term of the lease. In contrast, scheduled step increases in lease payments, which typically approximate inflationary-type increases, may be accounted for on a straight-line basis or as incurred. OBSERVATION Here is another place the framework allows flexibility in choosing an accounting policy. The common arrangement of including periodic increases in rent in the terms of the lease, typically to reflect an assumed inflation pattern may be presented either on a straight-line basis or may be expensed as incurred. Accounting Treatment by a Lessor It is not likely that an entity with significant activity as a lessor will be applying the FRF for SMEs framework. Therefore this chapter won't go into detail of the accounting by lessors. Leases Involving Land and Buildings A lease for land and buildings could be assessed as a capital lease, if ownership transfers at the end of the lease or there is a bargain purchase option. In that case, the land and building should be capitalized separately in proportion to the market values at the start of the lease. If a lease for land and buildings does not transfer ownership or contain a bargain purchase option, the land and building should be separated for evaluation. Market value of the land and building along with allocation of the payments between land and building would be considered. This would leave the possibility that the building portion of the lease might meet the criteria for a capital lease. The land portion would be an operating lease regardless. If the market value of the land is minor in relation to the building, then the land and building would be considered together. Related Party Leases Accounting for leases between related parties is handled in the same manner as other leases. STUDY QUESTION 94

96 3. All of the following statements about lease accounting are correct except: a. Scheduled increases in lease payments, which approximate inflationary type increases, may be expensed as incurred or adjusted to a straight-line basis over the term of the lease. b. Lease concessions, such as one or a few rent-free months during the course of a lease, may be expensed as incurred or adjusted to a straight-line basis over the term of the lease. c. Because land has an indefinite useful life, a land lease is operating, unless the lease indicates there is a reasonable likelihood that ownership will transfer by the end of the lease. d. The basic concept in the framework is that when substantially all the benefits and risks of ownership are transferred, a lease represents the acquisition of an asset and assuming a liability for a future stream of payments. Disclosures Capital lease for lessee. Financial statements should disclose the following for each major category of leased assets: Cost Accumulated amortization Amortization method including amortization term or rate. For obligations under capital leases, the following should be disclosed: Interest rate Maturity date Amount outstanding Mentions leases are secured, if that is the case Operating lease for lessee. Future minimum lease payments should be disclosed in the aggregate and for each of the five succeeding years. Lease expense should be disclosed. Leases with initial term of one year or less may be excluded from disclosure. 707 NONMONETARY TRANSACTIONS In a nonmonetary transaction, an entity should measure whichever is more reliable: the market value of the asset given up or the market value of the asset received. Exceptions to this accounting treatment are: The transaction lacks commercial substance. The items exchanged are held for sale in the ordinary course of business. The entity cannot reliably measure either the market value of the asset received or the asset given up. The nonmonetary transaction is with owners. The transaction is between related parties but is not in the normal course of business. If a nonmonetary transaction is not measured at market value, then the transaction will be recognized based on the carrying amount of the asset given up adjusted by any monetary consideration received or given. 95

97 Commercial Substance A nonmonetary transaction has commercial substance when future cash flows are expected to significantly change as a result of the transaction. Recognition of Gains and Losses Any gain or loss from a nonmonetary transaction is recognized in net income. Disclosure So that users can understand the effects of nonmonetary transactions, an entity should disclose the following in the year when a nonmonetary transaction occurs: Nature of the transaction The measurement, whether market value or carrying amount Amount Related gains or losses 96

98 CHAPTER 8: FRF for SMEs An Alternative to GAAP Pensions, Income Taxes 801 WELCOME The Financial Reporting Framework for Small- and Medium-Sized Entities (FRF for SMEs) is an alternative to GAAP for small entities who desire a simpler financial reporting framework to present their financial statements. This chapter describes the accounting for retirement and other postemployment benefits and also income taxes. Both areas are noticeably simpler than the corresponding rules in GAAP. 802 LEARNING OBJECTIVES Upon completion of this chapter, the reader should be able to: Identify the three accounting policy choices in accounting for retirement other postemployment benefits Describe the current contribution payable method Describe the accrued benefit obligation method Identify the two accounting policy choices in accounting for income taxes Describe the taxes payable method Define the deferred income tax method 803 INTRODUCTION CPAs trying to help their clients find simpler and easier ways to present financial information have long suggested one of the other comprehensive basis of accounting (known as OCBOA), such as modified cash basis or income tax basis. A new alternative is available. In June 2013 the AICPA published the Financial Reporting Framework for Small- and Medium-Sized Entities. Known as FRF for SMEs, this framework is categorized as one of the OCBOAs. This chapter is one in a series describing FRF for SMEs. The first chapter is FRF for SMEs An Alternative to GAAP Introduction. It describes how FRF for SMEs fits into the various options for financial reporting, and describes the basic financial concepts in the framework. That chapter also describes the general principle for transitioning financial statements to the first presentation under FRF for SMEs. This chapter will describe the accounting treatment for income taxes and retirement and other postemployment benefits. The framework allows significant latitude for entities to choose a very simple accounting treatment. A key point needs to be repeated in each of the chapters in this series FRF for SMEs is not generally accepted accounting principles. It is neither "small GAAP" nor GAAP light nor GAAP without some of the detailed rules. In one sentence, FRF for SMEs is another in the group of OCBOA frameworks that might be an acceptable alternative to GAAP for some companies in some circumstances. Just as modified cash basis or tax basis might be appropriate for some entities, FRF for SMEs might be an appropriate alternative. 804 RETIREMENT AND OTHER POSTEMPLOYMENT BENEFITS Accounting Policy Choice The recognition, measurement, and disclosure requirements for retirement and other postemployment benefits 97

99 for active employees to be provided to them when they are no longer providing active service is covered in 10 pages within the framework. The framework allows one of several approaches for defined benefit plans: Current contribution payable method Accrued benefit obligation method, which has two approaches: - Immediate recognition approach - Deferral and amortization approach OBSERVATION The framework allows tremendous latitude for treatment of defined benefit plans. In highly condensed form, the options are: An approach that is somewhat similar to what accountants are already familiar with in GAAP A highly simplified approach to recognize the net amount of plan assets and liability The simplest of all, which is recording a liability for the required contribution to the plan for the coming year The requirements of this chapter apply to any compensation arrangement that is in substance a benefit plan. The form or manner of the arrangements or the timing of funding do not affect whether it is essentially a retirement or postemployment plan. Unless there is contrary evidence, it is presumed that an entity previously paying benefits and currently promising to so in the future will continue that plan into the future. Defined Contribution Plans Payments into a defined contribution plan should be recognized as an expense in the current period. Measurement of the expense should usually be the contribution for the year, based on the accrual method. Disclosures for a defined contribution plan should include: General description of each plan Amount of expense recognized in the period Multiemployer Plans Payments into a multiemployer plan should be recognized as an expense in the current period. Measurement of expense should be the payment required for the year. If it is probable that participation in the plan will be terminated, then any amounts due should also be accrued and recognized as an expense. Disclosures for a multiemployer plan should include: Name and description of the plan If it is probable or reasonably possible the entity will withdraw the plan, the notes should disclose whether withdrawal will create an obligation Amount of expense recognized in the period Individual Deferred Compensation Contracts If future benefits are attributable to multiple years of service, the cost should be accrued over that period of time. At the end of that service period, the amount of the accrued liability should equal the present value of the future benefits expected to be paid. Defined Benefit Plans An entity is allowed to make an accounting policy election for defined benefit plans (not including multiemployer plans). The options are: Current contribution payable method Accrued benefit obligation methods, for which there another choice 98

100 If the entity chooses the accrued benefit obligation method, there is a secondary accounting policy election to be made. The entity may use the: Immediate recognition approach Deferral and amortization approach Current Contribution Payable Method The expense recognition under the current contribution payable method includes only the contribution that is attributable to the current year. Accordingly, the accounting for defined benefit plans under this method is quite simple. Disclosures under this method include: Description of the plan, including plan participants, and how the benefits are determined Funding status, which includes market value of the plan assets, the benefit obligation, and the excess of the benefit obligation over market value of plan assets at the reporting date Contributions in the current year and expected contributions for the subsequent year Expected rate of return on plan assets and the discount rate used to calculate the accrued benefit obligation Accrued Benefit Obligation Methods The framework provides a brief summary of the two options before going into detail. With the immediate recognition approach, an entity obtains the accrued benefit obligation from the actuarial variation report used to determine funding requirements. The net amount of the accrued benefit obligation and the market value of the plan assets are recognized in the statement of financial position. The implication of adjusting to the net amount is that any actuarial gains and losses along with any prior service costs are recognized in expense currently. With the deferral and amortization approach, an entity obtains the accrued benefit obligation from an actuarial valuation report prepared for accounting purposes. An accrued benefit liability or accrued benefit asset is recognized in the statement of financial position based on the sum of current and prior year benefit costs less accumulated contributions to the plan. Prior service costs are deferred and amortized. Actuarial gains and losses are also deferred and amortized. Disclosures would include the market value of plan assets and the accrued benefit obligation. If an entity has more than one pension plan, it must use the same accounting approach for all plans. Immediate Recognition Approach Under this approach, recognition on the statement of financial position would be the net of the accrued benefit obligation and the market value of plan assets as of the end of the period. Recognition on the statement of operations would include the cost for the year, which will be defined momentarily. OBSERVATION In very summary form, the impact of recognizing the net of accrued benefit obligation and plan assets on the statement of financial position is that all changes in either the plan asset or pension liability flow into the current year expense. Measurement of accrued benefit obligation. The liability is based on the most recently prepared actuarial valuation report which is used for funding purposes. If such a report has not been prepared, the accrued benefit obligation is calculated by management using the methodology for the deferral and amortization based on their best estimate. The actuarial valuation report only needs to be prepared at least once every three years. For the intervening 99

101 years, management can roll forward the accrued benefit obligation taken into consideration several specified sources of a change in the liability. However, if there is a significant event, such as a settlement, curtailment, or plan amendment, then an actuarial valuation report needs to be prepared in the year of the significant event. Measurement of plan assets. The plan asset should be measured at market value as of the date of the statement of financial position. If market values are not readily available, management should use a method that provides an approximation of market value. Example provided in the framework is to obtain an appraisal or reviewing market values of similar assets. OBSERVATION It is dramatically noticeable that the three sentences in the FRF for SMEs framework describing how to value plan assets do not make any use of the word fair value. This is another significant departure of the framework from GAAP. Management has significant latitude in determining the measurement of plan assets if a market value is not readily available. Definition of market value. In the FRF for SMEs framework, market value is defined as the amount that would be agreed upon in an arm's length transaction between knowledgeable, willing parties. Neither party would be under compulsion to act. OBSERVATION That is the extent of the definition of market value. None of the additional comments encountered in GAAP are present. There is no concept of principal market, highest and best use, or other expansive explanations of what constitutes market value. There is no mention of levels 1, 2, and 3 valuations. The glossary has two long paragraphs that discuss market value in the context of leases, but other than for leases, the definition of market value is covered in only 26 words. If the plan assets are greater than the accrued benefit obligation this creates an accrued benefit asset. This excess is recognized in the statement of financial position only to the extent that it will be recoverable in the future either through reduced contributions or refunds from the plan. Cost for the year. With the simple valuation methodology described above, the cost for a year would be the net of: Changes in the accrued benefit obligation excluding benefit payments to plan members and any employee contributions, and Actual return on plan assets, which is the difference between: - Market value of plan assets at the start of the year reduced by any benefit payments to plan members and increased by any contributions to the plan, and - Market value of plan assets at the end of the year. OBSERVATION In simplified form, that means the pension expense for the year will essentially be the difference between the net amount of plan asset and accrued benefit obligation at the start of the year and the net amount at the end of the year. The effect is essentially that all changes to the pension plan flow to the statement of activity currently, including actual earnings or losses on the plan assets, current service cost, actuarial gains or losses, settlements, curtailment, and plan changes. It all goes straight to the pension expense account. STUDY QUESTION 100

102 1. All of the following statements about the immediate recognition approach are correct except: a. Expense for the year consists of the change in accrued benefit obligation (excluding benefit payments to plan members and any employee contributions) and the actual return on plan assets b. Recognition of the plan on a statement of financial position is the net of the accrued benefit obligation and the market value of plan assets as of the end of the year c. Plan assets are measured at market value. If market values not readily available management should develop a methodology that provides an approximation of market value d. The actuarial valuation report used to support the determination of accrued benefit obligation needs to be prepared every year Deferral and Amortization Approach Accounting for a defined benefit plan applying the deferral and amortization approach goes through several steps: Prepare actuarial estimates about demographic variables such as turnover and mortality along with financial variables including future increases in salary and increasing medical costs Using actuarial techniques, determining the present value of the employer's obligation for retirement or other postemployment benefits Attribute the benefits to employee's service periods to allow calculation of the accrued benefit obligation and the current service cost Determine: - Interest cost on the accrued benefit obligation - Market value of plan assets - Expected return on plan assets - Prior service costs for a new plan or any amendments - The amount of actuarial gains and losses in total and amount for the current period. - Gain or loss from any curtailments or settlements. It is not necessary to prepare an actuarial calculation of the accrued benefit obligation every year. In years between valuations, management extrapolates from the previous valuation. Management reviews any changes to the plan and revises any assumptions as necessary. When the effect of any changes is significant it may be necessary to prepare a new valuation. The plan assets and accrued benefit obligation should be measured as of the date of the statement of financial position. Measurement at an earlier date up to three months prior is allowed, provided that date is used consistently from year to year. Discount rate. The accrued benefit obligation is dependent upon the rate used to discount the future payments to a present value. The discount rate used should be determined in relation to: Market interest rates on high-quality debt instruments with cash flow timing that matches the future benefit payments The interest rate implied for the amount at which the accrued benefit obligation could be settled The discount rate in use should be revisited as of each measurement date. As long-term interest rates change, the discount rate should be changed. The framework contains the same comment for valuing plan assets under the deferral and amortization approach as for the immediate recognition approach. Specifically, the plan assets should be measured at market 101

103 value. If market value is not readily available then another method should be used that provides an approximation of market value. OBSERVATION It is again a key point that the framework does not use the word fair value when discussing the value of plan assets. STUDY QUESTION 2. Which of the following is a part of applying the deferral and amortization approach? a. Obtain the annual actuarial calculation of the accrued benefit obligation. b. Determine interest cost on the accrued benefit obligation using the discount rate established at the initiation of the plan. c. Determine the fair value of the plan assets. d. Determine the expected return on plan assets. Determination of cost for the period. Periodic pension cost consists of: Current service cost Interest cost on the accrued benefit obligation Expected return on plan assets Amortization of prior service costs Amortization of net actuarial gain or loss Increase or decrease in valuation allowance for the carrying amount of an accrued benefit asset Gain or loss from a settlement or curtailment Expense for termination benefits Entities with two or more plans. If an entity has multiple plans using the deferral and amortization approach, the cost, accrued benefit obligation, and plan assets should be determined for each plan. Unfunded plans may be aggregated for measurement only when they provide: Different benefits to the same group of employees, or Same benefits to different groups of employees. Plans that are overfunded or underfunded may not be netted for presentation on the statement of financial position. Some plans may have an accrued benefit asset (plan assets greater than accumulated benefit obligation) at the same time as other plans have an accrued benefit liability (accumulated benefit obligation greater than plan assets). Those plans may be netted only if: The entity has the right to use one plan's assets to pay benefits for another plan Entity intends to exercise that right As with the immediate recognition approach, under the deferral and amortization approach an accrued benefit asset (i.e. plan assets greater than accumulated benefit obligation) is recognized in the statement of financial position only to the extent that it will be recoverable in the future either through reduced contributions or refunds from the plan. 102

104 Settlements and Curtailments Settlements and curtailments increase or decrease the accrued benefit obligation and are recognized as gain or loss in a statement of activity during the period they occur. When a pension liability is settled by purchasing an insurance contract, the accrued benefit obligation excludes any benefits that will be covered by the insurance. The insurance contract would not be included in plan assets. Disclosures Disclosures for both the immediate recognition and deferral and amortization approach for defined benefit plans include: Description of the plan, including plan participants, and how the benefits are determined Funding status, which includes market value of the plan assets, the benefit obligation, and the excess of the benefit obligation over market value of plan assets at the reporting date Expected rate of return on plan assets and the discount rate used to calculate the accrued benefit obligation OBSERVATION These disclosures are also required for the simplified current contribution payable approach. The difference in disclosures is that the current contribution payable approach also requires disclosure of the contributions in the current year and amount expected in the subsequent year. Termination benefits When it is probable that employees will be entitled to termination benefits and the amount can be reasonably estimated, the benefit should be recognized as a liability and expensed. In assessing whether payment of termination benefits is probable, one of two conditions should be met: The entity is contractually required to provide the termination benefits. Management has committed to and approved a plan of termination. Also, withdrawal from the plan is not realistically possible. The financial statement should disclose the nature and effect of any termination benefits provided in the year. 805 INCOME TAXES Accounting Policy Choice An entity can make an accounting policy choice between two options for income tax accounting: Taxes payable method Deferred income tax method Entities not subject to income taxes. Entities such as unincorporated businesses or subchapter S corporations are not directly liable for income taxes. Financial statements for entities that have their income taxed directly to the owners should not recognize any provision for income taxes. Taxes Payable Method Under this accounting policy choice, only current income tax assets and liabilities are recognized, to the extent they are unpaid or refundable. A benefit from a tax loss that will be carried back to recover previous periods income taxes should be recognized as a current asset. Intraperiod allocation. Under the taxes payable method, income taxes are allocated within a year in the same manner as they are under the deferred income tax method. The intraperiod allocation methodology will be described shortly. 103

105 OBSERVATION That's it. Other than the items discussed later, specifically intraperiod allocation, presentation, and disclosures, the accounting for the taxes payable method under the FRF for SMEs framework is covered in six short paragraphs. Deferred Income Tax Method The basic principle for the deferred income tax method is an entity recognizes a deferred income tax liability when the settlement of an asset or liability at the recorded carrying amount would result in a deferred income tax outflow. Likewise a deferred income tax asset is recognized when a settlement of an asset or a liability at the recorded carrying amount would result in a deferred income tax reduction. This requires looking at the carrying amount of an asset or liability recognized for purposes of the financial statements. This carrying amount would be compared to the amount that would be deductible or includable for determining taxable income, which is referred to as the tax basis. The difference between carrying amount and tax basis is a temporary difference, which could be either taxable or deductible. Taxable temporary differences lead to deferred income tax liabilities. Deductible temporary differences lead to deferred income tax assets. Unused tax losses, income tax reductions, and certain other items. It is possible to have unused tax losses and income tax reductions which don't relate to a particular asset or liability, but which can generate tax benefits which would meet the requirements to record a deferred tax asset. Some items may have a tax basis but are not recognized in the statement of financial position. Research costs are an example. Those costs are expensed as incurred for purposes of the financial statements but might not be deductible for determination of taxable income until a later year. Such item could generate a deferred income tax asset. Another example would be an entity that recognizes long-term contracts on a percentage of completion method for purposes of the financial statements but uses completed contract method for purposes of determining taxable income. The income deferred for tax purposes would generate a deferred income tax liability. Business combinations. Temporary differences arise from the differences between the carrying amounts in consolidated financial statements of each entity when compared to the tax basis that exists at the individual entities in the consolidated group. These temporary differences could be either taxable or deductible generating either deferred tax liabilities or deferred tax assets. Recognition Current income tax liabilities and current income tax assets. Current taxes are handled in the same way as under the taxes payable method, which means they are recognized to the extent current income taxes are unpaid or refundable. Deferred income tax liabilities and deferred income tax assets. As of each statement of financial position reporting date, a deferred income tax asset or liability should be recognized in the financial statements for all of the deductible and taxable temporary differences along with unused tax items and income tax reductions. Any deferred income tax assets should be recognized only to the extent that the amount is more likely than not to be realized. Realization of the tax benefits is dependent upon having sufficient taxable income in the future in a sufficient amount, related to the same tax authority and the same taxable entity, taking into consideration carryback and carry forward periods. Taxable income may be available from: Future reversals of taxable temporary differences Future taxable income Taxable income from prior years assuming carryback is permitted under the applicable tax law 104

106 Tax planning strategies that would be implemented to realize a deferred income tax asset, if needed An entity recognizes a deferred income tax asset for all of the deductible temporary differences, unused tax losses, and income tax reductions. The asset is reduced by a valuation allowance, if needed. Recognition in the statement of financial position should be limited to the amount that is more likely than not to be realized. Reassessment of deferred income tax assets. An entity reassesses the recognized and unrecognized deferred income tax assets as of the date of each financial statement. The amount recognized is revised to that which is more likely than not to be realized. Changes such as improvements in the volume of sales backlog or a deteriorating financial position could affect estimating probabilities of realization. Investments in subsidiaries and equity method investments. As mentioned earlier, temporary differences arise from a difference in carrying amount and tax basis at the consolidated level and subsidiary level. A deferred income tax liability or deferred income tax asset should be recognized for all such temporary differences at each statement of financial position date. If a temporary difference will not reverse the foreseeable future, it should not be recognized. Any resulting deferred income tax asset should only be recognized to the extent it is more likely than not to be realized. Because a parent has control over the dividend policy of subsidiaries, it is possible for the parent to control when timing differences will reverse. If a parent determines that profits in a subsidiary will not be distributed in the foreseeable future, a deferred income tax liability is not recognized. Temporary differences can also exist for investments accounted for using the equity method. A deferred income tax asset or liability would be recognized for such temporary differences because the investor is usually not able to control the timing of reversals. Business combinations and push-down accounting. Circumstances may arise when an acquirer can determine that a business combination means it will be able to realize a deferred income tax asset as a result of the combination that it otherwise would not have realized before the acquisition date. In that circumstance, the recognition of a deferred income tax asset would be revised in the period a business combination took place. However such a revision would not be a part of the accounting for the business combination. That means it would not roll into the calculation of goodwill or bargain purchase gain. During the measurement period after a business combination an entity can revise the provisional amounts recorded for the combination. A separate chapter in this module explains that a measurement period can last no longer than one year after the business combination or the amount of time it takes to gather all information needed to properly record the combination, whichever is shorter. If during the measurement period, an entity determines a deferred income tax assets exists as an identifiable asset at the acquisition date, the benefit should be applied to reduce goodwill. If the deferred income tax asset is greater than the amount of recorded goodwill, the excess is used to reduce income tax expense. If a deferred income tax assets arising from a business combination is identified after the end of the measurement period, the benefit is recognized into income tax expense. Measurement. Income tax rates and laws in effect as of the date of the statement of financial position should be used to measure income tax liabilities and income tax assets. Changes in income tax rates and laws enacted before the date the financial statements are available to be issued are disclosed as a subsequent event. Changes in deferred tax assets and liabilities arising from a change in tax rates or tax laws are recognized in deferred income tax expense included in income before discontinued operations. The reason is that changes in tax rates or tax laws are considered a part of normal business activity. If different tax rates apply to capital gains and losses than apply to other taxable income, the appropriate tax rate to use should reflect the expected manner the asset will be taxed. Intraperiod allocation. In general, the cost/benefit of current and deferred income taxes are presented as income tax expense as a part of net income/loss before discontinued operations. Exceptions to this presentation include: Cost/benefit of current and deferred income taxes that are related to discontinued operations is presented with the results of discontinued operations. 105

107 Cost/benefit of current and deferred income taxes associated with capital transactions which are directly presented as a part of equity should also be included directly into equity. This would apply to taxes associated with any other transactions that are classified directly into equity. Cost of deferred income taxes resulting from an entity renouncing deductibility of expenditures to an investor is treated as the cost of issuing the security. Cost/benefit of deferred income taxes from a business combination is handled as mentioned earlier. Cost/benefit of current and deferred income taxes arising from a correction of an error or change in accounting policy is recognized based on the underlying item. Treatment of accounting changes, changes in accounting estimates, and correction of errors are addressed in an earlier chapter in this module. STUDY QUESTION 3. All of the following statements about income tax accounting are correct except: a. Income tax rates used to measure income tax liabilities and income tax assets are those rates that are reasonably expected to be in effect when the underlying temporary differences are expected to reverse. b. If the tax assets and tax liabilities of an entity acquired in a business combination has implication that a deferred tax asset of the parent may now be realized, the impact should be recognized in income currently and not become part of accounting for the business combination. c. If different tax rates apply to capital gains and losses than the rates applicable to other taxable income, the appropriate tax rate for measuring those gains and losses should reflect how the underlying asset will be taxed. d. The cost or benefit of current and deferred income taxes that are related to discontinued operations are presented on the statement of operations along with the results of discontinued operations. Presentation Income tax expense that is a part of net income before discontinued operations is presented separately on the face of the statement of operations. Income tax liabilities and income tax assets. On a statement of financial position, income tax assets and liabilities should be presented separately from other assets and liabilities. The current portion of income tax assets and liabilities should be presented separately from the deferred portion. When an entity presents a statement of financial position classified as current and noncurrent, the current and noncurrent portion the deferred income tax assets and liabilities should also be presented as current and noncurrent. The classification of liabilities and assets which generated the deferred income tax is used to determine how to classify the deferred income tax between current and noncurrent. The current tax liability and current tax asset should only be offset if the items relate to the same tax authority for the same entity. Likewise for deferred income tax asset and liabilities, which should only be offset if they relate to the same entity and the same tax authority. The current and noncurrent portion of deferred income tax balances should not be offset. Disclosure An entity should disclose the following: 106

108 If an entity is not subject to income taxes because the earnings are taxed to the owners, such fact should be disclosed. The accounting policy choice regarding how to account for income taxes: - Taxes payable method, or - Deferred income taxes method When an entity chooses the taxes payable method, the following information should be disclosed: Income tax expense/benefit included in income/loss before discontinued operations Discussion of the difference between the income tax expense included in income/loss before discontinued operations and income tax at the statutory tax rate. This discussion could be in terms of either the tax rate or the tax expense. The discussion should include the nature of each significant reconciling item. The entity may either include or omit a numerical reconciliation between the statutory and recognized amounts or rates. Amount of income tax losses carried forward and unused income tax credit Amount of income tax expense/benefit included as a part of transactions recognized directly to equity When an entity chooses the deferred income taxes method, the following information should be disclosed: Current income tax expense/benefit included in income/loss before discontinued operations Deferred income tax expense/benefit included in income/loss before discontinued operations Amount of income tax expense/benefit included as a part of transactions recognized directly to equity Total amount of unused tax losses and income tax reductions Amount of deductible temporary differences for which deferred income tax assets have not been recognized Discussion of the difference between the income tax expense included in income/loss before discontinued operations and income tax at the statutory tax rate. This discussion could be in terms of either the tax rate or the tax expense. The discussion should include the nature of each significant reconciling item. The entity may either include or omit a numerical reconciliation between the statutory and recognized amounts or rates. Amount of income tax losses carried forward and unused income tax credit OBSERVATION The entire explanation of income tax accounting in the FRF for SMEs framework takes up 13 pages. If an entity chooses the taxes payable method, less than three pages of this chapter would apply. This simplicity may be a significant advantage from using the framework for a firm's clients who want to have a simpler, less costly way to communicate their financial condition. CPE NOTE: When you have completed your study and review of chapters 3-8, which comprise Module 2, you may wish to take the Quizzer for this Module. Go to CCHGroup.com/PrintCPE to take this Quizzer online. 107

109 CHAPTER 9: Monitoring as an Element of Quality Control 901 WELCOME This chapter summarizes the definitions and requirements of SQCS 8, relevant to the monitoring element of quality control, the provisions of PRP Section 10,000, and provides commentary on the elements of an effective monitoring program, and offers guidance on monitoring steps for practical implementation. 902 LEARNING OBJECTIVES Upon completion of this chapter, the reader should be able to Define key terms related to the monitoring element of quality control List the requirements of Statements on Quality Control Standards (SQCS) No. 8, A Firm's System of Quality Control related to monitoring Explain the application of these requirements to a variety of practical situations 903 INTRODUCTION Monitoring is a key element of quality control for firms with accounting or auditing practices. Yet, it is one of the least understood and most poorly applied elements. Guidance on monitoring comes from two sources: SQCS 8, which contains the requirements for monitoring Section 10,000, "Monitoring Guidance," of the AICPA Peer Review Program Manual (PRP Section 10,000), which contains implementation provisions Monitoring applies to all firms with accounting or auditing practices, even small firms that perform no services above the compilation level. This chapter summarizes the definitions and requirements of SQCS 8 relevant to the monitoring element of quality control, and the provisions of PRP Section 10,000. It also provides commentary on the elements of an effective monitoring program, and offers guidance on monitoring steps for practical implementation. 904 DEFINITIONS SQCS 8 defines the following terms related to monitoring for purposes of the SQCSs: Engagement Documentation The record of work performed, and the results and conclusions thereof, also known as working papers or workpapers. Engagement Partner The partner or other person in the firm who is responsible for the engagement, its performance, and the firm's report on it. When required, the engagement partner has appropriate authority from a legal, regulatory, or professional body. Firm An organization engaged in the practice of public accounting that is in a form permitted by law or regulation and whose characteristics conform to resolutions of the Council of the AICPA. 108

110 Inspection A retrospective evaluation of the adequacy of a firm's Quality Control (QC) policies and procedures, its personnel's understanding of them, and its compliance with them. It includes a review of completed engagements. Monitoring A process comprising an ongoing consideration and evaluation of the firm's QC system, including inspection or periodic review of engagement documentation, reports, and clients' financial statements for a selection of completed engagements. Monitoring is designed to provide the firm with reasonable assurance that its QC system is appropriately designed, and is operating effectively. Partner Any person with the authority to bind the firm with respect to performing a professional services engagement. This may include an employee with this authority who is not an owner. Personnel Partners and staff. Staff Non-partner professionals, including specialists employed by the firm. STUDY QUESTION 1. The difference between monitoring and inspection is that: a. Monitoring is a retrospective evaluation of a firm's QC policies and procedures, while inspection is an ongoing consideration and evaluation of that system. b. Inspection is designed to provide the firm with reasonable assurance that its QC system is appropriately designed and functioning properly, while monitoring is not. c. Monitoring is an ongoing evaluation and consideration of a firm's QC system, while inspection is a retrospective evaluation that includes a review of selected completed engagements. d. Inspection is designed to provide a basis for reliance by outside parties on the firm's QC system, while monitoring is performed strictly for internal purposes. 905 REQUIREMENTS SQCS 8 contains the following presumptively mandatory requirements. Presumptively mandatory requirements are signaled in the professional standards by the word should. Auditors must comply with presumptively mandatory requirements in all cases in which they are relevant, except in rare circumstances when that procedure would not be effective in achieving the intent of the requirement. There are no unconditional requirements related to monitoring. Monitoring the Firm's QC Policies and Procedures Firms should establish a monitoring process designed to provide reasonable assurance that their QC policies and procedures are relevant, adequate, and operating effectively. This process should: Include an ongoing consideration and evaluation of the QC system, including inspection or periodic review of engagement documentation, reports, and clients' financial statements for a selection of completed engagements 109

111 Require that a partner, partners, or others with sufficient appropriate experience and authority assume responsibility for monitoring Assign performance of monitoring to qualified individuals Evaluating, Communicating and Remedying Identified Deficiencies Firms should evaluate the effects of deficiencies noted as a result of monitoring, and determine whether they are either: Non-systemic instances, which do not indicate that the QC system is insufficient to provide the firm with reasonable assurance of compliance Systemic, repetitive or other significant deficiencies that require prompt corrective action OBSERVATION This section notes that any QC system has inherent limitations that can reduce its effectiveness. Deficiencies in individual engagements do not, by themselves, indicate that the QC system is insufficient. Firms should communicate to relevant engagement partners and other appropriate personnel, deficiencies noted as a result of monitoring, and recommend remedial actions. Those recommendations should include one or more of the following: Taking appropriate remedial action with respect to a specific engagement or individual Communicating findings to those responsible for training and professional development Changes to QC policies and procedures Disciplinary action against personnel who fail to comply with the firm's policies and procedures, especially repeat offenders Firms should establish policies and procedures to address cases in which the results of monitoring disclose that a report may be inappropriate or that procedures were omitted during the performance of an engagement. Those policies and procedures should require the firm to: Determine what further action is appropriate Consider whether to obtain legal advice Firms should communicate the monitoring results to the firm's leadership, engagement partners and other appropriate personnel at least yearly. This communication should: Be sufficient to enable the firm and its recipients to take prompt appropriate action when necessary Describe the monitoring procedures performed State the conclusions drawn Describe systemic, repetitive or other significant deficiencies, if any, and actions taken to resolve them When firms operate under a network, and place reliance on common monitoring policies and procedures, those policies and procedures should require that the network communicate: The overall scope, extent and results of monitoring to appropriate individuals within the network at least annually Identified deficiencies in the QC system to appropriate individuals within the network firms promptly Complaints and Allegations Firms should establish: Policies and procedures to provide reasonable assurance that they deal appropriately with: 110

112 - Complaints and allegations that their work fails to comply with professional standards or legal and regulatory requirements - Allegations of noncompliance with their QC system Clearly defined channels for personnel to raise concerns in a manner that enables them to do so without fear of reprisal Firms should take appropriate action if investigation into complaints and allegations identifies deficiencies in the design or operation of the QC system or instances of noncompliance with it. OBSERVATION In smaller firms where it is impracticable for the partner supervising the investigation not to be involved in the engagement, the services of a suitably qualified external person or another firm may be used to carry out the investigation into complaints and allegations. STUDY QUESTION 2. In distinguishing between systemic and non-systemic deficiencies, SQCS 8 notes that: a. Deficiencies in individual engagements indicate that the firm's QC system is inadequate. b. Non-systemic deficiencies do not indicate that the QC system is inadequate. c. Systemic deficiencies do not require corrective action. d. QC systems should not be subject to inherent limitations. Auditing Standards In addition to the requirements of SQCS 8, which apply to a firm's accounting and auditing practice, firms with an auditing practice should also comply with the requirements of AU-C Section 220, Quality Control for an Engagement Conducted in Accordance with Generally Accepted Auditing Standards. It states that an effective QC system includes a monitoring process that provides the firm with reasonable assurance that QC policies and procedures are relevant, adequate, and operating effectively. AU-C Section 220 requires the engagement partner to consider: The results of the firm's monitoring process as evidenced in the latest information circulated to the engagement partner by the firm and, if applicable, other network firms Whether deficiencies noted in that information may affect the audit engagement 906 ELEMENTS OF A MONITORING PROGRAM The Application and Other Explanatory Material (AOEM) of AU-C Section 220 states that the main purpose of a firm's monitoring program is to assess whether the firm is achieving the objective to establish and maintain a QC system that provides it with reasonable assurance that the professional standards and applicable legal and regulatory requirements are complied with and that reports issued are appropriate in the circumstances. This is best accomplished by evaluating whether: Professional standards and legal and regulatory requirements are adhered to The firm's QC system is appropriately designed and effectively implemented Policies and procedures operate effectively to ensure that reports issued are appropriate in the circumstances An effective monitoring process may identify the need to implement changes to the firm's policies and 111

113 procedures or areas where compliance needs to be improved. A firm's ongoing monitoring procedures may include: Reviews of selected personnel records and administrative files related to the QC elements Reviews of engagement documentation, reports, and clients' financial statements Discussions with firm personnel Determination of corrective actions or improvements to be made in the QC system Communication within the firm of weaknesses in the QC system or of problems in understanding or complying with the system Follow-up actions to assure timely modifications to the system when necessary Assessments of: - The appropriateness of the firm's practice aids and guidance materials - New professional pronouncements, and how they are reflected in the firm's policies and procedures - Written confirmation of compliance with independence policies and procedures. - The effectiveness of professional development activities, including training. - Client and engagement acceptance and continuance decisions - Firm personnel's understanding and implementation of QC policies and procedures Timing of Monitoring Monitoring should include an ongoing consideration and evaluation of the firm's QC system. They should be performed throughout the year. However, a firm will still effectively comply with the monitoring requirement if it evaluates compliance with the system at a fixed time during the year or through a combination of fixed and ongoing procedures. OBSERVATION Many firms, especially smaller ones, find that it is efficient, for annual engagements, to combine the inspection of the prior engagement with the planning for the current year. The requirement for ongoing consideration is intended to ensure that the firm can take necessary corrective action on a timely basis if and when deficiencies are identified. If monitoring procedures were performed only at a fixed time during the year, especially if a firm were, for example, to perform retrospective evaluations of multiple engagements at the end of the busy season, the firm would run the risk that systemic deficiencies in a particular engagement could not be corrected before reports were issued on other engagements subject to the same deficiencies. Therefore, fixed points should be selected to make sure necessary corrective actions can be taken before subsequent engagements are completed. Assignment of Appropriate Personnel to Perform Monitoring The individual assigned overall responsibility for the firm's monitoring program should have sufficient and appropriate experience and the authority to assume that role. In many cases, especially in a smaller firm, this is the same person who is assigned overall responsibility for the firm's QC system. Procedures themselves may be performed by one or more qualified individuals, under that person's direction. In some cases, especially in smaller firms, individuals performing monitoring procedures are also responsible for compliance with the firm's QC policies and procedures. These persons are in effect monitoring their own compliance. In such cases, it may be more beneficial for the firm to engage a qualified external specialist or another firm to perform monitoring procedures than to have individuals monitor their own compliance. Inspection and Postissuance Review SQCS 8 provides two methods of evaluating a firm's compliance with its QC policies and procedures: Inspection, which is defined in the Definitions section of this chapter. 112

114 Postissuance review, which is a review of engagement documentation, reports, and clients' financial statements for selected engagements after the report release date, performed on an ongoing basis but after the report release date. Postissuance Review Postissuance reviews are performed on an ongoing basis after the report release date. In order for a postissuance review to be considered part of the firm's monitoring procedures, it should, with the exception of a small firm with a limited number of qualified management level personnel, be performed or supervised by an individual who is not a member of the engagement team. A postissuance review should meet the following criteria in order to be considered part of the firm's monitoring procedures: It should be comprehensive enough for the firm to assess compliance with all applicable professional standards and the firm's QC policies and procedures Engagement deficiencies indicating the need to modify QC policies and procedures or for improvements in compliance with them are periodically documented, summarized, and communicated to firm personnel having the responsibility and authority to make changes Systemic causes of deficiencies that indicate the need for improvements are timely considered Appropriate actions are determined Planned actions are implemented promptly Changes are communicated to affected personnel Appropriate follow up is made PRP Section 10,000, Monitoring Guidance, of the AICPA Peer Review Program Manual notes that the following risk factors should be considered when determining whether to perform inspection procedures, postissuance reviews, or both: The firm's size Risks related to specific clients and engagements The number and locations of its offices The results of prior monitoring procedures, peer reviews, regulatory reviews, and inspections For multi-office firms, the degree and authority of both personnel and office The nature and complexity of the firm and its practice The results of engagement quality control reviews performed throughout the year and the type and complexity of engagements reviewed The need for and extent of inspection procedures is influenced by the effectiveness and existence of the firm's other monitoring procedures. The same considerations used when determining whether to perform inspection procedures, postissuance reviews, or both may enter into developing inspection procedures. Cost-benefit considerations may also be taken into account. A firm should design its inspection based on the existence and effectiveness of other QC procedures, including other monitoring procedures. Inspection procedures will vary from firm to firm, based on differences in QC policies and procedures and the results and effectiveness of other monitoring procedures. Inspection procedures are not required if a firm performs other types of effective monitoring procedures. Practically speaking, however, most firms will find it most effective to perform some type of inspection procedures. 113

115 Effect of Firm Size on Monitoring For larger firms with more than a limited number of management-level individuals responsible for the conduct of its accounting and auditing practice, inspection procedures emphasizing the engagement performance aspect of the QC system are particularly appropriate. A number of issues arise from lack of segregation of duties in small firms when personnel monitor their own work. Monitoring procedures in those firms may need to be performed by some of the same people who are responsible for compliance with the firm's QC system. In this case: A person should be able to critically review his or her own performance, assess his or her own strengths and weaknesses, and maintain an attitude of continual improvement. Changes in conditions and firm environment may indicate a need to have another qualified individual performing monitoring procedures. A person inspecting his or her own work may be less effective than another qualified individual because there is a higher risk that noncompliance will not be detected. Smaller firms may find it beneficial to have monitoring performed by a qualified external person or another firm. Relationship of Peer Review to Monitoring A firm is required to perform its own monitoring procedures and cannot substitute peer review for its monitoring process. However, peer reviews of specific engagements can be substituted for some or all of a firm's engagements for a period covered by a peer review as long as its monitoring policies and procedures require inspection procedures for some or all engagements for the period covered by the peer review and permit such a substitution. In this case the firm does not need to perform inspections of any engagements during the year of its peer review. The firm should note, however, that the peer reviewer will need to review the inspection procedures performed during the two years between peer reviews. Complaints and Allegations Complaints and allegations of noncompliance with the QC system (which do not include those that are clearly frivolous) may originate from firm personnel, clients, state boards of accountancy, other regulators, or other third parties. They may be received by engagement team members or other firm personnel. Firms should have policies and procedures to ensure that the partner responsible for investigating any complaints and allegations: Has sufficient appropriate experience Has authority within the firm Is not otherwise involved in any engagement that is subject to a complaint or allegation Considers whether to obtain legal advice In smaller firms where it is impracticable for the partner supervising the investigation not to be involved in the engagement, a qualified external person or another firm may be used to carry out the investigation. 907 MONITORING STEPS Monitoring activities involve evaluating: Whether the firm's policies and procedures are relevant, adequate, and operating effectively The appropriateness of the firm's guidance materials and practice aids for its practice The effectiveness of the firm's professional development activities Compliance with the firm's quality control policies and procedures 114

116 Monitoring activities also involve: Summarizing the results of monitoring and preparing a written report Communicating monitoring results Following up on corrective actions Evaluating Policies and Procedures SQCS 8 requires firms to conduct an ongoing process to provide reasonable assurance that the policies and procedures related to its QC system are relevant, adequate, and operating effectively. PRP Section 10,000 suggests that one of the ways this is accomplished is by assigning monitoring responsibilities and activities to qualified individuals with sufficient authority and experience to: Evaluate whether events have occurred or circumstances have changed that indicate a revision to policies and procedures may be necessary. Such events or circumstances might include: - Changes in professional standards - Changes in regulatory or legal requirements - Mergers with another firm, divestitures of portions of the firm's practice, or other changes in the firm's structure - Results and related recommendations from monitoring activities, peer reviews, or other QC activities - Employee feedback and complaints, allegations, litigation, or regulatory enforcement actions against the firm - Acquisition or loss of personnel with specialized skills, expertise, or knowledge - Changes in technology that may impact the methods of operations of either the firm or its clients - Changes in industry standards and operations that impact client operations or reporting Determine whether those responsible for maintaining the firm's standards of quality are appropriately informed of their responsibilities. Identify the need to improve compliance with policies and procedures related to other QC elements. Identify the need to revise policies and procedures related to other QC elements that are inappropriately designed or are not operating effectively. Evaluating Guidance Materials and Practice Aids Monitoring procedures include assessing the appropriateness of the firm's guidance materials and any practice aids on an ongoing basis. This can be accomplished by assigning this responsibility to a person with sufficient and appropriate experience and authority to: Determine the impact of new professional pronouncements on the firm's guidance materials and practice aids Ensure that the materials are updated and tailored as necessary Provide appropriate guidance to personnel regarding: - New professional standards - New regulatory and legal requirements - Related changes to the firm's practice aids OBSERVATION In evaluating whether third-party practice aids or other QC materials are appropriately designed, consideration should be given to whether those materials have been subjected to a quality control materials review under the AICPA peer review program. 115

117 Evaluating Professional Development Activities Monitoring includes assessing the appropriateness and effectiveness of the firm's continuing professional development, including training. The firm should assign this responsibility to a person with sufficient and appropriate experience and authority to: Determine whether the firm's continuing professional development and training is appropriate, effective, and meets the needs of the firm based on the nature of its practice. Determine whether the firm is in compliance with the Continuing Professional Education (CPE) requirements of the AICPA and relevant regulatory bodies. For example, if the firm performs audits under Government Auditing Standards, the firm would ensure that engagement personnel meet the Yellow Book CPE requirements. Determine whether the firm's personnel are satisfied with the effectiveness of the training programs they have attended. Consider the results of the firm's reviews of its engagements in connection with the effectiveness of its professional development program. Determine whether consultations indicate a need for additional professional development programs. Evaluating Compliance with QC Policies and Procedures Monitoring includes evaluating: Adherence to applicable professional standards and regulatory requirements Whether the QC system has been appropriately designed and implemented Whether policies and procedures have been operating effectively This can be accomplished by assigning a partner or partners or other persons with sufficient and appropriate experience and authority in the firm to be responsible for supervising procedures at the broad functional element level and engagement level. Monitoring procedures at the broad functional level may include: Review of selected administrative and personnel records pertaining to the QC element of human resources Discussions with the firm's personnel to assess the firm's "tone at the top" In addition to reviewing the broad functional elements, the following functional elements are reviewed at the engagement level: Documentation of consultations on independence, integrity, and objectivity matters and acceptance and continuance decisions Resolution of matters reported by professional personnel on independence, integrity, and objectivity circularization forms to determine that matters have been appropriately considered and resolved Other consultation on accounting and auditing matters The AICPA Peer Review Program Manual includes engagement checklists for various types of engagements as well as for certain industries. These checklists are designed with the peer reviewer in mind, but firms can use them during their monitoring process to: Perform inspections and postissuance reviews Identify potential QC system issues Better anticipate and be prepared for the firm's peer review 116

118 Selecting Engagements for Review Effective engagement selection should be risk-based, taking into account the number and types of engagements and partner coverage, and should include a reasonable cross-section of the firm's A&A engagements using criteria including: An appropriate cross-section based on the level of service Engagements required to be selected for peer review including: - Engagements subject to Government Auditing Standards - Engagements subject to Federal Deposit Insurance Corporation Improvement Act requirements - Employee benefit plan audits - Carrying broker-dealer audits - Examinations of service organizations (SOC 1 and 2 engagements) Initial engagements Engagements involving foreign companies An appropriate cross section of engagement partners' A&A engagements, especially considering any partners who had negative results in any prior reviews High risk engagements and engagements for clients in specialized industries SEC registrants Engagements in which findings have been identified as findings in other reviews, such as regulatory reviews, prior peer reviews, or monitoring Engagements from a merged-in practice Evaluating, Summarizing and Reporting on Results Firms are required to evaluate whether deficiencies detected during monitoring: Prevent an appropriate report from being issued Indicate that procedures were omitted Indicate systemic, repetitive, or other significant deficiencies that cause the QC system to be insufficient and that require prompt corrective action The firm's policies and procedures should address these types of deficiencies and require the firm to determine what further action is appropriate and whether to obtain legal advice. Recommendations for appropriate remedial actions may include: Taking appropriate remedial action in relation to specific engagements or personnel Additional training and professional development Changes to QC policies and procedures Updates or additions to practice aids and technical manuals Changes in staff assignments Disciplinary actions All of the deficiencies noted during monitoring procedures, not just those noted through reviews of engagements, should be periodically summarized in a manner that will enable the firm to determine what actions, if any, are necessary to prevent their recurrence. 117

119 Communicating Results After summarizing the deficiencies, a written summary report is prepared and submitted to the appropriate partner(s) of the firm. At least annually, the firm should communicate the results of the monitoring to engagement partners and other appropriate individuals within the firm, including the firm's leadership. Communication should include: A description of the monitoring procedures performed The engagement selection criteria A risk assessment, which forms the basis for the selection of engagements for review and takes into account the number and types of engagements and partner coverage The conclusions drawn When relevant, a description of: - Situations that would require the firm to take action to prevent future reliance on a report that it issued - Situations that would require the firm to perform additional procedures to provide a basis for a report issued - Systemic, repetitive, or other significant deficiencies identified and of the actions taken to resolve or amend them A summary of engagements reviewed Follow-Up Actions Timely and effective follow-up on implementation of planned corrective actions is critical to effective monitoring. Within a reasonable period of time after the firm is scheduled to take those actions, steps are taken to determine whether the planned corrective actions have been acted upon and whether they have achieved the objectives for which they were designed. STUDY QUESTION 3. Monitoring activities include evaluating all of the following except: a. Compliance with the firm's QC policies and procedures b. The relevance and adequacy of the firm's QC policies and procedures c. The appropriateness of the firm's practice aids d. Whether qualified external persons have been engaged to investigate any complaints or allegations 118

120 CHAPTER 10: Engagement Quality Control Review 1001 WELCOME This chapter summarizes the definitions and requirements of SQCS 8, relevant to engagement quality control review, provides commentary on the elements of an effective engagement quality control review program, and offers practical implementation guidance LEARNING OBJECTIVES Upon completion of this chapter, the reader should be able to: Define key terms related to engagement quality control review (EQCR) List the requirements of Statements on Quality Control Standards No. 8, A Firm's System of Quality Control (SQCS 8) related to engagement quality control review Explain the application of these requirements to a variety of practical situations 1003 INTRODUCTION Engagement quality control review is a key component of the engagement performance element of quality control for firms with accounting or auditing practices. However, it is one of the least understood and most poorly applied components. The requirements for EQCR are prescribed by SQCS 8. These requirements apply to all firms with accounting or auditing (A&A) practices, even small firms that do not perform services above the compilation level. This chapter summarizes the definitions and requirements of SQCS 8 pertaining to EQCR, provides commentary on the elements of an effective EQCR program, and offers practical implementation guidance DEFINITIONS SQCS 8 defines the following terms related to EQCR for purposes of the SQCSs: Engagement Documentation The record of work performed, and the results and conclusions thereof, also known as working papers or workpapers. Engagement Partner The partner or other person in the firm who is responsible for the engagement, its performance, and the firm's report on it. When required, the engagement partner has appropriate authority from a legal, regulatory, or professional body. Engagement Quality Control Review A process designed to provide an objective evaluation, prior to the report release, of the significant judgments made by the engagement team, and the conclusions it reached in formulating the report. The EQCR process is only for those engagements, if any, that the firm has determined in accordance with its policies and procedures that an EQCR is necessary. Engagement Quality Control Reviewer A partner or other suitably qualified person (or team of persons), either within or outside of the firm, not a part of the engagement team, with sufficient and appropriate experience and authority to objectively evaluate the 119

121 significant judgments made by the engagement team, and the conclusions it reached in formulating the report. Engagement Team All partners and staff performing the engagement, and any individuals engaged by the firm or a network firm who perform procedures on an engagement. This definition excludes external specialists used by the firm or a network firm. Firm An organization engaged in the practice of public accounting that is in a form permitted by law or regulation and whose characteristics conform to resolutions of the Council of the AICPA. Inspection A retrospective evaluation of the adequacy of a firm's QC policies and procedures, its personnel's understanding of them, and its compliance with them. It includes a review of completed engagements. Monitoring A process comprising an ongoing consideration and evaluation of the firm's QC system, including inspection or periodic review of engagement documentation, reports, and clients' financial statements for a selection of completed engagements. Monitoring is designed to provide the firm with reasonable assurance that its QC system is appropriately designed, and is operating effectively. Partner Any person with the authority to bind the firm with respect to performing a professional services engagement. This may include an employee with this authority who is not an owner. It is important to note that firms may use different titles to refer to individuals with this authority. Personnel Partners and staff. Staff Non-partner professionals, including specialists employed by the firm. Suitably Qualified External Person A person outside the firm who has the competence and capabilities to act as the engagement partner. STUDY QUESTION 1. According to the definitions of SQCS 8, which of the following statements with respect to EQCR is correct? a. It should be completed before the report is released. b. It is a post-issuance review of a specific engagement. c. It should be conducted by the engagement partner. d. It should be conducted by a suitably qualified external person REQUIREMENTS SQCS 8 contains the following presumptively mandatory requirements related to EQCR. Presumptively mandatory requirements are signaled in the professional standards by the word should. Practitioners must comply with presumptively mandatory requirements in all cases in which they are relevant, except in rare circumstances when that procedure would not be effective in achieving the intent of the requirement. There are no unconditional requirements related to EQCR. 120

122 Under SCQS 8's requirements for EQCR, firms should establish: Criteria against which all A&A engagements should be evaluated to determine whether an EQCR should be performed. All engagements that meet those criteria should be subjected to EQCR. Policies and procedures setting forth the nature, timing and extent of EQCRs. These policies and procedures should require that the EQCR take place before the report is released. Policies and procedures requiring that the EQCR include: - Discussion of significant issues and findings between the EQCR reviewer and the engagement partner - Reading the financial statements or other subject matter of the engagement, and the draft report - Reviewing selected engagement documentation concerning significant judgments made by the engagement team, and its related conclusions - Evaluating the conclusions reached in drafting the report, and considering whether the draft report is appropriate Eligibility Criteria for EQCR Reviewers SQCS 8 addresses the criteria for eligibility of EQCR reviewers. It requires firms to establish policies and procedures to: Appoint EQCR reviewers Establish the EQCR reviewer's eligibility considering their: - Technical qualifications - Experience - Authority Establish the degree to which the EQCR reviewer can consult on the engagement without losing objectivity. Maintain the objectivity of the EQCR reviewer. These should include: - Satisfying the independence requirements for the engagement - Not being selected by the engagement partner, when this is practicable - Not otherwise participating in the engagement during the period under EQCR - Not making decisions for the engagement team - Freedom from considerations that would threaten the EQCR reviewer's objectivity - Replacement of the EQCR reviewer when his or her objectivity is likely to have been impaired EQCR Documentation SQCS 8 states that firms should establish policies and procedures that require documentation of the following on EQCRs: The procedures required by the firm's EQCR policies and procedures have been followed The EQCR has been completed before the report release date The reviewer is not aware of any unresolved matters that would lead him or her to believe that significant judgments and conclusions of the engagement team were inappropriate STUDY QUESTION 2. According to SQCS 8's requirements, EQCR should include: a. Reviewing all engagement documentation concerning judgments made by the 121

123 engagement team b. Consultation with the engagement partner during the conduct of the engagement c. Discussion of significant issues and findings between the EQCR reviewer and the engagement team d. Reading the financial statements or other subject matter of the engagement 1006 COMMENTARY Recent peer reviews indicate that many firms have a poor understanding of EQCR. The key elements to understand are that a EQCR is: A pre-report issuance procedure, not a post-issuance exercise such as an inspection Conducted by persons with no previous connection to the engagement The most common misconceptions or shortcomings observed by the peer review program include: Mistaking EQCR for pre-issuance review conducted by the engagement partner or other members of the engagement team Mistaking EQCR for post-issuance reviews, such as inspections that are conducted in connection with the firm's monitoring program Mistakenly believing that all engagements should be subjected to EQCR Mistakenly believing that professional standards mandate EQCR for certain types of engagements Failing to specify criteria for engagements to be subjected to EQCR. Writing inappropriate or impractical EQCR criteria, such as: - All A&A engagements. Such a criterion is far in excess of what would be practicable for most firms, and would be so expensive that it would not likely be observed consistently. - All audit (or, all review, or all full-disclosure) engagements. This criterion might be appropriate for a firm that does only one, or a very few of any of these engagements. For any firm that performs numerous such engagements, this would create the same problem as the criterion immediately above. - Only those engagements that in the engagement partner's judgment should be subjected to EQCR. This criterion is inappropriate because it is not specific enough and it leaves the decision entirely up to the engagement partner, which is contrary to the intent of the standard. EQCR criteria have to be objective enough that an engagement that falls within them will be readily determinable. However, it is legitimate to include one or more subjective criteria like this one along with other objectively determinable criteria, so that jobs that have some characteristic that is not covered by the firm's other criteria could be selected based on a subjective determination. This could be nothing more than the engagement partner's feeling of not "being comfortable" with the engagement. - Other criteria that the firm does not reasonably expect to comply with on a consistent basis. This would cause the firm to have a compliance deficiency in the application of its QC system, and could lead to finding or deficiencies in its peer review, especially if deficiencies are found in specific engagements that should have been detected by EQCR. It is legitimate to write EQCR criteria such that only once in a while would any engagement fall under them. This might not be appropriate for firms with diverse and complex practices, or for growing firms that are frequently taking on clients and engagements in new industries and levels of service. On the other hand, stable firms with specialty practices that do not often take on new clients and that seldom venture outside of their specialty areas might safely adopt criteria that it only rarely expects an engagement to meet (e.g., accepting an engagement 122

124 outside of its area of specialization). STUDY QUESTION 3. Common misconceptions or shortcomings surrounding EQCR noted by the AICPA Peer Review Program include all of the following except: a. All A&A engagements should be subjected to EQCR. b. Professional standards require specific types of engagements to undergo EQCR. c. EQCR should be conducted by persons having no previous connection to the engagement. d. Engagements should be selected for EQCR at the engagement partners' sole discretion. 123

125 CHAPTER 11: Peer Review Update 1101 WELCOME As the American Institute of Certified Public Accountants (AICPA) Peer Review Program continues to evolve, important changes affecting both the administrative processes, substantive requirements, and the qualification process for becoming a peer reviewer have been made. This chapter provides an update and overview of these changes and their practical implications for the peer review process LEARNING OBJECTIVES Upon completion of this chapter, the reader should be able to: List the objectives and capabilities of the AICPA's new electronic system for documenting and administering peer reviews Identify changes to previous peer review practice created by the revised Peer Review Program Manual Identify current requirements to qualify for service as a peer reviewer 1103 INTRODUCTION As the American Institute of Certified Public Accountants (AICPA) Peer Review Program continues to evolve, important changes affecting the administrative processes, substantive requirements, and the qualification process for becoming a peer reviewer have been made. These include: The implementation of the initial phases of an electronic system for documenting and administering peer reviews, called the Peer Review Information System Manager, or PRISM Revisions to the AICPA's Peer Review Program Manual (PRPM) that contain important changes to previous practice Additional training courses and new avenues for qualification to serve as a peer reviewer This chapter provides an update and overview of these changes and their practical implications for the peer review process PEER REVIEW INFORMATION SYSTEM MANAGER (PRISM) Background In mid-2013 the AICPA introduced a new electronic system for documenting and administering peer reviews. That system is called the Peer Review Information System Manager, or PRISM. The system does not change the substance of the peer review program, but it has important implications for the process of performing a peer review, both for peer reviewers, and for reviewed firms. PRISM is conceived as a system through which all peer review forms and documentation will eventually be filed on-line through the AICPA's Website. In its initial roll-out in 2013 and early 2014, however, its function was limited to two forms: the "Matter for Further Consideration" (MFC) form, and the "Disposition of Matters for Further Consideration" (DMFC) form. The MFC form concerns both reviewers and reviewed firms. This is the form that the peer reviewer uses to document potential departures from professional standards or deficiencies in a firm's system of quality control. It contains spaces for the reviewer's description of the matter, the firm's response, and the reviewer's further 124

126 comments. It also requires the reviewer to identify the matter by type of engagement or level of service (i.e. a review engagement, or a compilation that omits substantially all disclosures), the client's industry, the specific question number within the related AICPA peer review checklist, and a citation to the applicable professional standard. The DMFC form is used by the peer reviewer to summarize all of the MFC forms generated during the review, and to indicate their disposition into one of four categories: A matter that represents a deficiency or significant deficiency, such that it would cause the firm not to pass its peer review, and that would, therefore, appear in the peer review report A matter that is less serious, but still warrants the firm's attention, which is carried forward to another form the "Finding for Further Consideration" (FFC). This form is the reporting vehicle for most of the matters that arise in peer reviews A matter that is discussed with the firm but does not rise to the level of an FFC form. A matter that was cleared by discussion The AICPA envisions that PRISM will enable it to capture this data in an electronic database, giving it better ability to analyze problems in compliance with professional standards by level of service, industry, and specific standards. Having just come through its first season of implementation, however, this effort is still in its infancy. Practical Implications for the Peer Review Process The AICPA envisions that PRISM will eventually encompass peer reviews performed for both AICPA member and non-member firms. At present, however, only AICPA member firms are served by PRISM. Practical implications of this process include: Peer reviewers are required, for AICPA member firms, to complete the MFC forms on-line, through the AICPA's Website. Reviewed firms are required to log onto the AICPA's Website, respond to, and authenticate the MFC form. Reviewers are then required to log back onto the Website, make further comments if appropriate, authenticate the MFC, complete the DMFC, and transmit both to the AICPA. It is important, at the outset of a peer review, for both the reviewer and the reviewed firm to make sure that they can log onto PRISM within the AICPA Website. Any firm that has recently purchased a product, such as a publication or a continuing education course through the AICPA or CPA2Biz should be able to use the same user name and password to access PRISM. Those who do not, however, will need to register and establish a user name and password. This process can take 24 hours. It is therefore advisable to log onto the Website well in advance of the planned peer review date, to assure that its progress will not be delayed. In spite of extensive field testing, the PRISM system was plagued with numerous practical difficulties during its initial implementation season in late During that time, the system crashed more than once. Many users have commented that the system is quirky and less than intuitive to use. Peer reviewers have also noted that the process of revising an MFC, such as in response to a technical review note from their administering entity, is occasionally difficult, and involves tasking the reviewed firm to re-authenticate the revision through PRISM. Many reviewed firms say that they find this to be a cumbersome task. The AICPA is well aware of these issues, and is working to resolve them. Until that is accomplished, however, peer reviewers and firms both should be aware that the MFC process may take them somewhat more time and effort than they are accustomed to under the paper-based system. 125

127 STUDY QUESTION 1. Which of the following statements about the PRISM system is true? a. All firms undergoing a peer review are now required to respond to their MFC forms within PRISM. b. Firms required to use PRISM should assure that they are registered and have a valid user name and password well in advance of the planned date of the peer review. c. The PRISM system currently enables peer reviewers to file all peer review documentation on-line. d. The PRISM system introduces important substantive changes to the peer review process PEER REVIEW PROGRAM MANUAL UPDATES The PRPM is the primary source of the forms and guidance needed to perform a peer review. It is typically updated by the AICPA twice a year, in January and in March or April. The January revision has historically consisted largely of technical changes, with larger substantive changes being reserved for the later revision. The AICPA has instructed administering entities not to accept peer reviews submitted on outdated forms, even though the changes to those forms may have been minor. Thus, both firms who are undergoing peer review, and peer reviewer should be certain that they are using the revision that pertains to the period of their review. The April 2014 update to the PRPM contains some notable changes to previous practice. Those include: A requirement for the reviewer to file the firm's representation letter with the administering entity. Previously, reviewers were required to obtain the representation letter, but not to file it with the administering entity. Deletion of the requirement to file the team captain checklist for system reviews with the administering entity for most reviews. Reviewers are still required to fill out this checklist, but not to submit it. The Summary Review Memorandum and the Team Captain Checklist for system reviews, and the Review Captain Summary (previously known as the Review Captain Checklist) for Engagement Reviews are now available in Microsoft Excel trade; form, as an alternative to the existing Adobe Acrobattrade; format. Submission of these documents is acceptable in either format. The various checklists for reviews of engagements that are contained in the PRPM are useful tools for firms that are planning for their peer review. Because of the rapid pace at which professional standards are changing, firms should get the most current forms from the AICPA Website. STUDY QUESTION 2. The April 2014 revision of the PRPM contains which of the following changes to previous practice? a. The Review Captain Checklist for engagement reviews has been deleted. b. Peer reviewers are no longer required to fill out the Team Captain Checklist for system reviews. c. Peer reviewers are required to submit the Summary Review Memorandum for system reviews in Microsoft Excel trade; format. d. Peer reviewers are required to file the firm's representation letter as a part of the peer 126

128 review documentation submitted to the administering entity BECOMING A PEER REVIEWER The PRPM sets forth the requirements for qualification as a peer reviewer at the system and engagement review levels and for a system review team captain. In order to supply the growing demand for peer reviewers, the AICPA has made additional training courses and new avenues for qualification to serve as a peer reviewer available. General Qualifications In order to become a peer reviewer, a member should, at a minimum: Be an AICPA member in good standing. Be currently active in public practice at a supervisory level in the accounting or auditing function of a firm enrolled in the program, as a partner of the firm, or as a manager, or person with equivalent supervisory responsibilities. To be considered currently active, a reviewer should be presently involved in the accounting or auditing practice of a firm supervising one or more of the firm's accounting or auditing engagements or carrying out a quality control function on the firm's accounting or auditing engagements. Be associated with a firm (or all firms, if associated with more than one firm) that has received a peer review rating of pass on its most recent system or engagement review that was accepted timely, ordinarily within the last three years and six months. Have current knowledge of applicable professional standards, including knowledge about the rules and regulations pertaining to the industries of the engagements to be reviewed, including quality control and peer review standards. Have at least five years of recent experience in public accounting in the accounting or auditing function. Have provided the administering entity with information that accurately reflects the qualifications of the reviewer including recent industry experience, and which is updated timely. Qualifications for System Review Team Captain or Engagement Review Captain A team captain is required to meet all of the general qualifications for a peer reviewer listed above. In addition, a team captain must: In the case of a system review, be a partner or owner. Have completed peer review training that meets the requirements established by the board. Complete peer review training that meets the requirements established by the board. In addition to peer-review specific training, peer reviewers should obtain at least 40 percent of the AICPA required continuing professional education in subjects related to auditing, accounting and quality control. This includes taking at least 8 hours in any one year, and 48 hours every three years. Ensure that all team members have the necessary competencies and capabilities to perform their responsibilities, and that they are adequately supervised. Training for Initial Qualification Three options are available to initially qualify as a system review team captain: Complete the AICPA two-day introductory reviewer training course, "How to Conduct a Review Under the AICPA Practice Monitoring Program" in live seminar format. 127

129 Complete a combination of theory and practice qualifying training consisting of one of the following: - Day 1 of the live seminar "How to" course, plus participation in the Mentoring Program - The self-study "How to" course, plus participation in the Mentoring Program Pass a "Peer Review Competency Exam" and either: - Participate in the mentoring program, or - Take day 2 of the live seminar "How to" course OBSERVATION The mentoring program is a new program in which potential peer reviewers gain qualifying experience by serving alongside an experienced peer reviewer in the planning and conduct of peer reviews. The AICPA maintains a list of approved mentors. Because the mentoring program is in its initial stages, there are very few mentors nationwide, and mentors are not currently available in many states. Three options are available to initially qualify as a review captain for an engagement review: Meet the initial qualifications for a system review team captain. Complete Day 1 of the live seminar "How to" course. Complete the live seminar "How to Perform an Engagement Review Under the AICPA Practice Monitoring Program." Training for Ongoing Qualification To maintain qualification as a system review team captain, eight hours of continuing education in peer review training is required within three years prior to the commencement of a review. Options for obtaining that training include: Attendance at the AICPA's annual National Peer Review Conference Completion of the "AICPA Advanced Course: Overview of the AICPA Peer Review Program Standards" Participation in eight hours of approved peer review webcasts Completion of either Day 1 or Day 2 of the "How to" course. Note that this option will not be available after May 2015 To maintain qualification as an engagement review captain, eight hours of continuing education in peer review training is required within three years prior to the commencement of a review. Options for obtaining that training include: Meeting the ongoing qualification requirements for a system review team captain, or Completing the live seminar "How to Perform an Engagement Review under the AICPA Practice Monitoring Program" Entry Considerations As with any type of specialized engagement, performing peer reviews involves a learning curve that reviewers must absorb to enter the business, and fixed costs (notably continuing education) to stay in. Accordingly, it usually is not economical to perform only one or two peer reviews a year. The balance point in this equation depends to a large extent on the size and nature of the peer reviews. On the one hand, a reviewer's learning curve for performing engagement reviews is much less than for performing system reviews. On the other hand, the fees for engagement reviews are almost always less than for system reviews. A reviewer can usually expect that his or her first review will come back from the administering entity with one or more "technical review notes." These notes may ask the reviewer to clarify certain matters related to the review, to provide additional documentation, or, less frequently, to rewrite a report or other piece of review 128

130 documentation. Resolving these notes can be time-consuming. As a result, firms usually expect that they will not realize their full rates on their first few peer reviews. However, the cost to perform any peer review should not be judged by the firm's first or even second experience with the particular level of review. Ordinarily, the number and frequency of technical review notes tapers off as the reviewer gains experience. After this tapering off occurs, a firm can feel that it has mastered the learning curve and can better assess its true costs for performing reviews. STUDY QUESTION 3. The minimum requirements to become a peer reviewer include which of the following? a. Be associated with a firm that has received a peer review rating of pass on its most recent system or engagement review within the last five years. b. Be currently active in public practice as a partner of a firm. c. Have at least three years of recent experience in public accounting in the accounting or auditing function. d. Be an AICPA member in good standing. 129

131 CHAPTER 12: Using the Work of Internal Auditors 1201 WELCOME In certain circumstances it is efficient and effective to rely on the work of internal auditors while performing an audit engagement. The internal audit function can be used to gather audit evidence. Individual internal auditors can provide direct assistance under the direct supervision of the external auditor. Statement on Auditing Standards 128, Using the Work of Internal Auditors, describes the requirements for considering whether it is appropriate to rely on the internal auditors. The nature and extent of work that can be provided by internal auditors is covered. The goal of the standard is to prevent over use or undue use of internal audit LEARNING OBJECTIVES Upon completion of this chapter, the reader should be able to: Identify the presumptively mandatory requirements in the standard Describe the factors used to evaluate whether the internal audit function can be used to obtain audit evidence Describe the nature and extent of work the internal audit function can provide in obtaining audit evidence Describe the review and reperformance that should be performed by an external auditor for work performed by the internal audit function in obtaining audit evidence Describe the factors used to evaluate whether internal auditors can be used to provide direct assistance Describe the nature and extent of work that can be provided as direct assistance by internal auditors Describe the review and testing that should be performed by the external auditor for work provided as direct assistance by internal auditors 1203 INTRODUCTION In February 2014, the Auditing Standards Board issued Statement on Auditing Standards Number 128, Using the Work of Internal Auditors (SAS 128) PRESUMPTIVELY MANDATORY REQUIREMENTS SAS 128 contains a number of presumptively mandatory requirements. These are identified by the use of the word should in the standard. The SAS literature specifies two categories of professional requirements, each of which creates a certain degree of responsibility for accountants. The two levels are unconditional requirements and presumptively mandatory requirements. The words must, should, and should consider now have a very specific meaning. As these phrases are encountered in the literature, it is important to remember the definitions. When a SAS identifies an unconditional requirement, the accountant has to comply with that requirement in all situations for which the unconditional requirement applies. The word must or is required indicates such an 130

132 unconditional requirement. When the SAS literature identifies a presumptively mandatory requirement, the accountant has to comply with that requirement in those situations for which the presumptively mandatory requirement applies. In rare occasions, the accountant may depart from such a presumptively mandatory requirement only if the accountant documents in the workpapers the justification for such departure and how alternative procedures achieve the same objectives. The word should indicates such a presumptively mandatory requirement. Another category of requirement is something that uses the phrasing of should consider. In this situation the accountant is required to give consideration to the procedure but is not required to carry it out. SAS 128 does not have any unconditional requirements. It does use the word should indicating a presumptively mandatory requirement 26 times in the requirements section while the word should consider is used twice. The standard addresses the situations when the external auditor intends to use the work of internal auditors either to obtain audit evidence or to provide direct assistance under supervision of the external auditor. It will not apply if the entity does not have an internal audit function, or the external auditor will not be using the internal auditor to either gather audit evidence or provide direct assistance. The introduction to the standard contains a reminder that the external auditor has sole responsibility for the audit opinion. That responsibility is not reduced by any work performed by the internal audit function. The standard provides a framework to guide the external auditor's judgment in order to prevent overuse or undue use of work performed by internal auditors. The new standard will be effective for audits of financial statements for periods ending on or after December 15, For most CPA firms, it will first apply to audits of December 31, 2014 financial statements. The requirements are broken down into three sections: Determining whether the internal audit function can be used to obtain audit evidence and to what extent Determining whether the internal auditors can be used to provide direct assistance and to what extent Documentation 1205 GATHERING AUDIT EVIDENCE DETERMINING WHETHER, AND IN WHICH AREAS, THE INTERNAL AUDIT FUNCTION CAN BE USED TO OBTAIN AUDIT EVIDENCE AND TO WHAT EXTENT Evaluating the Internal Audit Function To determine whether the work of internal auditors can be used to obtain audit evidence, the external auditor should assess: The extent that the organizational status and policies and procedures support objectivity of the internal auditors Competency of the internal audit function Whether the internal audit function uses a systematic and disciplined approach, including quality control The application and other explanatory material (AOEM) indicates factors such as organizational status, lack of conflicting responsibilities, lack of constraints on a function, and membership in appropriate professional bodies as a few factors entering into assessment of objectivity. OBSERVATION The application and other explanatory material (AOEM) contained in the standard is located after the section that contains all the requirements. Even though the AOEM does not contain any presumptively mandatory requirements, the auditor needs to be familiar with the material and 131

133 know what impact it may have on the audit. Competence refers to gaining and maintaining the knowledge and skills necessary for the function as a whole to perform assigned tasks diligently and with an appropriate level of quality. The AEOM indicates factors that demonstrate applying a systematic and disciplined approach would include use of documented internal audit procedures, risk assessments, and work programs, all of which are appropriate in relation to the size of the internal audit function given the complexity of the entity. Other factors would be whether the function has appropriate quality control policies and procedures. Those would address factors such as leadership, human resources, engagement performance, etc. There may be quality control guidance provided by professional bodies for internal auditors that have been implemented. STUDY QUESTION 1. When determining whether the work of the internal audit function can be used to obtain audit evidence, an external auditor should consider all of the following factors except: a. Relative efficiency of work performed by internal audit function in relation to external audit staff b. Competency of the internal audit function c. Whether the internal audit function uses a systematic and disciplined approach d. Extent to which several factors support objectivity of the internal audit function Determining the Nature and Extent of Work of the Internal Audit Function That Can Be used to Obtain Audit Evidence The auditor should consider the work that has been performed by the internal audit function or is planned to be performed in relation to the external auditor's overall audit strategy and audit plan. While assistance can be provided by an entity's internal audit function, it is important to note that the external auditor should make all significant judgments in the audit engagement. This would include items such as: Assessing risks of material misstatement Evaluating: - Sufficiency of test performed - Appropriateness of management's assessment of going concern assumption - Significant accounting estimates - Adequacy of disclosures Those matters along with other significant judgments would not be appropriate areas for the internal audit function to address. To prevent undue use of the internal audit function, the external auditor should plan to use less work of the function and perform more of the work directly when: More judgment is needed to plan or perform the audit procedures or evaluate the resulting audit evidence Assessed risk of material misstatement at the assertion level is higher, particularly regarding significant risks Less support for the objectivity of internal auditors is provided by their status in the organization and their policies and procedures 132

134 Lower levels of competence exist in the internal audit function The external auditor should also evaluate whether, in total, using the work of the internal audit function still leaves the external auditor in the position of being sufficiently involved in the audit considering the external auditor has sole responsibility for the opinion on the financial statements. The AOEM indicates this assessment is based on a qualitative assessment of external auditor's responsibility to address all requirements of performing an audit. A quantitative assessment, such as calculating the portion of total hours on the engagement that were performed by internal auditors, would not be appropriate. Other sections of the SASs address the auditor's obligation to communicate planned scope and timing of the audit to those charged with responsibility for governance of the organization. The auditor should include in those communications a discussion of the planned use of the internal audit function to obtain audit evidence. Using the Work of the Internal Audit Function in Obtaining Audit Evidence The external auditor should discuss the planned use of work performed by the internal audit function if the auditor plans to use at work in obtaining audit evidence. The external auditor should perform sufficient procedures on the work performed by the internal audit function that will allow the external auditor to evaluate whether: Work performed is properly planned, performed, supervised, reviewed, and documented Sufficient appropriate evidence was gathered which in turn allowed the internal audit function to draw reasonable conclusions Conclusions reached by internal audit function are appropriate and reports prepared by the function consistent with results of the work The AOEM indicates this overall review would allow the external auditor to evaluate the overall quality of the work and the objectivity used when performing work. The nature and extent of the procedures performed in this review would be based on the external auditor's assessment of: Amount of judgment involved in planning and performing the procedures and in evaluating the resulting audit evidence Assessed risk of material misstatement Level of objectivity provided by the functions organizational status and its policies and procedures Competency level of the internal audit function The AOEM indicates this review could include procedures such as: Making inquiries of appropriate individuals in the function Observing procedures performed Reviewing work programs and working papers Apart from the review above, the external auditor should also reperform some of the work of the internal audit function for that work which is used as a part of obtaining audit evidence. The AOEM indicates reperformance in this context involves the external auditors independently performing procedures to validate conclusions already reached. This could be accomplished either by examining items that have already been tested by the internal audit function or examining other items. Reperformance provides more persuasive evidence about the adequacy of the work performed than the review procedures described previously. The external auditor is more likely to focus reperformance on areas where: More judgment is necessary in performing the work 133

135 More judgment is needed to evaluate the results, or There is higher risk of material misstatement OBSERVATION The standard does not indicate the extent of reperformance that is necessary. The extent would therefore appear to be a matter of professional judgment. The standard does say it is not necessary to have some reperformance in every area. It does indicate the areas subject to reperformance would be determined based upon professional judgment with an emphasis on higher risk areas. STUDY QUESTION 2. Which of the following is the most accurate description of when the external auditor reperforms work completed by internal auditors? a. Reperformance is required when the internal audit function has an impaired objectivity. b. Reperformance is a presumptively mandatory requirement when competency of the internal audit function is not assessed at a very high level. c. Reperformance is required in each area where the internal audit function has performed work gathering audit evidence to support the audit opinion. d. Reperformance is required when the internal audit function has performed work gathering audit evidence but the areas to be reperformed are based on professional judgment of the external auditor DIRECT ASSISTANCE DETERMINING WHETHER THE INTERNAL AUDIT FUNCTION CAN BE USED TO PROVIDE DIRECT ASSISTANCE AND TO WHAT EXTENT Determining Whether Internal Auditors Can Be Used to Provide Direct Assistance for Purposes of the Audit If the external auditor plans to use internal auditors to provide direct assistance, external auditor should evaluate the following for those internal audit staff expected to assist: Existence and significance of threats to the objectivity of internal auditors who will be assisting Any safeguards applied to reduce or eliminate those threats Level of competence of the internal auditors who will be providing the direct assistance An external auditor should not use an internal auditor for direct assistance if the internal auditor lacks either the necessary objectivity or necessary competence to perform the proposed work. Determining the Nature and Extent of Work That Can Be Assigned to Internal Auditors Providing Direct Assistance There are several factors that would enter into determining the nature and extent of work that internal auditors may provide through direct assistance. These factors would also affect the nature, timing, and extent of supervision and review provided by the external auditor. The external auditor would consider: Existence and significance of threats to objectivity 134

136 Effectiveness of safeguards applied to reduce or eliminate those threats Level of competence of the internal auditors who will be providing the direct assistance Assessed risk of material misstatement Amount of judgment involved in planning and performing the audit procedures and the judgment involved in evaluating the resulting audit evidence The AOEM indicates the guidance mentioned earlier about determining the nature and extent of work the internal audit function can provide in regards to gather audit evidence also applies to using internal auditors to provide direct assistance. The AOEM indicates there are areas where it would be inappropriate to have internal auditors provide direct assistance. The only two examples provided are: Inquiries regarding identification of fraud risk and procedures to respond to those risks directed towards entity personnel and those charged with governance Determining unpredictable audit procedures OBSERVATION The AOEM provides no further explanation of what areas would be inappropriate to have internal auditors provide direct assistance. The common thread between the two examples provided is that both items require high levels of professional judgment in determining a procedures and evaluating the results. Recall a previous section indicated an external auditor is obligated to include in communication to those charged with governance appropriate comments about using the internal audit function to gather audit evidence. Likewise, when the external auditor intends to use internal auditors to provide direct support, plans to do so should be included in the communication with those charged with governance. Using Internal Auditors to Provide Direct Assistance The external auditor's assessment of whether the internal auditor's involvement leaves the external auditor being sufficiently involved also applies when internal auditors are used to provide direct assistance. The external auditor should evaluate if the direct assistance still leaves the external auditor sufficiently involved. The AOEM indicates only one assessment needs to be made if both the internal audit function is used for gathering audit evidence and internal auditors used for direct assistance. Before internal auditors are used to provide direct assistance, the external auditor should receive written acknowledgment from either management or those charged with governance that the internal auditors involved will be allowed to follow the external auditor's instructions. Acknowledgment should also indicate the entity will not intervene in the work performed by the internal auditor in direct assistance. The AOEM indicates this acknowledgment could be in either the audit engagement letter or in a separate communication. The external auditor should direct, supervise, and review the direct assistance performed by internal auditors. The nature timing and extent of the supervision and review should be responsive to the factors considered in determining what work to assign to the internal auditors. Recall this included an assessment of the threats to the internal auditor's objectivity, pertinent safeguards, level of competence, assessed risk of material misstatement, and amount of judgment involved in the procedures. The external auditor should direct the internal auditor to bring identified accounting and auditing issues to the attention of the external auditor. Review procedures of the work performed by internal auditors should include testing some of the work that was performed. 135

137 OBSERVATION The standard does not provide any further guidance regarding the nature or extent of testing the work performed during direct assistance. Implications from the AOEM suggest the review would be at least the same as provided for the firm's own staff with the addition of some specific retesting. As with the reperformance requirement related to gathering of audit evidence, the nature and extent of retesting would be based on professional judgment. Cautious wisdom would recommend specific documentation for the reasoning behind the nature and extent of retesting and reperformance that was considered necessary. The AEOM indicates the supervision and review of direct assistance provided by the internal auditors needs to be sufficient for the external auditor to be satisfied the appropriate audit evidence has been obtained to support conclusions. The nature and extent of the review may be different than that provided for members of the engagement team because individuals in the internal audit function are not independent. While supervising and reviewing direct assistance provided by internal auditors, the external auditor should remain alert for indications that previous evaluations of threats to the internal auditor's objectivity, pertinent safeguards, and level of competence are no longer appropriate. Documentation If the external auditor uses the work of the internal audit function to obtain audit evidence, the external auditor should document the following: Results of evaluation of: - The extent that the organizational status and policies and procedures supports objectivity of the internal auditors - Competency level of the internal audit function - Whether the internal audit function uses a systematic and disciplined approach, including quality control Nature and extent of the work used. This would include the period covered and the results of the work. The basis for making those decisions would be addressed also. External auditor's procedures performed to evaluate the adequacy of the work used Procedures used by the external auditor to reperform some portion of the work performed by the internal audit function If the external auditor uses the work of the internal auditors to provide direct assistance, the external auditor should document the following: Evaluation of - The existence and significance of threats to the objectivity of internal auditors who will be assisting - Any safeguards applied to reduce or eliminate those threats - Level of competence of the internal auditors who will be providing the direct assistance Basis of the decision for the nature and extent of direct assistance performed by the internal auditors Nature and extent of the external auditor' review of the internal auditors work Nature and extent of the external auditor's testing of the work performed by the internal auditors Working papers prepared by the internal auditors while providing direct assistance on the engagement Recall the comment that relying on the internal audit function to either gather audit evidence or having internal auditors provide direct assistance does not change the external auditor's sole responsibility for the audit opinion expressed. With that in mind, if the external auditors use internal audit for either gathering audit evidence or providing direct assistance, the external auditor should document an evaluation whether using work of the 136

138 internal auditors still leaves the external auditor in the position of being sufficiently involved in the audit. STUDY QUESTION 3. Which of the following statements about documentation requirements is most accurate? a. The external auditor is required to prepare a quantitative calculation of the extent of involvement on the engagement by the internal audit function. b. The external auditor is required to document that involvement by the internal audit function still leaves external auditor in the position of being sufficiently involved in the audit. c. If the internal audit function is tasked with gathering audit evidence regarding an evaluation of the adequacy of disclosures, such evaluation should be documented. d. If the involvement by the internal audit function or individual internal auditors exceeds a specified threshold of total effort on the engagement (based on qualitative and quantitative factors) the external auditor is required to document the level of involvement does not impair the external auditor's ability to support the audit opinion. 137

139 CHAPTER 13: Private Company Council Relief from Some GAAP Rules for Private Business 1301 WELCOME Smaller companies and the accountants who serve them have long wished for relief from some of the accounting requirements which are perceived to be more helpful to large entities than small entities. FASB has established the Private Company Council (PCC), which will identify specific alternatives for certain private companies. There specific areas have been identified by PCC and approved by FASB. This chapter will describe these simpler alternatives and explain what entities may apply each option LEARNING OBJECTIVES Upon completion of this chapter, the reader should be able to: List the types of entities which generally may elect to follow the accounting treatments approved by FASB and PCC Identify the differential factors distinguishing the needs of users of financial statements of private companies compared to public companies Describe the way FASB and PCC will look at recognition, measurement, disclosure, display, effective date, and transition of accounting alternatives Describe the alternative accounting, effective date, and transition for the accounting alternatives addressing goodwill after initial recognition; receive-variable, pay-fixed interest rate swaps; and treatment of lessor company that leases to another private company when both are under common control Identify the impact a private company electing to follow an accounting alternative may have on the auditor's report or accountant's report for a compilation our review 1303 INTRODUCTION The last couple generations of accountants have been yearning for "Little GAAP." While that phrase may not have been defined with any precision, the underlying wish has been to find an alternative to the ever increasing complexity of accounting rules with evermore voluminous disclosure requirements. While that long dreamed of place may never be realized, there is a new option within the GAAP framework for private businesses. The Financial Accounting Standards Board (FASB) has created the Private Company Council (PCC). In one sentence, the PCC will carve out for private companies certain exceptions from some GAAP requirements. The PCC will identify specific issues for specific relief and develop proposed rules to address those carve outs. Those proposals are developed in consultation with FASB. After going through a comment period, the rules will be considered by FASB, and if approved will be issues as an Accounting Standards Update (ASU). Those changes will then be incorporated into the Accounting Standards Codification. If that process sounds familiar, it is because that's the procedure currently in use for other changes in accounting rules. The PCC has proposed and FASB has approved three Accounting Standards Updates which allows simplified 138

140 accounting on an issue for private companies. The issues are: Accounting for goodwill after acquisition Accounting for receive-variable pay-fixed interest rate swaps Consolidating certain variable interest entities involved with leasing These will be discussed in turn ITEMS ON THE AGENDA In the summer of 2014, there are two items on PCC's agenda list. The first is Issue No , Definition of a Public Business Entity (phase 2). The second item is Issue No A, Accounting for Identifiable Intangible Assets in a Business Combination. The project is addressing the accounting for identifiable intangibles, such as non-compete agreements and customer-related intangibles. There are several views under consideration regarding which would be recognized and the criteria for doing so FRAMEWORK FOR PRIVATE COMPANY COUNCIL In December 2013, FASB published Private Company Decision-Making Framework A Guide for Evaluating Financial Accounting and Reporting for Private Companies. This guide provides the framework for making decisions on what GAAP rules will be revised for private companies. A more technical explanation is the guide will be used to guide decision making when considering alternatives for private companies reporting under GAAP in terms of recognition, measurement, disclosure, display, effective date, or transition guidance. As a refresher for accountants who don't focus on the concepts behind accounting rules or the explanations for decisions, here is a brief comment on some common terms: Recognition when to include transactions within financial statements; in other words what activity or balances are recorded Measurement the amount to use when recording transactions Disclosure -the amounts and explanations that appear in notes Display how items are presented in the basic financial statements. This would include how items are grouped and subtotaled. What items to include in gross margin or categorization of items as current or long-term assets are two examples of display issues The guide defines private companies to exclude not-for-profit entities as well as employee benefit plans. In broad terms, public companies are excluded. Specifically, business entities are not able to use alternative accounting approaches from PCC if they meet any of the following criteria: Financial statements are filed or furnished to the Securities and Exchange Commission (SEC). This would include entities whose financials are included as a part of a filing with the SEC. Financial statements are filed or furnished to another regulatory agency under the 1934 securities act. There are three more conditions dealing with business entities that have certain kinds of securities traded over-the-counter market or the entity is expected to issue securities. Precise details of those three criteria aren't needed for this chapter. On a standard-by-standard basis, FASB and PCC may change the boundaries of what entities may or may not elect to follow a particular rule. The guide indicates that it is possible that some public companies could be included within the scope of a specific pronouncement. It is also possible that not-for-profit organizations, or employee benefit plans could be included. In one of the three approved ASUs, certain private companies were 139

141 defined out of eligibility to elect the option. Differential Factors FASB and PCC have determined there are five differential factors that identify why users of financial statements from private companies may have different needs than users of financial statements of public companies. These differential factors also affect the cost-benefit consideration of financial reporting of private companies compared to public companies. The five factors and a brief comment on each are: Number of primary users and their access to management There are generally far fewer users of financial statements from private companies than public companies. Those users typically would have better and more frequent access to management. This has an impact on disclosures. If more information is needed on a particular disclosure, it would be very easy for a user to call management of a private company and quickly get an answer. This has less impact on recognition and measurement. OBSERVATION The implication of this differential factor would be to allow reduced disclosure for private companies. Investment strategies of primary users Investors in public companies are able to liquidate investments quickly through the stock market. Investors in private companies will need to rely on the entity's future cash flows to cover debt payments or dividend distributions. This creates a different focus. Investors in private companies are very interested in cash flow and less concerned about non-cash accounting issues. Investors in public companies are interested in cash flow but also are focused on broader metrics, such as fair value, and other broad accounting issues. OBSERVATION Since investors in private companies are less focused on matters such as fair value and other non-cash items, we can expect to see simplification in non-cash areas. That is quite visible in the first three pronouncements. They deal with amortizing goodwill instead of annual evaluations for impairment, simplified treatment for the most common type of interest rate swap, and not consolidating a variable interest entity (VIE) when that entity is leasing items to the private company. The last item, not consolidating certain VIEs, illustrates the point. Lenders and investors are concerned about the cash flow and assets of the entity that will repay their loan or provide dividends. They aren't as concerned about the cash flow of VIEs. This would suggest certain other areas will not be significantly modified for private companies, such as tax disclosures, related party activity, and equity transactions. Ownership and capital structure public and private companies have different ownership structures. Private companies have very different tax focuses and may have more related party transactions with nonconsolidated entities and multiple entities under common control. By contrast, corporations typically are structured as a passthrough. This could lead to different information needs, possibly with private companies needing more disclosures of related party transactions and unconsolidated entities. Accounting resources Generally private companies will have fewer accounting personnel and those staff have less specialized experience. Private companies are less likely to participate in the standard-setting process and less likely to monitor changes in the accounting requirements. Generally public companies will have more staff resources in accounting with specialized knowledge along with staff that is dedicated to monitoring changes in accounting requirements and how those changes affect the accounting of the corporation. This may have an implication on effective dates and transition guidance. The guide suggests it may be necessary to focus on increased plain-english guidance and reaching out to private company staff and 140

142 stakeholders to provide more information. The guide suggests these implications could carry over to smallersized public companies. OBSERVATION FASB pronouncements generally allow additional implementation time for nonpublic entities. The implication of this differential factor would suggest additional time for private companies to implement standards and perhaps simpler transition guidance. An illustration of the simpler transition guidance would be to allow a private company the option to implement a change as of the first of the current fiscal year instead of applying a full retroactive restatement of the earliest year presented. Learning about new financial reporting guidance Feedback provided to FASB and PCC indicated many private company preparers learn about new pronouncements from their auditors, which learning typically takes place during planning or preparation for the current year audit. In contrast, quarterly reporting requirements, including external reviews, push public companies to learn about and apply new pronouncements earlier than private companies. Implication of this differential factor is private companies need additional time to apply new standards. One factor to ease the timing and learning load would be to include in new pronouncements illustrative examples for common private company fact patterns. OBSERVATION The implication of this factor would be delayed implementation for private companies. These differential factors point to the likely direction of PCC revisions to GAAP to ease the accounting and disclosure load on private companies. Determining Recognition and Measurement Guidance PCC will look at the relevance to users combined with the cost and complexity in evaluating recognition and measurement guidance. A few of the questions to consider in evaluating relevance to users would include: Does the transaction, event, or balance affect cash flow or some major reference point such as adjusted EBITDA? For lending decisions or loan monitoring, do users take into consideration the item under consideration? Some of the questions to consider in evaluating the cost and complexity would include whether outside assistance is required at substantial cost, whether changes are necessary to internal systems, and whether the treatment is costly to audit, review, or compile. PCC and FASB will place more weight on the issue of relevance to users than cost and complexity. Determining Disclosure Requirements If disclosures provide relevant information to typical users, PCC generally won't consider disclosure alternatives for private companies. A few of the factors that will be considered for disclosure alternatives are: Typical needs of lenders and investors who are using private company financial statements Relevance of the measurement attribute to typical users of the financial statements Ability of users to obtain additional information directly from management or preparers of financial statements Although of less importance, PCC will consider the resource constraints faced by many private 141

143 companies and cost for external accountants along with private companies concerned about possibly disclosing proprietary information Determining Display Requirements As a general matter, private companies and public companies should apply the same financial statement display. The presumption is information presented on the face of the financial statements is relevant to most users. A few of the factors that would be considered are whether private companies already have an exception from the pertinent display requirement and whether the information is a focus of typical users of private company financial statements. Determining the Effective Date of Guidance Generally, the effective date of pronouncements for private companies will be one year after the effective date for public companies. In addition, generally new pronouncements will be effective first for the annual period and then for the interim periods of the following year. The effective date may be accelerated if there's an immediate need for the information, or may be postponed further if the pronouncement is complex or requires retrospective application. Determining the Transition Method for Applying Guidance The FASB and PCC will consider whether there is justification to allow private companies to apply modified retrospective method when public companies are required to use the full retrospective method. Consideration will then be given to whether prospective application would be allowed. STUDY QUESTION 1. Which of the following best describes factors that will be used by FASB and PCC in evaluating accounting alternatives? a. The cost and complexity of an accounting issue would be given priority over the userrelevance of the information provided. b. Identifying areas where users of private company financial statements have different needs in terms of display requirements will be a priority. c. Effective dates will typically be the same for private companies as for public companies. d. For disclosures, consideration will be given to whether users of private company financial statements have higher levels of access to management than users of public company financial statements GOODWILL In January 2014, FASB issued Accounting Standards Update No , Intangibles Goodwill and other (Topic 350) Accounting for Goodwill - a consensus of the Private Company Council. Stakeholders of private companies provided PCC with feedback indicating the benefits of goodwill accounting after initial recognition don't justify the costs. Users of private company financial statements provided feedback they do not consider the information to the decision-useful. The reason is that users generally disregard goodwill accounting in analyzing the financial condition and results of operations of a private company. Preparers and auditors provided feedback about the high cost and complexity in addressing goodwill impairment testing. 142

144 OBSERVATION Consider that feedback from stakeholders in relation to the comments earlier about the criteria used to assess whether to provide alternatives to private companies. Users of financial statements indicated they do not use goodwill amounts and goodwill impairment in assessing private companies. Preparers and auditors indicated the complexity and cost of addressing goodwill accounting was unusually high. That would obviously put a high priority on goodwill as a topic for providing an alternative for private companies. This ASU does not apply to public business entities, not-for-profit entities, and employee benefit plans. A private company that chooses to apply this ASU is obligated to follow all of the measurement, derecognition, presentation, and disclosure requirements in it. A private company can elect to follow the guidance of this ASU. If it so chooses, goodwill should be amortized on a straight-line basis over 10 years. An amortization term less than 10 years may be used if the entity demonstrates a shorter useful life is more appropriate. An entity electing this approach is required to make an accounting policy election to test goodwill for impairment. The goodwill may be tested for impairment at either the entity level or the reporting unit level. Goodwill should be tested for impairment when a triggering event occurs which indicates the fair value of an entity or the reporting unit may be below its carrying amount. When a triggering event occurs, the entity has the option to first assess qualitative factors to determine whether a quantitative impairment test is necessary. If the result of the qualitative assessment is more likely than not that goodwill is impaired, then the entity must perform the quantitative test. In the quantitative test, the entity compares the fair value of the entity or reporting unit to the carrying amount including goodwill. Any excess of carrying amount (including goodwill) over the fair value results in a goodwill impairment loss. That quantitative test can be performed at either the entity level or reporting unit level. The impairment loss cannot exceed the goodwill. Presentation Total goodwill net of accumulated amortization and impairment should be presented on a separate line in the statement of financial position. Amortization of goodwill and impairment losses should be included within continuing operations, unless the amortization of goodwill loss is related to a discontinued operation, in which case the expense should be included in discontinued operations on a net-of-tax basis. Disclosure Some of the disclosure requirements for this ASU are: Weighted average amortization period in total and for each major business combination Gross amount of goodwill, accumulated amortization, and accumulated impairment loss Total amortization expense for the year Each goodwill impairment loss should have the following disclosed: Description of the facts and circumstances leading to the impairment Amount of the impairment loss Method of determining the fair value of the entity or reporting unit Describe the caption in the income statement where the impairment loss is presented 143

145 Effective Date The stated effective date is for annual periods beginning after December 15, For most private companies, this would be for the December 31, 2015 financial statements. Early application is permitted, including any financial statements that have not yet been made available for issuance. The accounting alternative should be applied prospectively to goodwill as of the beginning of the year of adoption and for goodwill recognized in the year. OBSERVATION The prospective implementation and option for early application allows substantial latitude for private companies compared to what is required without the alternative treatment INTEREST RATE SWAPS In January 2014, FASB issued Accounting Standards Update No , Accounting for Certain Receive- Variable, Pay-Fixed Interest Rate Swaps Simplified Hedge Accounting Approach - a consensus of the Private Company Council. Frequently private companies will want to use fixed-rate loans for funding their operations. This allows for a predictable cash flow over the life of the loan. However, borrowing by businesses or by an individual for a business purpose is normally categorized as a commercial loan, which means lenders will rarely make a fixed loan and instead insist on a variable rate. To smooth out the interest and mitigate the risk of fluctuations in payments, private companies can enter into an interest rate swap. Such a transaction is tied to the balance on the loan as it amortizes over its life and is also linked to the floating rate. The swap agreement will result in a payment to the private company at a variable rate (equal to or extremely close to the loan being hedged) and a payment made by the private company at a specified fixed rate. The variable and fixed portions of the swap agreement are netted with periodic settlement of the difference. This means that as the interest rate on the underlying loan goes up or down, the net amount of the swap will go the opposite direction which leaves the private company in the position of essentially having a fixed-rate loan. The recognition and measurement of such an interest rate swap is addressed in the derivatives topic in GAAP. Feedback to the PCC from private companies indicates some companies are choosing to avoid the hedge accounting provisions of GAAP due to complexity. This increases income statement volatility. Other stakeholders have raised concerns regarding the relevance and cost of determining the fair value of such a swap. Recognition and Measurement This ASU provides private companies with a hedge accounting alternative in certain circumstances. The alternative treatment in this ASU is available to private companies. Public business entities, not-for-profit entities, and employee benefit plans are defined to be outside the scope. In addition, financial institutions are excluded. This would include banks, savings and loan associations, savings banks, credit unions, finance companies, and insurance entities. OBSERVATION The careful tailoring of what entities are allowed to use this alternative illustrates the care that PCC is using in defining scope. On one hand, this adds an extra degree of complexity due to tracking the scope of each provision. On the other hand, it provides increased flexibility to precisely tailor accounting alternatives based on the nature of each issue. As a general description, this alternative for simplified hedge accounting is for a swap which has the purpose of converting a variable-rate borrowing into fixed-rate. The interest expense on the income statement is comparable to the amount which would result if the private company had a fixed-rate borrowing arrangement 144

146 instead of a variable-rate arrangement plus a swap. This alternative may be used for a cash flow hedge of variable-rate borrowing with a receive-variable, pay-fixed interest rate swap if all of the following conditions are met: The variable rate on the swap and the borrowing are based on the same index with the same reset period. For example both the borrowing and swap are based on the three-month London Interbank Offered Rate (LIBOR). The swap is what is generally considered to be a "plain-vanilla" swap. In addition there is no floor or cap on the variable interest rate portion of the swap unless that floor or cap matches the borrowing rate. Repricing and settlement dates for the swap and borrowing either match or differ by only a few days. Fair value of the swap at its inception is either at or near zero. The notional amount of the swap matches the principal amount of the borrowing being hedged. Notional amount refers to the reference number or reference point specified in the agreement upon which the interest rates are applied. It is acceptable to hedge less than the full amount of the principal amount. The interest payments on the borrowing are designated as hedged. An entity applying this alternative may assume there is no ineffectiveness for qualifying swaps designated as a hedge. Under this alternative, a private company can measure the designated swap at its settlement value instead of fair value. One component of using settlement value is that it does not include the risk of nonperformance, which would be considered in determining fair value. Without this alternative, the documentation required to qualify for hedge accounting would need to be completed concurrently with the inception of the hedge. With this alternative, the documentation to qualify a new swap for hedge accounting must be completed by the time the annual financial statements are available to be issued. The option within derivative accounting which allows election of hedge accounting on a swap-by-swap basis carries over to this alternative treatment. This means that before the financial statements are available to be issued, the private company may select the individual swaps to which this alternative treatment would be applied and prepare the appropriate documentation. OBSERVATION The accounting under this option is substantially easier than what GAAP would otherwise require. At first glance, it would appear the very narrow scope of what swaps would qualify means this would not be an option very often. However, this type of swap is so common that this accounting alternative will likely cover a large portion of the swaps in use by smaller private companies. Effective Date and Transition The simplified hedge accounting approach under this ASU is effective for annual periods beginning after December 15, For most private companies this would be financial statements for the year ending December 31, Early adoption is permitted. A transition to this alternative approach can be applied in either of the following ways: Modified retrospective approach With this approach, adjustments are made to the assets, liabilities, and opening balance of retained earnings, accumulated other comprehensive income, or other appropriate components of equity for the current period presented to reflect application of hedge accounting from the date the interest rate swaps were entered into. The net impact of this approach 145

147 would be to change opening equity accounts of the current year to reflect what would have otherwise been the prior year income statement impact. This means prior year financial statements would not be changed. Full retrospective approach This approach would adjust prior year financial statements to reflect the period-specific effects of applying hedge accounting from the date the interest rate swaps were entered into. Corresponding adjustments would be made to the assets, liabilities, and opening balance of retained earnings, accumulated other comprehensive income, and other appropriate components of equity as of the earliest year presented. The net impact of this approach would be to restate the financial statements of prior years as if the alternative approach had been applied since inception of the swaps. STUDY QUESTION 2. Which of the following best describes the transition required for the interest rate swap accounting alternative? a. Either the modified retrospective approach or full retrospective approach may be used. b. The alternative may only be applied prospectively to covered interest rate swaps entered into after the date the private company elects to follow this alternative. c. The full retrospective approach must be used. d. The accounting alternative must be applied to all swaps that meet the criteria specified in the accounting alternative CONSOLIDATION OF VARIABLE INTEREST ENTITIES THAT PROVIDE LEASING In March 2014, FASB issued Accounting Standards Update No , Consolidation (Topic 810) Applying Variable Interest Entities Guidance to Common Control Leasing Arrangements - a consensus of the Private Company Council. Feedback to PCC from private company stakeholders indicated that consolidating an entity under common control that provide leasing under the variable interest entities guidance does not provide sufficient benefits to justify the implementation costs. The feedback indicated a common owner typically sets up a leasing activity separate from the private company for reasons other than to structure off-balance-sheet financing. Factor such as tax concerns, estate planning, or legal liability tend to drive such transactions. Many users of private company financial statements indicated their loans are secured by the standalone private company rather than the consolidated entity. This has an impact on their needs from several directions. First, users of those financial statements are concerned about the cash flows and financial position of the unconsolidated entity because that company will be the source of their repayment. From another direction, legal liability concepts (including protections available under the bankruptcy law) mean that the assets and cash flows of the entities consolidated under VIE guidance are not available under any circumstance to repay obligations of the private company. Feedback from users indicates they need to remove the consolidated entities from the financial statements to analyze the specific entity they look to for repayment. This leads many users to request a consolidating schedule, which generates additional effort and cost for the private company. OBSERVATION Consider this feedback in relation to the user-relevance and cost-benefit factors that are 146

148 considered by PCC. Consolidating lessor entities under VIE guidance reduces the relevance of financial information to users of private company financial statements. The cost for private companies is higher than public companies because users often will request consolidating schedules. It is easy to see why lower user-relevance and higher costs for private companies made dealing with lessor companies under common control a prime candidate for alternative accounting. Recognition The alternative accounting under this ASU is not available to public business entities, not-for-profit entities, and employee benefit plans. A private company may elect this alternative of not applying VIE guidance to a lessor entity if all of the following conditions are met: The private company and the lessor entity are under common control The private company has a lease arrangement with the lessor entity Substantially all activity between the private company and lessor entity is related to leasing activity between those two entities If the private company explicitly guarantees any liabilities of the lessor entity related to the asset under lease, then at the inception of the lease the guarantee did not exceed the value of the asset leased between the entities. Likewise if the private company provides collateral to secure the lessor entities obligations than a principal amount of the collateral does not exceed the value of the asset leased. OBSERVATION A simplified illustration of those conditions would be an owner of one company setting up a second company for the sole purpose to lease something to the first company. Under this accounting alternative, that separate leasing company would not be consolidated. If a private company elects to follow this accounting alternative, the specific accounting treatment should be applied to all current and future lessor entities that are under common control which meet the criteria for this approach. Disclosures otherwise required by VIE guidelines for such a lessor entity are not required under this accounting alternative. Instead, the private company lessee would disclose: The amount and key terms of liabilities of the lessor entity that expose the private company to provide financial support, and A qualitative description of the circumstances that expose the private company to providing financial support to the lesser entity which are not recognized in the financial statements The ASU provides a reminder that other disclosures, such as guarantees, leases, and related party transactions, would still apply. Effective Date and Transition This alternative is effective for annual periods beginning after December 15, For most private companies this would make it effective for fiscal years ending December 31, Early application is permitted. This includes any financial statements that have not yet been made available for issuance. If a private company chooses this accounting alternative, it should be applied retrospectively to all periods presented. 147

149 1309 AUDIT OPINIONS AND ACCOUNTANT'S REPORTS Adopting one or several of the accounting alternatives approved by the PCC and FASB is a change in accounting principle. Such a change needs to be disclosed in the notes to the financial statements. Audits under Statements on Auditing Standards (SAS) The AICPA has issued TIS section , Modification to the Auditor's Report When a Client Adopts a PCC Accounting Alternative. This TIS provides a reminder that an auditor is required to add an emphasis-of-matter (EOM) paragraph to the auditor's report describing a material change in accounting principle. The EOM paragraph would be needed until the changes been reflected in all periods presented. If the change is applied retrospectively to all prior periods presented, the EOM paragraph is only needed in the year of such change. As a further reminder, the auditor's EOM paragraph should describe the change and provide a reference to the note disclosure. A sample paragraph would be: Change in Accounting Principle As discussed in Note X to the financial statements, the Company has elected to change its method of accounting for goodwill in 201x. Our opinion is not modified with respect to this matter. TIS section , Modification to the Auditor's Report When a Client Adopts a PCC Accounting Alternative That Results in a Change to a Previously Issued Report, addresses a likely situation. A private company may have not previously consolidated a VIE which resulted in a qualified auditor's report. If that company adopts the provision of this ASU retrospectively, that would change the prior auditor's report by removing the qualification. This TIS provides a reminder that the SAS literature already addresses such a situation. An EOM paragraph is required which would provide the date of the previous auditor's report, the type of opinion previously expressed, the substantive reasons for the different opinion, and state that the auditor's opinion on the previous report was different. Engagements Performed Under Statements on Standards for Accounting and Review Services (SSARS) The AICPA has provided guidance for three specific issues for compilations and reviews. TIS section Modification to the Accountant's Compilation or Review Report When a Client Adopts a Private Company Council Accounting Alternative This provides a reminder that the SSARS does not contain a requirement for an EOM for any reason. An accountant may voluntarily include an EOM paragraph. Such a paragraph should not be added to a compilation report when the financial statements omit substantially all disclosures. The exception would be if the notes disclose the matter. TIS section Compilation or Review Report in Which Management Refuses to Include Disclosure Related to Adoption of a PCC Accounting Alternative This provides a reminder that if management does not disclose adopting an alternative accounting presentation which is material, the SSARS literature already provides guidance on how to modify the accountants report. Both a compilation report (assuming the financial statements do not omit substantially all disclosures) and a review report should be modified in accordance with guidance already located in SSARS. TIS section Modification to the Accountant's Review Report When a Client Adopts a Private Company Council Accounting Alternative That Results in a Change to a Previously Issued Report This addresses the same situation described above for an audit. The guidance in this TIS provides a reminder the SSARS literature already addresses this situation. The accountant's report should include an explanatory paragraph which indicates the date of their previous report, the circumstances or events that caused the reference to be changed, and if appropriate, a comment that the financial statements of the prior period have been changed. 148

150 STUDY QUESTION 3. Which of the following statements best describes the effective date for the accounting alternatives approved by FASB and PCC? a. The alternatives are effective for years beginning after December 15, b. Only one of the alternatives allows for early application. c. All of them either require or allow retrospective application. d. All of them allow prospective application. CPE NOTE: When you have completed your study and review of chapters 9-13, which comprise Module 3, you may wish to take the Quizzer for this Module. Go to CCHGroup.com/PrintCPE to take this Quizzer online. 149

151 CHAPTER 14: Audit Evidence 1401 WELCOME This chapter is intended as a top-level summary and overview of the significant definitions and requirements of the twelve pronouncements that make up the "Audit Evidence" section of the clarified audit standards LEARNING OBJECTIVES Upon completion of this chapter, the reader should be able to: Define key terms related to audit evidence Explain significant audit planning and performance requirements related to audit evidence Recognize areas of significant audit risk that require specific forms of audit evidence Describe required contents of documentation for audit evidence 1403 INTRODUCTION The standards on audit evidence comprise twelve sections in the clarified standards: AU-C Section 500, Audit Evidence AU-C Section 501, Audit Evidence Specific Considerations for Selected Items AU-C Section 505, External Confirmations AU-C Section 510, Opening Balances Initial Audits, Including Reaudit Engagements AU-C Section 520, Analytical Procedures AU-C Section 530, Audit Sampling AU-C Section 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates and Related Disclosures AU-C Section 550, Related Parties AU-C Section 560, Subsequent Events and Subsequently Discovered Facts AU-C Section 570, The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern AU-C Section 580, Written Representations AU-C Section 585, Consideration of Omitted Procedures After the Report Release Date This chapter is intended as a top-level summary and overview of the significant definitions and requirements of those standards. Auditors should consult the full text of the specific standards for detailed guidance AUDIT EVIDENCE AU-C Section 500, Audit Evidence, explains what constitutes audit evidence and addresses the auditor's responsibility to design and perform audit procedures to obtain sufficient appropriate audit evidence from which to draw reasonable conclusions and base an opinion. Definitions Accounting records. Records of initial accounting entries and supporting records, including: 150

152 Checks Electronic funds transfer records Invoices Contracts General and subsidiary ledgers Journal entries and other adjustments to the statements (i.e. "worksheet adjustments") not reflected in journal entries Other worksheets supporting: - Cost allocations - Computations - Reconciliations - Disclosures Appropriateness of audit evidence. A qualitative measure of the relevance and reliability of evidence providing support for the conclusions on which the auditor's opinion is based. Audit evidence. Information used by the auditor in arriving at the conclusions on which the audit opinion is based. This includes both information contained in the underlying accounting records and other information. Management's specialist. A person or organization with expertise in other than accounting or auditing, whose work is used by the entity to assist in financial statement preparation. Sufficiency of audit evidence. The measure of the quantity of audit evidence. The quantity needed is affected by the auditor's assessment of the risks of material misstatement, and by its quality or appropriateness. Obtaining a greater quantity of evidence may not compensate for poor quality of the evidence. Requirements AU-C Section 500 contains the following presumptively mandatory requirements. Presumptively mandatory requirements are indicated throughout the Standards by the word "should." Auditors must comply with presumptively mandatory requirements in all cases in which they are relevant, except in rare circumstances when that procedure would not be effective in achieving the intent of the requirement. The twelve "audit evidence" sections contain no unconditional requirements. Sufficient appropriate audit evidence. Auditors should design and perform audit procedures that are appropriate in the circumstances to obtain sufficient appropriate audit evidence. OBSERVATION The appropriateness of audit evidence is a qualitative measure whereas sufficiency relates to the quantity of evidence. The appropriateness of audit evidence may be influenced by its source and nature, and depends on the circumstances under which it is obtained. Information to be used as audit evidence. Auditors should consider the relevance and reliability of information to be used as evidence when designing and performing audit procedures. If information has been prepared using the work of a management's specialist, auditors should consider the significance of that work for their purposes, to the extent necessary, by: Evaluating the specialist's competence, capabilities and objectivity Obtaining an understanding of the specialist's work Evaluating the appropriateness of the specialist's work as audit evidence for the relevant assertion Auditors should evaluate the reliability of entity-prepared information as necessary, including: Obtaining evidence about its accuracy and completeness 151

153 Evaluating whether it is sufficiently precise and detailed for audit purposes Inconsistencies or doubts over reliability. When audit evidence obtained from one source is inconsistent with that obtained from another, or the auditor has doubts about the reliability of information to be used as evidence, the auditor should: Determine what modifications or additions to the audit procedures are necessary to resolve the matter, and Consider the effects, if any, on other aspects of the audit 1405 AUDIT EVIDENCE SPECIFIC CONSIDERATIONS FOR SELECTED ITEMS AU-C Section 501, Audit Evidence Specific Considerations for Selected Items, addresses audit evidence for four specific areas: Valuation of investments in securities and derivative instruments Existence and condition of inventory Completeness of litigation, claims & assessments Presentation and disclosure of segment information Requirements Investments in Securities and Derivatives Securities valued based on investee's financial results. When securities investments are valued based on the investee's financial results (excluding equity method investments) auditors should: Obtain and read the investee's financial statements and related auditor's report. Determine if the auditor's report is satisfactory for their purposes. If the statements are unaudited, or if the auditor's report is not satisfactory: - Apply, or request the investor entity to arrange with the investee to have another auditor apply appropriate auditing procedures to the financial statements, considering the materiality of the investment to the investor entity's statements. - Obtain sufficient appropriate audit evidence to support amounts, if any, reflected in the carrying amount of the investment that are not recognized in the investee's financial statements, or fair values that are materially different from the investee's carrying amounts. Determine whether the difference between the investor and investee's financial statement periods, if any, has or could have a material effect on the investor entity's statements, and determine: - Whether the investor entity's management has considered the lack of comparability - Effects, if any, on the auditor's report If unable to obtain sufficient appropriate evidence due to inability to apply one or more of these procedures, auditors should determine whether a modified opinion is necessary. Auditors should also consider the effects of subsequent events by reading the investee's subsequent interim financial statements and inquiring of management. Derivatives and securities measured or disclosed at fair value. Auditors should: Ascertain the requirements of applicable financial reporting framework (basis of accounting) for determining fair value. Evaluate whether management's determination is consistent with those requirements. 152

154 Gain an understanding of valuation models used by broker-dealers or other third party sources used in estimating fair value, where applicable, and consider the requirements of AU-C Section 500 ("Audit Evidence") regarding management's specialists. When derivatives or securities are valued by the entity using a valuation model, obtain sufficient appropriate evidence to support management's assertions about fair value using the model. Impairment losses. Auditors should: Evaluate management's conclusion about the need to recognize an impairment loss, including the relevance of the information considered. Obtain sufficient appropriate audit evidence supporting the amount of the impairment adjustment. Evaluate compliance with the requirements of the applicable financial reporting framework. Unrealized appreciation or depreciation. Auditors should: Obtain sufficient appropriate audit evidence about the amount of unrealized appreciation or depreciation in the fair value of a derivative that is recognized or disclosed due to the ineffectiveness of a hedge. Evaluate compliance with the requirements of the applicable financial reporting framework. STUDY QUESTION 1. When derivatives or securities are measured or disclosed at fair value, AU-C Section 501 auditors should: a. Independently develop a valuation model for the securities or derivatives. b. Obtain an understanding of valuation models used by broker-dealers or other third party sources used in estimating fair value, when applicable. c. Employ a specialist to assess the valuation model used. d. Trace stated values to prices on publicly traded exchanges. Inventory. When inventory is material, auditors should obtain sufficient appropriate evidence about its existence and condition by: Attending physical inventory counting, unless impracticable, to: - Evaluate management's instructions and procedures for counting and recording - Observe performance of count procedures - Inspect inventory - Perform test counts Performing audit procedures to determine whether final inventory records accurately reflect actual counts. When inventory is counted at other than the balance sheet date, auditors should, in addition to the above procedures, obtain evidence about whether changes between the count date and the balance sheet date are properly recorded. When unable to attend inventory counting due to unusual circumstances, auditors should make or observe some counts on an alternative date and perform audit procedures on the intervening transactions. When attendance at inventory counting is impracticable, auditors should perform alternative procedures to obtain sufficient appropriate evidence about the condition and existence of inventory. A modified auditor's opinion is required if this is not possible. 153

155 OBSERVATION According to the Application and Other Explanatory Material (AOEM), general inconvenience is not sufficient grounds for a decision that attendance at the inventory count is impracticable. It states that inventory that is held in a location that poses threats to the auditor's safety is a sufficient reason. When material inventory is in the custody of a third party, auditors should perform one or both of the following: Request confirmation of quantities and condition from the third party. Perform inspection or other procedures as appropriate. Litigation, claims and assessments. Auditors should design and perform procedures to identify litigation, claims and assessments that may give rise to the risk of material misstatement of the entity's financial statements, including: Inquiries of management and in-house legal counsel Obtaining from management a description and evaluation of litigation, claims and assessments that existed at the financial statement date and through the date the information is provided, including matters referred to legal counsel Reviewing minutes, and documents obtained from management regarding litigation, claims and assessments Reviewing correspondence with legal counsel regarding litigation, claims and assessments Reviewing legal expenses and invoices from legal counsel When actual or potential litigation, claims and assessments are identified, auditors should obtain evidence about the: Period in which the cause for legal action occurred Probability of an unfavorable outcome Amount or range of potential loss Communication with entity legal counsel. Auditors should seek direct communication with the entity's external legal counsel, through a letter of inquiry prepared by management and sent by the auditor, unless no actual or potential litigation, claims or assessments that may give rise to risk of material misstatement exist. Similar letters should be sent to in-house legal counsel, when applicable, however, they are not a substitute for direct communication with external counsel. Communication with legal counsel should include, when applicable, management's permission for counsel to discuss matters with the auditor. Auditors should also: Document the basis for any determination not to seek direct communication with legal counsel Consider inquiring of management about reasons for changing legal counsel, when applicable Modify the audit opinion if: - Legal counsel refuses to give appropriate response to the letter of inquiry and the auditor is unable to obtain sufficient appropriate evidence through alternative procedures - Management refuses to give permission to communicate or meet with external legal counsel AU-C Section 501 contains a detailed list of required content for these communications. Readers should consult the actual text of the standard for this list. Segment information. Auditors should obtain sufficient appropriate evidence about the presentation and disclosure of segment information by: Obtaining an understanding of how management determines segment information and: 154

156 - Evaluating whether its methods are likely to result in proper disclosure - Testing the application of those methods when appropriate Performing analytical or other audit procedures as appropriate 1406 EXTERNAL CONFIRMATIONS AU-C Section 505, External Confirmations addresses the auditor's use of external confirmation procedures to obtain relevant and reliable audit evidence. The auditor's objective in using external confirmations is to design and perform the procedures so as to obtain reliable and relevant audit evidence. Definitions Exception. A confirmation response that indicates a difference between the information provided by the confirming party and the entity's records or the information requested to be confirmed. External confirmation. Audit evidence obtained as a direct written response from a third party (the confirming party) to the auditor, either in paper form or by electronic or other medium (for example, through the auditor's direct access to information held by a third party). Negative confirmation request. A request in which the confirming party is requested to respond to the auditor only if the confirming party disagrees with the information provided in the request. Nonresponse. A failure of the confirming party to respond, or to fully respond, to a positive confirmation request, or a confirmation request that is returned undelivered. Positive confirmation request. A request in which the confirming party is requested to respond directly to the auditor by providing the requested information or indicating whether the confirming party agrees or disagrees with information provided in the request. Requirements External confirmation procedures. Auditors should maintain control over external confirmation requests, including: Determining the information to be confirmed or requested Selecting the appropriate confirming party Designing the confirmation request, including determining that it: - Is properly directed to the confirming party - Provides for a direct response to the auditor Sending requests, including follow-up requests if applicable, to the confirming party OBSERVATION The requirement in the previously existing standard to confirm accounts receivable has not been eliminated. Rather, is has been moved to AU-C Section 330, Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained. Management's refusal to allow confirmations. When management refuses to allow auditors to perform external confirmation procedures, they should: Inquire about the reasons for the refusal Seek audit evidence about their reasonableness and validity Evaluate the implications of the refusal on the: - Auditor's risk assessment, including fraud risk - Nature, timing and extent of other audit procedures 155

157 Perform alternative audit procedures designed to obtain relevant and reliable audit evidence When auditors determine that the refusal to allow confirmation is unreasonable, or that they are unable to obtain relevant, reliable audit evidence through alternative procedures, they should: Communicate the matter to those charged with governance Determine the implications for the audit and the auditor's opinion, including whether a modifiedopinion is necessary Results of External Confirmation Procedures Reliability of responses. When auditors identify factors that cause them to doubt the reliability of a confirmation response, they should obtain additional evidence to resolve the doubts. When they determine that a response is not reliable, they should evaluate the implications for the: Assessment of risks of material misstatement Assessment of fraud risk Nature, timing and extent of other audit procedures Nonresponses and oral responses. Auditors should perform alternative procedures in the case of nonresponses. OBSERVATION An oral response does not constitute an external confirmation because it is not a direct written response. Auditors may, however, take oral responses into consideration when determining the nature and extent of alternative procedures. In documenting the oral response, the auditor may include such details as the: Respondent's name Respondent's position Time and date of the conversation When a written response is necessary. When an auditor determines that a written response is necessary, such as, for example, correspondence with the client's attorney over a significant legal matter, alternative procedures will not provide the needed evidence. When a written response is not received under these circumstances, the auditor should determine the implications for the audit, and his or her opinion. STUDY QUESTION 2. If a written confirmation response that the auditor has determined to be necessary is not received, the auditor should: a. Obtain sufficient appropriate audit evidence through other available sources. b. Perform alternative audit procedures. c. Determine the implications for the audit, and the auditor's opinion. d. Modify the auditor's opinion. Exceptions. Auditors should investigate exceptions to determine if they indicate misstatements. OBSERVATION Not all exceptions represent misstatements. Exceptions may also be caused by: 156

158 Timing Measurement Clerical errors in the confirmation process Negative Confirmations Negative confirmations give less reliable evidence than positive confirmations. Thus, auditors should not use them as the only substantive procedure to address an assessed risk of misstatement at the assertion level, unless all of these conditions are met: The auditor has assessed the risk of material misstatement as low. The auditor has obtained sufficient appropriate evidence about the operating effectiveness of internal controls relevant to the assertion. The confirmation population consists of a large number of small, homogeneous balances, transactions or conditions. A very low exception rate is expected. The auditor is not aware of reasons why recipients would disregard the confirmation requests. Evaluating Evidence Auditors should evaluate whether confirmation results provide reliable, relevant evidence, or whether further audit evidence is needed OPENING BALANCES AU-C Section 510, Opening Balances-Initial Audit Engagements, Including Reaudit Engagements, states that reviewing a predecessor's audit documentation cannot be the only procedure performed to obtain sufficient appropriate evidence regarding opening balances in initial audits. Review of the predecessor's work may provide evidence about opening balances and consistent application of accounting principles. But the nature, timing and extent of audit work performed and conclusions reached on the current period audit are the sole responsibility of the successor auditor. The auditor's determination of whether to rely on evidence obtained as a result of reviewing the predecessor auditor's work is influenced by the auditor's assessment of the predecessor's professional competence and independence. The auditor's objectives are to obtain sufficient appropriate evidence about whether: Opening balances contain misstatements that materially affect the current period's financial statements. Accounting policies reflected in the opening balances have been consistently applied in the current period's financial statements. Changes in accounting policies have been properly accounted for, adequately presented and disclosed in accordance with the applicable financial reporting framework. Definitions Initial audit engagement. One in which either: The prior period financial statements were not audited, or Those statements were audited by a predecessor auditor Opening balances. Balances existing at the beginning of the period. These balances: Are based on the closing balances of the prior period Reflect the effects of transactions and events of prior periods 157

159 Reflect the accounting policies applied in the prior period Include matters requiring disclosure that existed at the beginning of the period, such as contingencies and commitments Predecessor auditor. An auditor from a different audit firm who has reported on the most recent audited financial statements, or who was engaged to perform but did not complete the audit. Reaudit. An initial audit engagement to audit financial statements that were audited by a predecessor auditor. Requirements Audit procedures. Auditors should read the most recent financial statements, and the predecessor's report on them, for any information relevant to opening balances. This includes: Reading the disclosures Evaluating consistency in the application of accounting policies Auditors should ask management to authorize the predecessor auditor to allow a review of his or her audit documentation, and for the predecessor to respond fully to inquiries, to provide information for planning and performing the current audit. Opening balances. Auditors should obtain sufficient appropriate evidence about whether the opening balances contain material misstatements that could be material to the current period by: Determining whether prior period closing balances are brought forward correctly Determining whether opening balances reflect appropriate application of accounting policies Evaluating whether current period audit procedures provide evidence about opening balances by means of performing one or both of the following: - Reviewing the predecessor's audit documentation - Performing specific procedures related to opening balances If the opening balances contain misstatements that could be material to the current statements, the auditor should perform additional audit procedures as appropriate in the circumstances. If those misstatements affect the current period, they should be communicated to management and those charged with governance. When a predecessor auditor reported on those statements, the successor auditor should: Request management communicate the matter to the predecessor, and Ask management to arrange for all three parties to discuss and try to resolve the issue If management declines to inform the predecessor that the prior period statements may need revision, or if the successor auditor is not satisfied with the resolution of the matter, the successor auditor should evaluate: The implications on the current engagement Whether to withdraw from the engagement If withdrawal is not possible under law or regulation, disclaim an opinion Consistency of accounting policies. Auditors should obtain sufficient appropriate evidence about whether: The current period's accounting policies are consistently applied with respect to the opening balances. Changes in accounting policies are: - Appropriately accounted for - Adequately presented and disclosed Relevant information in the predecessor's report. If the predecessor's opinion was modified, the successor auditor should evaluate the effects of the matter in assessing the risk of material misstatement in the current period. 158

160 STUDY QUESTION 3. To obtain sufficient appropriate audit evidence about whether the opening balances contain misstatements that could be material to the current period, auditors should do all of the following except: a. Determine whether opening balances reflect appropriate application of accounting policies. b. Evaluate whether current period audit procedures provide evidence about opening balances by both performing specific procedures related to those balances and reviewing the predecessor's audit documentation. c. Determine whether closing balances from the prior period have been brought forward correctly. d. Request management to authorize the predecessor auditor to allow a review of his or her audit documentation. Audit conclusions and reporting. Auditors should not refer to the report or work of a predecessor auditor as the basis, in part, for their own opinions. Certain conditions related to opening balances, may require an auditor to express a modified opinion or disclaim an opinion, such as: Inability to obtain sufficient appropriate evidence about opening balances Inconsistent application of accounting policies Inappropriate accounting for, or presentation or disclosure of a change in accounting policies A modification to the predecessor auditor's report that remains relevant and material in the current period 1408 ANALYTICAL PROCEDURES AU-C Section 520, Analytical Procedures, requires that auditors apply analytical procedures in the final review stages for all audits of financial statements. In addition, it recognizes that auditors use professional judgment to determine whether analytical procedures should be employed as substantive tests to collect evidential matter related to account balances or classes of transactions. Definition Analytical procedures. Evaluations of financial information through analysis of plausible relationships between both financial and nonfinancial data, including investigation, as needed, of fluctuations or relationships that are inconsistent with other relevant information or that differ significantly from expectations. Requirements Substantive analytical procedures. When designing analytical procedures as substantive procedures, whether alone or in combination with tests of details, auditors should: Determine the suitability of the particular procedures for the given assertions. Evaluate the reliability of data from which expectations about recorded amounts or ratios is developed. Develop an expectation of recorded amounts or ratios. Evaluate whether the expectation is sufficiently precise to identify a material misstatement. Determine the amount of any difference of recorded amounts from expected values that is acceptable 159

161 without further investigation. Compare recorded amounts, or ratios developed from them, with expectations. Analytical procedures in forming an overall conclusion. Auditors should design and perform analytical procedures near the end of the audit to assist in forming an overall conclusion about whether the financial statements are consistent with their understanding of the entity. Investigating results. When analytical procedures identify fluctuations or relationships that are inconsistent with other relevant information or that differ significantly from expectations, they should: Inquire of management and obtain appropriate evidence related to management's responses. Perform other audit procedures as necessary. Documentation. Audit documentation should include the following when substantive analytical procedures have been performed: The expectation on which the procedures are based and factors considered in their development, unless otherwise readily determinable from the audit documentation. The results of comparisons of expectations to recorded amounts or ratios developed from them. Any additional audit procedures performed as a result of identified fluctuations, inconsistencies with other relevant information, or significant differences from expectations. STUDY QUESTION 4. Documentation requirements for substantive analytical procedures include requirements to record all of the following except: a. Scanning of untested expense balances b. Additional auditing procedures performed to investigate significant unexpected differences arising from the analytical procedure c. The results of the comparison of the expectation to the amounts recorded in the financial statements, or to ratios derived from those amounts d. The factors considered in developing the expectations used, unless those expectations are obvious from the documentation of the work performed 1409 AUDIT SAMPLING AU-C Section 530, Audit Sampling, applies when an auditor decides to use audit sampling in performing audit procedures. It addresses the use of both statistical and nonstatistical sampling. The objective in using audit sampling is to provide a reasonable basis for drawing conclusions about the population from which a sample is selected. Definitions Audit sampling (sampling). The selection and evaluation of less than 100 percent of the relevant population, such that the auditor expects the items selected (the sample) to be representative of the population and therefore likely to provide a reasonable basis for conclusion about the population. Representative, for this purpose, means that the evaluation of the sample will result in conclusions that, subject to the limitations of sampling risk, are similar to those that would have been drawn if the same procedures were applied to the entire population. 160

162 Nonsampling risk. The risk that the auditor reaches an erroneous conclusion for any reason not related to sampling risk. Population. The entire set of data from which a sample is selected and about which the auditor wishes to draw conclusions. Sampling risk. The risk that the auditor's conclusion from the sample may differ from the conclusion if the entire population had been subjected to the same audit procedure. Two types of erroneous conclusions may result: For control tests, that controls are more effective than they actually are, or for tests of details, that a material misstatement does not exist when in fact it does. This type of error is of great concern to auditors because it affects audit effectiveness and is more likely to lead to an inappropriate opinion. For control tests, that controls are less effective than they actually are, or for tests of details, that material misstatement exists when in fact it does not. This type of error affects audit efficiency because it leads to additional work to establish that the initial conclusion is incorrect. Sampling unit. The individual units that make up a population. Statistical sampling. An approach to sampling with the following characteristics: Random selection of the sample items Use of an appropriate statistical technique to evaluate sample results, including measurement of sampling risk A sampling approach that does not have both of these characteristics in defined as nonstatistical sampling. Stratification. The process of dividing a population into subpopulations, each of which is a group of sampling units with similar characteristics. Tolerable misstatement. A monetary amount set by the auditor, with reference to which the auditor seeks to obtain an appropriate level of assurance that this monetary amount is not exceeded by the actual misstatement in the population. Tolerable rate of deviation. A rate of deviation set by the auditor with reference to which the auditor seeks to obtain an appropriate level of assurance that this rate of deviation is not exceeded by the actual deviation in the population. Requirements Sample design, size and selection. In designing an audit sample, auditors should: Consider the purpose of the audit procedure and characteristics of the population Determine a sample size sufficient to reduce sampling risk to an acceptably low level Select sample items in a way such that they are reasonably expected to be representative of the population, and likely to provide the auditor with a reasonable basis for conclusions about the population Performing audit procedures. Auditors should apply audit procedures to each item selected. When a procedure is not applicable to a selected item, they should perform the procedures on a replacement item. When unable to apply the designed audit procedures or alternative procedures to a selected item (such as when the entity cannot locate the supporting documentation), that item is considered a deviation from the prescribed control (in the case of a control test) or a misstatement (in the case of a test of details.) Nature and cause of deviations and misstatements. Auditors should investigate the nature and cause of any identified deviations or misstatements, and evaluate their possible effects on the purpose of the audit procedure and other audit areas. Projecting sampling results. Auditors should project the results of audit sampling to the population. OBSERVATION 161

163 Failure to project sampling results to the population is one of the most common deficiencies related to sampling noted in the AICPA's practice monitoring programs. Evaluating sample results. Auditors should evaluate: The results of the sample, including sampling risk. Whether the sample has provided a reasonable basis for conclusions about the population. STUDY QUESTION 5. Which of the following statements about AU-C Section 530 is correct? a. It applies only to statistical sampling. b. It requires auditors to project the results of the sample to the population as a whole. c. It defines tolerable misstatement as the maximum monetary amount of misstatement that the auditor is willing to accept in the financial statements taken as a whole without modifying his or her audit opinion. d. When a planned substantive test is not applicable to a selected item, it requires auditors to regard the item as a misstatement AUDITING ACCOUNTING ESTIMATES AU-C Section 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates and Related Disclosures, addresses the auditor's responsibilities for accounting estimates, including fair value estimates, and related disclosures. It also expands on other relevant sections are to be applied with regard to accounting estimates. Some financial statement amounts cannot be precisely measured, but must be estimated. The nature and reliability of information to support estimates varies widely, and thus affects the degree of estimation uncertainty. This, in turn, affects the risk of material misstatement associated with accounting estimates, including their susceptibility to management bias. The measurement objectives of accounting estimates may vary, depending on the applicable financial reporting framework and the item to be reported. Some estimates forecast the outcome of transactions, conditions or events, while others seek to measure the fair value of a current transaction or financial statement item based on current conditions. The difference between the outcome of an accounting estimate and the amount originally recognized or disclosed does not necessarily indicate a misstatement, but could rather be the result of estimation uncertainty. The auditor's objectives are to obtain sufficient, appropriate audit evidence about whether: Accounting estimates, whether recognized or disclosed, are reasonable Related disclosures are adequate Definitions Accounting estimate. An approximation of a monetary amount in the absence of a precise means of measurement. This term is used for amounts measured at fair value when there is estimation uncertainty, and for other amounts requiring estimation. Auditor's point estimate or auditor's range. The amount or range of amounts, respectively, derived from audit evidence for use in evaluating recorded or disclosed amounts. Estimation uncertainty. The susceptibility of an accounting estimate and its related disclosures to an inherent 162

164 lack of measurement precision. Management bias. A lack of neutrality by management in preparing and fairly presenting information. Outcome of an accounting estimate. The actual monetary amount resulting from the resolution of underlying transactions, events or conditions addressed by the accounting estimate. Requirements Risk assessment procedures and related activities. Auditors should obtain an understanding of the following, when performing risk assessment procedures, to provide a basis for identifying and assessing risks of material misstatement of accounting estimates: The requirements of the applicable financial reporting framework for accounting estimates and related disclosures How management identifies transactions, conditions and events that may give rise to the need to recognize or disclose accounting estimates. This should include inquiries of management about changes in circumstances that may give rise to the need for new or revised accounting estimates. How management makes accounting estimates, and the data on which they are based, including: - Methods and, if applicable, models used - Relevant controls - Whether management has employed a specialist - Underlying assumptions - Whether there has been, or ought to have been changes from prior periods methods or assumptions, and if so, the reasons - Whether management has assessed the effect of estimation uncertainty, and if so, how Auditors should review the outcome of prior periods' accounting estimates, or their subsequent reestimation for the current period. This review is not intended to call into question the auditor's professional judgment made based on available information in prior periods. Rather, it is done to assist in identifying and assessing risks of material misstatement of estimates in the current period. Identifying and assessing risks of material misstatement. Auditors should: Evaluate the degree of estimation uncertainty associated with the accounting estimate. Determine whether any of those accounting estimates that have been identified as having high estimation uncertainty give rise to significant risks. Responding to assessed risks. Based on the assessed risks of material misstatement, auditors should determine: Whether management has appropriately applied the requirements of the applicable financial reporting framework for accounting estimates. Whether the estimation methods are appropriate and consistently applied. Whether changes in estimates from prior periods, if any, are appropriate. In responding to assessed risks of material misstatement, and taking into account the nature of the estimate, auditors should undertake one or more of the following: Determine whether subsequent events through the date of the auditor's report provide evidence about the estimate. Test how management made the estimate, and the data on which it is based, including evaluating the: - Appropriateness of the measurement method - Reasonableness of management's assumptions - Reliability of the underlying data for audit purposes Test the operating effectiveness of controls over how management made the estimate, and perform 163

165 substantive tests. Develop a point estimate or range to evaluate management's point estimate. A range should be narrow enough that all outcomes within it are reasonable. Auditors should also consider whether specialized skills related to the accounting estimate are required in order to obtain sufficient appropriate evidence. Further Substantive Procedures Estimation uncertainty. For accounting estimates that give rise to significant risks, in addition to other substantive procedures, auditors should evaluate: How management considered alternative assumptions or outcomes Why it rejected those alternatives, or how it has otherwise addressed estimation uncertainty Whether management's significant assumptions are reasonable Management's intent and ability to carry out specific course of action, when relevant to its assumptions Auditors should develop a range with which to evaluate the reasonableness of the estimates if management has not, in their professional judgment, adequately addressed the effects of estimation uncertainty. Recognition and measurement criteria. For accounting estimates that give rise to significant risk, auditors should obtain sufficient appropriate evidence about whether the following are in accordance with the applicable financial reporting framework: Management's decision to recognize or not recognize accounting estimates. The selected measurement basis for the estimates. Evaluating reasonableness and determining misstatements. Auditors should evaluate whether accounting estimates are either reasonable or are misstated in the context of the applicable financial reporting framework. Disclosures. Auditors should: Obtain sufficient appropriate evidence about whether disclosures related to estimates are in accordance with the applicable financial reporting framework. Evaluate the adequacy of the disclosure of estimation uncertainty in the context of the applicable financial reporting framework, for estimates that give rise to significant risk. Indicators of possible management bias. Auditors should review management's decisions and judgments in making accounting estimates to identify whether indications of bias exist. Such indicators do not, in themselves, constitute misstatements for purposes of drawing conclusions on the reasonableness of individual estimates. Documentation. Auditors should include in their audit documentation: The basis for their conclusions about the reasonableness of accounting estimates and disclosures for estimates that give rise to significant risk. Indicators of management bias, if any. STUDY QUESTION 6. The concept of estimation uncertainty recognizes that: a. The reestimation in the current period of a prior period's accounting estimate calls into question the auditor's professional judgment made based on available information in prior periods. b. The difference between the outcome of an accounting estimate and the amount originally 164

166 recognized or disclosed indicates a misstatement in the prior period's financial statements. c. Accounting estimates and their related disclosures are subject to an inherent lack of measurement precision. d. The reestimation in the current period of a prior period's accounting estimate indicates a management bias in the prior period RELATED PARTIES AU-C Section 550, Related Parties, addresses the auditor's responsibilities for related party transactions and relationships in an audit. These include responsibilities to: Understand the entity's related party transactions and relationships. Perform audit procedures to identify assess and respond to risk of material misstatement due to an entity's failure to appropriately account for or disclose related party relationships, balances or transactions. Due to the inherent limitations of the audit process, this is important because management may: - Be unaware of the existence of related party transactions or relationships. - Have greater opportunity for collusion, concealment or manipulation. Plan and perform the audit with professional skepticism. While some related party transactions occur in the normal course of business, and are of no more risk than similar transactions with unrelated parties, others may pose higher risks of material misstatement. Factors entering into this consideration may include, for example: Complexity and extent of related party relationships, structures and transactions. Ineffectiveness of information systems at identifying or summarizing related party balances and transactions. Conduct of related party transactions for no consideration or under other than market terms. Concealment of misappropriation of assets or of fraudulent financial reporting. The auditor's objectives are to: Obtain an understanding of related party relationships sufficient to be able to: - Recognize fraud risk factors arising from related party transactions and relationships. - Conclude whether the financial statements achieve fair presentation of related party transactions and relationships. Obtain sufficient appropriate audit evidence about whether related party relationships and transactions are appropriately accounted for and disclosed. Definitions Arm's length transaction. A transaction conducted on terms and conditions such as would prevail in a transaction between a willing buyer and willing seller who are unrelated, acting independently and pursuing their own best interests. Related party. A party defined as related in GAAP, as promulgated by designated standard setting bodies according to AICPA Rule 202. OBSERVATION GAAP frameworks refer to specific related party disclosure requirements. If the applicable financial reporting framework does not have such requirements, auditors nevertheless evaluate 165

167 whether related party disclosures are comparable to GAAP. Requirements Risk assessment procedures and related activities. Auditors should perform the following audit procedures and related activities to help identify risks of material misstatement arising from related party relationships and transactions: Specifically consider the risk of fraud or error associated with related party relationships or transactions. Inquire of management regarding: - Identities of related parties - Changes in related parties from prior period - Nature of relationships - Whether related party transactions exist during the period - The type and purpose of any related party transactions Maintain alertness during the audit for indications of the existence of related party transactions and relationships. Inspect the following for indications of unidentified or undisclosed related party relationships or transactions: - Bank confirmations - Minutes - Other records that the auditor considers necessary Inquire of management, when significant transactions outside the normal course of business are identified, about: - The nature of the transactions - Whether related parties could be involved Share the identity of, and other relevant information about related parties with the members of the engagement team. Determine whether identified risks associated with related party relationships and transactions are significant risks. Regard related party transactions outside of the normal course of business as significant risks. Consider identified fraud risk factors in identifying and assessing fraud risk associated with related parties. Responses to risks of material misstatement. Auditors should design and perform further audit procedures to obtain sufficient appropriate audit evidence about risks of material misstatement associated with related party transactions and relationships. Unidentified or undisclosed related parties or related party transactions. When auditors identify information that suggests the existence of previously unidentified or undisclosed related party relationships or transactions, they should: Determine whether circumstances confirm the existence of those relationships or transactions. Communicate relevant information about the newly identified related parties or transactions to members of the engagement team. Request management to identify all transactions with the newly identified related parties. Inquire why internal controls failed to identify or disclose the relationships or transactions. Perform appropriate substantive procedures on newly identified related parties or significant related 166

168 party transactions. Reconsider the risk that other unidentified related parties or related party transactions may exist, and perform additional audit procedures as necessary. Evaluate the implications of apparently intentional nondisclosure by management. Related party transactions outside the normal course of business. For significant related party transactions outside the normal course of business, auditors should: Inspect underlying contracts or agreements and evaluate whether: - The business rationale of the transactions suggests that they may have been entered into to perpetrate a fraud. - The terms of the transaction are consistent with management's expectations. - The transactions are properly accounted for and disclosed. Obtain evidence that the transactions are appropriately authorized and approved. Arm's length assertions. Auditors should obtain sufficient appropriate evidence about arm's length assertions made by management. Evaluation of accounting and disclosure. Auditors should evaluate the following with respect to related party relationships and transactions in forming an opinion: Appropriateness of accounting and disclosure Whether the effects of related party relationships and transactions cause the financial statements not to be fairly presented Communication with those charged with governance. Unless all persons charged with governance are involved in the entity's management, auditors should communicate with them regarding significant audit findings or issues concerning related parties. Documentation. Audit documentation should contain the names of the identified related parties and the nature of the relationships. STUDY QUESTION 7. Upon discovery that a significant related party transaction outside the normal course of business has occurred auditors should do all of the following except: a. Obtain evidence that the transaction has been properly approved. b. Report the transaction to those charged with governance. c. Inspect underlying contracts or agreements to evaluate the business rationale for the transaction. d. Regard it as an area of significant risk SUBSEQUENT EVENTS AND SUBSEQUENTLY DISCOVERED FACTS AU-C Section 560, Subsequent Events and Subsequently Discovered Facts addresses the auditor's responsibilities regarding subsequent events that require adjustment to or disclosure in the financial statements, and subsequently discovered facts that became known to the auditor after the audit report date. It categorizes subsequent events into two types: Those that provide evidence of conditions that existed at the financial statement date 167

169 Those that provide evidence of conditions that arose after the financial statement date The auditor's objectives are to: Obtain sufficient appropriate evidence about whether subsequent events that require adjustment to or disclosure in the financial statements are appropriately reflected. Respond appropriately to facts that become known to the auditor after the report date that would have caused a revision to the auditor's report had they been known at that date. For predecessor auditors who are asked to reissue a previously issued report on financial statements that are to be presented on a comparative basis with audited statements of a subsequent period, to perform specified procedures to determine whether the previous report is still appropriate before it is reissued. Definitions Date of the auditor's report. The date that the auditor dates the audit report. Date of the financial statements. The date of the end of the latest period covered by the statements. Subsequent events. Events that occur between the date of the financial statements and the date of the auditor's report. Subsequently discovered facts. Facts that became known to the auditor after the date of the auditor's report that may have caused a revision to the auditor's report had they been known at that date. Requirements Subsequent events. Auditors should perform the procedures to obtain sufficient appropriate evidence that all subsequent events that require adjustment to or disclosure in the financial statements have been identified. This does not, however, require auditors to perform additional audit procedures on matters to which previously applied procedures have provided satisfactory conclusions. These procedures should cover the period from the statement date to the report date, or as close as practicable thereto, and should include: Consideration of the auditor's risk assessment Obtaining an understanding of management's procedures for identifying subsequent events Inquiring of management and, if appropriate, those charged with governance, about whether subsequent events that might affect the statements have occurred Reading subsequent minutes, if any, and inquiring about matters discussed in meeting for which minutes have not been prepared Reading the latest subsequent interim statements, if any If auditors identify subsequent events that require adjustment to or disclosure in the financial statements as a result of these procedures, they should determine whether each such event is properly reflected in accordance with the applicable financial reporting framework. Subsequently discovered facts before report release. Auditors are not required to perform any audit procedures after the report date. However, if they subsequently discover a fact before the report is released, they should: Discuss it with management and, if appropriate, those charged with governance. Determine whether it requires revision of the financial statements and, if so, inquire how management intends to address the matter in the statements. If management revises the statements, auditors should perform the audit procedures necessary in the circumstances on the revision, and should either: Date the auditor's report as of a later date, and extend the subsequent events procedures and request updated management representations through that date, or, 168

170 Include an additional date in the auditor's report on the revised statements that is limited to the revision, indicating that audit procedures after the original date are limited solely to the revision described in the relevant footnote. In this case, auditors should request additional management representations as of the additional date in the report addressing whether: - Any of the previous representations should be modified - Any other subsequent events have occurred that would require adjustment to or disclosure in the statements If management does not revise financial statements that the auditor believes require revision, they should modify their audit opinion. Subsequently discovered facts after report release. When a fact is discovered after the report release date, auditors should: Discuss it with management and, if appropriate, those charged with governance Determine whether it requires revision of the financial statements and, if so, inquire how management intends to address the matter in the statements If management revises the statements, auditors should apply the procedures described under "subsequently discovered facts before report release" immediately above. If the previously issued statements and auditor's report have been made available to third parties, auditors should assess whether management's steps to inform anyone in receipt of the statements about the matter are timely and appropriate. These steps should include informing those parties that the statements are not to be relied upon. If management does not take the necessary steps, auditors should: Notify management and those charged with governance that they will seek to prevent future reliance on their report. If after such notification, management declines to take necessary steps, auditors should take appropriate action to seek to prevent reliance on the report. Auditors should disclose the following in an emphasis-of-matter or other-matter paragraph in their report on the revised statements, when the opinion differs from that previously expressed: The date of the previous auditor's report The type of opinion previously expressed The substantive reasons for the different opinion That the opinion on the revised statements is different from the previous opinion When management does not revise statements in circumstances that the auditor believes call for revision, the auditor should: Notify management and those charged with governance not to make the audited statements available to third parties without the necessary revision, and until a new auditor's report has been provided. If the statements have already been made, or are nevertheless made available to third parties without the necessary revisions, auditors should assess the timeliness and appropriateness of management's steps to notify the recipients, as discussed above. In the event that management does not take necessary steps, should take the actions as noted above. Predecessor auditor reissuance. Before reissuing a previous report on statements that are to be presented on a comparative basis with audited statements of a subsequent period, the predecessor auditor should perform the following procedures to determine that the report is still appropriate: Read the subsequent statements that are to be presented on a comparative basis Compare those statements to the prior period audited statements 169

171 Request written management representations at or near the date of reissuance about whether: - Management believes that any of the previous representations should be modified - Any subsequent events have occurred that would require adjustment to or disclosure in the prior period statements Obtain written representations from the successor auditors stating whether their audit revealed matters that would require adjustment to or disclosure in the prior period statements If a fact is subsequently discovered as a result of these procedures, the predecessor auditor should take the applicable steps as outlined above under "Subsequently discovered facts after report release." 1413 GOING CONCERN AU-C Section 570, The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern, addresses the auditor's responsibilities for evaluating whether there is substantial doubt about an entity's ability to continue as a going concern. Financial reporting normally presumes that an entity will continue as a going concern absent significant information to the contrary. Auditors are responsible for evaluating whether there is substantial doubt about an entity's ability to continue as a going concern for a reasonable period of time. This evaluation is based on the auditor's knowledge of relevant conditions or events that exist or occur before the date of the auditor's report. Information about these conditions or events is obtained from applying audit procedures to achieve the objectives related to management's assertions embodied in the financial statements. Auditors cannot always predict future events or conditions that may cause going concern problems. For this reason, the fact that an entity may cease to exist as a going concern after receiving an audit report that does not refer to a substantial doubt about going concern, even within a year after the statement date, does not indicate an inadequate audit. Similarly, the absence of a reference in an auditor's report to substantial doubt is not a guarantee as to the entity's ability to continue as a going concern. Definition Reasonable period of time. A period not to exceed one year after the date of the statements being audited. Requirements Evaluating whether substantial doubt exists. Auditors should evaluate whether there is substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time, based on the results of the audit procedures required in the following subsections of this course. Identifying indicators of substantial doubt. The auditor should consider: Whether procedures performed during the course of the audit identify conditions or events that in the aggregate indicate that there could be substantial doubt about the entity's ability to continue as a going concern The need to obtain additional information about those conditions or events, and audit evidence to support information that mitigates the auditor's doubt Indicators of substantial doubt may include: Negative trends, such as recurring losses, working capital deficiencies, negative cash flows or adverse financial ratios Other indications of financial difficulty, such as: - Default on loan agreements - Arrearages in dividends - Denial of usual trade credit from suppliers - Debt restructuring - Noncompliance with statutory capital requirements - Need to seek new sources or methods of financing 170

172 - Need to dispose of substantial assets Internal matters, such as: Work stoppages or other labor difficulties Substantial dependence on the success of a particular project Uneconomic long-term commitments Need for significant revisions to operations External matters, such as: Legal proceedings Legislation or similar matters that might jeopardize the entity's ability to operate Loss of a license, patent or franchise Loss of a major customer or supplier Uninsured or underinsured catastrophe OBSERVATION Auditors are not required to design special procedures solely to detect conditions or events that would indicate substantial doubt about going concern. Risk assessment procedures and the further audit procedures designed to gather evidence in response to them are normally expected to be sufficient. These procedures may include: Analytical procedures Review of subsequent events Review of compliance with debt agreements Reading of minutes Inquiry of legal counsel Confirmations with third parties of the details of arrangements to provide or maintain financial support OBSERVATION GAAP currently offers no guidance about management s responsibilities to evaluate going concern matters, or to provide related disclosures. The Financial Accounting Standards Board (FASB), in August 2014, issued Accounting Standards Update No, , Presentation of Financial Statements Going Concern (Subtopic ), in order to provide that guidance. The amendments in this Update take effect for the annual period ending after December 15, 2016, and for subsequent interim and annual periods. Early application is permissible. These amendments incorporate and expand upon certain principles of GAAS. Specifically, they: Define the term substantial doubt Require evaluation in every reporting period, including interim periods Provide principles for considering the mitigating effects of management s plans Require certain disclosures when substantial doubt is alleviated Require an express statement and other disclosures when substantial doubt is not alleviated Require an assessment period for one year after the issue or available-to-be-issued date of 171

173 the financial statements STUDY QUESTION 8. Which of the following statements best applies to AU-C Section 570? a. The absence of a reference in an auditor's report to substantial doubt about going concern guarantees the entity's ability to continue as such. b. Auditors are required to design special auditing procedures to detect conditions that indicate substantial doubt about going concern. c. AU-C Section 570 defines a reasonable period of time as a period not to exceed one year after the date of the auditor's report. d. AU-C Section 570 applies to audits of financial statement audits prepared on the cash or tax basis. Considering management's plans. After considering identified conditions or events in the aggregate, if the auditor has substantial doubt about going concern, the auditor should obtain information about management's plans to mitigate their effects. The auditor should: Assess the likelihood that adverse effects would be mitigated for a reasonable period of time Identify the elements of management's plans that are particularly significant to overcoming those adverse effects Perform audit procedures to obtain evidence about those elements, including, when applicable, considering the adequacy of support regarding the ability to obtain additional financing or the planned disposal of assets Assess the likelihood that management's plans can be implemented When prospective financial information is particularly significant to management's plans, the auditor should: Ask management to provide that information Consider the adequacy of support for significant underlying assumptions Give special attention to assumptions that are: - Material - Especially sensitive - Susceptible to change - Inconsistent with historical trends Read the prospective financial information Compare prior periods' prospective financial information to actual results Compare the current period's prospective financial information to actual results to date Discuss the effect on that information of factors that the auditor is aware of, but that are not reflected in the information, with management and, if necessary, request revision of the information Considering financial statement effects. If the auditor has substantial doubt about going concern after considering management's plans, the auditor should consider: The possible effects on the financial statements The adequacy of related disclosures 172

174 When the auditor concludes based upon consideration of management's plans, that substantial doubt is alleviated, the auditor should consider: The need for and adequacy of disclosure of the principal conditions or events that initially gave rise to the substantial doubt Their possible effects and any mitigating factors, including management's plans Written representations. If auditors have substantial doubt about going concern before considering management's plans, they should obtain written representations from management concerning: Its plans for mitigating the adverse effects of conditions or events that gave rise to substantial doubt The likelihood that those plans can be effectively implemented The completeness of financial statement disclosures of all going concern matters that management is aware of, including principal conditions or events and management's plans Considering effects on auditor's report. Auditors should include an emphasis-of-matter paragraph in the auditor's report when they conclude that substantial doubt remains. That paragraph should contain the phrase: "substantial doubt about (the entity's) ability to continue as a going concern" or similar wording that includes the words "substantial doubt" and "going concern." Auditors should not use conditional language in expressing a conclusion about substantial doubt as to an entity's ability to continue as a going concern. When auditors conclude that the entity's going concern disclosures are inadequate, they should express a modified opinion. This section does not prohibit an auditor from disclaiming an opinion in cases involving uncertainties. A report with a disclaimer should not, however, contain an emphasis-of-matter paragraph for going concern. Rather, it should describe the substantive reasons for the disclaimer. When issuing a disclaimer, auditors should consider the adequacy of disclosure of the uncertainties and their possible effects on the financial statements. Communicating with those charged with governance. Auditors should communicate the following to those charged with governance when, after considering identified events or conditions and management's plans, they conclude that substantial doubt about going concern remains: The nature of the events or conditions identified Their possible financial statement effect and the related disclosures The effects on the auditor's report Comparative presentations. When substantial doubt about going concern existed in a prior period that is presented on a comparative basis, and the doubt has been removed in the current period, the emphasis-ofmatter paragraph from the prior period should not be repeated. The fact that substantial doubt arose in the current period does not imply that doubt existed in the prior period. It therefore does not affect the auditor's report on the prior period that is presented on a comparative basis. Eliminating a going-concern paragraph. An auditor may be asked to reissue a report to eliminate a going concern emphasis-of-matter paragraph. These requests normally occur when the matters giving rise to the substantial doubt have been resolved. Although there is no obligation to do so, if the auditor decides to reissue the report, he or she should reassess the entity's going concern status by: Performing audit procedures related to the transaction or event that gave rise to the request to eliminate the going concern paragraph Performing subsequent events procedures at or near the date of reissuance Reconsidering, based on conditions or circumstances at the date of reissuance, the matters discussed 173

175 above in the subsections captioned: - Identifying indicators of substantial doubt - Considering management's plans - Written representations Considering the implications on the auditor's report Documentation. When auditors believe, before consideration of management's plans, that there is substantial doubt about going concern, the audit documentation should contain: The conditions or events that gave rise to the substantial doubt The elements of management's plans that the auditor considers significant to overcome the adverse effects of those conditions or events The audit procedures performed and evidence obtained to evaluate those elements The auditor's conclusion as to whether substantial doubt remains or is alleviated - If substantial doubt remains, the auditor should also document the possible effects of the conditions or events on the statements, and the adequacy of related disclosures - If substantial doubt is alleviated, the auditor should also document a conclusion about the need for and, if applicable, the adequacy of disclosure of the conditions or events that initially gave rise to the substantial doubt 1414 WRITTEN REPRESENTATIONS AU-C Section 580, Written Representations, addresses the auditor's responsibility to obtain written representations from management and, when appropriate, those charged with governance when performing an audit. These representations are audit evidence that complement other auditing procedures. They do not, on their own, provide sufficient appropriate audit evidence about any of the matters that they cover, and do not affect the nature or extent of other audit procedures. The auditor's objectives are to: Obtain written representations that management (and, where applicable, those charged with governance) believe that they have met their responsibilities for preparation and fair presentation of the statements and for the completeness of information provided to the auditor. Support other audit evidence with written representations if considered necessary by the auditor or required by other AU-C Sections. Respond appropriately to written representations, or in the event that management does not provide the representations requested by the auditor. Definition Written representation. A written statement that management gives to the auditor to confirm certain matters or support other audit evidence. In this context, those representations do not include the financial statements or assertions therein, or supporting books and records. Requirements Auditors should request, in the form of a representation letter addressed to the auditor, the following written representations from management personnel with appropriate responsibilities for the financial statements and knowledge of the matters concerned: That management has fulfilled its responsibility, as set out in the engagement letter, for: - Preparation and fair presentation of the statements - Design, implementation and maintenance of internal controls over preparation and fair presentation of statements that are free from material error due to either fraud or error 174

176 That it has provided the auditor with all relevant information and access, as agreed to in the engagement letter That all transactions are recorded and reflected in the financial statements That it acknowledges responsibility to design, implement and maintain internal controls to prevent and detect fraud That significant assumptions used in making accounting estimates are reasonable That it has disclosed to the auditor: - Any knowledge of fraud or suspected fraud involving management, employees with significant roles in internal control, or others when fraud could materially affect the statements - Any knowledge of allegations of fraud or suspected fraud communicated by employees, former employees, regulators, or others - All instances of identified or suspected noncompliance with laws or regulations whose effects should be considered by management in the preparation of the financial statements - All known actual or possible litigation or claims whose effects should be considered by management in the preparation of the financial statements, and that they are properly accounted for and disclosed in the statements - The identity of related parties and all related party transactions and relationships, and that they are properly accounted for and disclosed in the statements Whether it believes that uncorrected misstatements, if any, are immaterial individually and in the aggregate to the statements as a whole. A summary of these misstatements should accompany or be included in the representations. Other representations that the auditor determines are necessary or that are required by other AU-C sections These representations should be as of the date of the auditor's report, and should cover all financial statement periods covered in the report. Doubts about reliability of representations. When auditors have doubts about management's competence, integrity, ethical values, diligence, or its commitment to any these, they should determine the effect that those concerns may have on the reliability of representations, whether or not written, and on audit evidence in general. When written representations are inconsistent with other audit evidence, auditors should perform audit procedures to resolve the inconsistency. If it remains unresolved, auditors should reconsider their assessment of management's competence, integrity, ethical values, diligence, or its commitment to any these, and determine the effect on the reliability of representations and of audit evidence in general. When auditors conclude that written representations are unreliable, they should take appropriate action, including the possible effect on the audit report. Auditors should disclaim an opinion or withdraw from the engagement if: They have sufficient doubt about management's integrity that they conclude that the written representations are unreliable, or Management does not provide written representations. Representations not provided. If management does not provide one or more of the requested written representations, auditors should: Discuss the matter with management. Reevaluate management's integrity and the effect this may have on the reliability of representations and audit evidence in general. Take appropriate actions including determining possible effects on the audit report. 175

177 STUDY QUESTION 9. According to AU-C Section 580, which of the following statements applies to management's written representations? a. Auditors have grounds for withdrawal from an audit engagement when they have sufficient doubt about management's integrity to conclude that their written representations are not reliable. b. The financial statements, the assertions therein, and supporting books and records comprise a part of management's written representations. c. Auditors should express an adverse opinion on the financial statements if management does not provide written representations. d. The representations should be dated prior to the date of the auditor's report CONSIDERATION OF OMITTED PROCEDURES AU-C Section 585, Consideration of Omitted Procedures After the Report Release Date, addresses the auditor's responsibility when, after the report release, the auditor becomes aware that one or more audit procedures that he or she considered necessary in the circumstances existing during the audit were omitted. This section does not apply when the auditor's work is the subject of threatened or pending legal proceeding or regulatory investigation. The auditor's objectives are to: Assess the effect of the omitted procedure on his or her ability to support the previously expressed opinion on the financial statements, and Respond appropriately Definition Omitted procedure. An audit procedure considered necessary by the auditor in the circumstances existing during the audit that was not performed. Requirements When auditors become aware of an omitted procedure after the report release date, they should assess its effect on their ability to support their previously expressed opinion. When they become aware that the omission impairs their ability to support a previous opinion, and they believe that users are currently relying, or likely to rely on that opinion, auditors should: Promptly perform the omitted procedure or alternate procedures, to determine whether there is satisfactory basis for the previously expressed opinion. Include those procedures in the audit documentation. Apply the provisions of AU-C Section 560 when they become aware, as a result of these procedures, of facts that existed as of the report release date that would have caused them to revise the audit report. 176

178 CHAPTER 15: Fraud in a Financial Statement Audit 1501 WELCOME This chapter examines fraud in the financial statement audit from an academic and professional perspective that is concerned with conceptual models, and a professional liability insurance company's claims experience LEARNING OBJECTIVES Upon completion of this chapter, the reader should be able to: Explain the various conceptual models for assessing fraud risk List the strengths and weaknesses of each model Describe public versus auditor perceptions of the auditor's responsibility for fraud detection Explain the implications of evolving models of fraud risk and malpractice claims experience for audit practice 1503 INTRODUCTION This chapter examines fraud in the financial statement audit from two perspectives: An academic and professional perspective that is concerned with conceptual models for assessing fraud risk. These models have evolved considerably over several decades. Updated models provide expanded frameworks for auditors to use in assessing fraud risk. A professional liability insurance company's perspective, which in some cases is dealing with mitigation of damages caused by an auditor's failure to detect fraud, and in others, is attempting to reconcile within the legal system the public's perception of the auditor's responsibility for detecting fraud versus the actual requirements of professional standards and good practice. Both of these perspectives offer lessons for auditors. The conceptual models provide expanded frameworks for understanding the fraud perpetrator's thought processes, and thus for assessing the risk of material misstatement due to fraud. The insurance claims provide an "after the fact" view of what the auditor could have or might have done to avoid or lessen the effect of a malpractice claim EVOLVING MODELS OF FRAUD RISK Jack Dorminey, A. Scott Fleming, Mary-Jo Kranacher, and Richard Riley, in their article "Beyond the Fraud Triangle" (The CPA Journal, New York State Society of Certified Public Accountants: July 2010), provide an insightful analysis of the evolution of the conceptual frameworks that auditors have used to assess fraud risk. Their analysis identifies strengths and weaknesses in each, and suggests new dimensions to the traditional models that auditors will find useful, particularly in framing their thought processes about predatory or careercriminal types, of fraud perpetrators. This chapter will survey some of the new ways auditors are conceptualizing their understanding of fraud. Classic Fraud Triangle The "classic fraud triangle" forms the basis for AU-C section 240, Consideration of Fraud in a Financial Statement Audit. The triangle, which originated in the 1940s, seeks to model the thought processes of individual perpetrators. Its elements are: 177

179 Incentive or pressure. In the case of fraudulent financial reporting, this could be pressure from outside sources to meet a particular earnings target, or a personally generated desire to achieve a particular financial goal in order to earn a bonus. In the case of asset misappropriation, pressure could arise, for example, from uninsured expenses of an illness, or from lifestyles that are beyond an individual's means. In the academic research, this is typically referred to as a "non-sharable financial pressure," although that phrase is not usually present in the audit literature. Opportunity. A perceived opportunity to commit fraud may arise when an individual believes that he can override internal controls, by virtue of being in a position of authority, or circumvent them by virtue of knowledge about specific internal control deficiencies. Rationalization. Honest individuals may give in to pressures that allow them to rationalize committing a fraudulent act. Dishonest individuals have attitudes, character, or ethical values that allow them to commit deliberate acts of fraud. This model is usually illustrated by drawing a three-sided triangle. Each corner or side is then labeled with one of the three factors. This creates a visualization showing that incentive, opportunity, and rationalization blend together to facilitate a fraud incident. This model holds that all three of these elements must be present for fraud to occur. It is a strong explanatory model for what Dorminey and his colleagues call "the accidental fraudster." This is commonly a person who is: A first-time perpetrator Well-educated In a position of trust Considered to be a good citizen Absent some non-shareable financial pressure, this person would never consider committing fraud. Many of these people rationalize the fraud as a temporary condition, such as a small misappropriation that they will pay back out of their next paycheck, or "as soon as things get better." This person may never "work out" of his pressure situation, and over time may misappropriate larger amounts of money or company assets. This model's chief inadequacy, however, is that two of its elements, pressures and rationalizations, cannot always be observed by auditors. This is one of the reasons why it does not do a very good job of explaining the "predatory" or career criminal type of perpetrator. The authors cite the example of a former vice-chairman of Wal-Mart, with a $6 million annual compensation package. Over five years this person appears to have engaged in questionable transactions totaling possibly as much as $500,000 for items as small as a $1,000 pair of custom-made boots and a $2,500 pen for his hunting dogs. This case is inconsistent with the classic fraud triangle because there appears to have been no nonshareable financial pressure, and it seems irrational that a person would risk so large a compensation package for so small a reward. As a response to the lack of objective criteria for identifying incentives or pressures and rationalizations, an alternate version of the fraud triangle evolved. This model relies on observable actions and quantifiable results. Its elements are: The act that constitutes the fraud itself. Concealment. This involves the auditor gathering evidence of the intent to deceive. Conversion. This refers to the measurement of the economic damage suffered by the victim. Collusion is one of the central elements of complex frauds. The Association of Certified Fraud Examiners reports that the average loss per incident of fraud is $80,000 when one person is involved. With two perpetrators, the median loss more than doubles to $200,000. With three people involved the median almost doubles again to $355,000. The classic triangle is not a good tool for assessing the likelihood of collusive fraud, because it generally takes into account only an individual acting alone. (2014 Report to the Nations on Occupational Fraud 178

180 and Abuse. Copyright 2014 by the Association of Certified Fraud Examiners, Inc., Page 4) Collusion can occur between persons within an organization, or across organizations. Controls centered on segregation of duties are usually ineffective in preventing collusion. Internal controls, however, can assist in detecting collusion. Independent monitoring, for example, may detect that controls have been circumvented by collusion. STUDY QUESTION 1. The classic fraud triangle is best suited as a tool for assessing the likelihood of fraud by which of the following types of perpetrator? a. Perpetrators acting in collusion b. Individual, first-time perpetrators c. Predatory, career-criminal perpetrators d. Highly compensated senior management Fraud Scale The fraud scale was developed in the 1980s because a reliable profile of occupational fraud perpetrators did not exist. This model assesses fraud risk by evaluating the relative forces of: Pressure Opportunity Personal integrity It substitutes personal integrity for the element of rationalization in the classic fraud triangle. It is structured as a continuum rather than a triangle. In that continuum, as pressure and opportunity increase and personal integrity decreases, fraud risk increases. This model is particularly applicable to fraudulent financial reporting, because sources of pressure, such as analysts' forecasts, management earnings guidance, or a history of earnings or sales growth, are observable inputs. An individual's decisions and decision-making processes can also be observed. Thus, his or her commitment to ethical decision-making can be assessed. When auditors consider an individual's decisions in an ethical context, they can assess the risk of that person committing fraud. Fraud Diamond The fraud diamond adds an individual's capabilities as a fourth element to the classic triangle. This model suggests that even though the three classic triangle elements are present, frauds, especially some of the multibillion-dollar financial statement frauds, could not occur without the right person with the right capabilities to implement its details. It asks who could turn a fraud opportunity into a reality. The authors of this model suggest four observable perpetrator traits for frauds that span extended periods and involve large sums: Position or function of authority within the organization Capacity to understand the accounting system and exploit internal weaknesses, and possibly to leverage responsibility and abuse authority to complete and conceal the fraud Confidence that the fraud will go undetected, and in the ability to talk their way out of trouble if caught Capability to handle the stress that arises in an otherwise good person who commits a fraud This model requires that auditors observe, assess, and document the capabilities of top executives, key personnel, and employees who could perpetrate and conceal fraud. 179

181 If the picture to analyze fraud is a three sided triangle, the fraud diamond is four-sided. Each side is labeled: Incentive Opportunity Rationalization Capability "MICE" Model The acronym "MICE" stands for the motivational factors of: Money Ideology Coercion Ego/entitlement Money. The authors of this model hold that the classic triangle oversimplifies the motivations behind fraud. The risks that the perpetrator took in the Wal-Mart case, for example, are similar to those that other highly compensated CFOs and CEOs take in fraudulent financial reporting. With fraudulent financial reporting, the perceived financial pressure element of the classic triangle is modified to consider such other motivators as bonuses, stock options, or other monetary incentives. The pressure that top executives feel to deliver financial results is not the same as the non-shareable financial pressure felt by other perpetrators. Ideology. Ideology is most often associated with tax evasion, and lately with terrorist funding. In these cases, the perpetrator feels that the government is not entitled to his or her money, or the perceived greater good of their ideological causes justifies the means. Coercion. Most large frauds involve an element of coercion, in which, as posited in the fraud diamond, a person in authority overrides a control and coerces a subordinate into an act that facilitates or conceals the scheme. Low-level or unwilling participants may later turn into whistleblowers. Ego/entitlement. Perpetrators in infamous multibillion-dollar frauds like Enron and ZZZZ Best are most often motivated by a combination of money, ego, or entitlement. As in the fraud diamond, they are confident in their abilities to conceal the fraud or to talk their way out of it. Their positions and the corporate culture surrounding them often allow them to feel that they are entitled to the $10,000 lunches, as in Enron, or the $1,000 boots in the Wal-Mart case. Predator vs. Accidental Fraudster Diamond Dorminey and his colleagues note that fraud perpetrators fall into two broad categories, the "accidental fraudster," as discussed above, and the "predator" or pathological fraudster. In the latter category, illegal acts tend to be followed by other illegal acts. This continuum of illegal acts defines the predator. Predators have the following characteristics: They seek out organizations where they can begin their schemes soon after being hired. They may start out as accidental fraudsters and, if not detected, turn into predators. Financial statement fraud perpetrators may start out as benign earnings managers, and move to accidental fraudsters and then to predators. They are better organized than accidental fraudsters, have better concealment schemes, and are better equipped to deal with auditors or internal oversight. They require no pressure or rationalization, only opportunity. The new fraud diamond in this model is really two back-to-back triangles with the common element of opportunity. The accidental fraudster fits into the classic triangle. The triangle for the predator, however, replaces 180

182 the classic pressure element with criminal mind-set, and the rationalization element with arrogance. Instead of the visual illustration of a simple triangle, imagine drawing two triangles with a common side. As mentioned, the top triangle for the accidental fraudster has the three sides that auditors are familiar with: pressure, rationalization, and opportunity. The triangle on the bottom for the predator is formed with the same opportunity side and then adds two new sides for criminal mindset and arrogance. Implications for Audit Practice Fraud deterrence generally depends on reducing two elements of the triangle: opportunity and rationalization. This article notes that fear of getting caught and fear of punishment are key fraud deterrents. It offers a checklist focusing on these factors. This checklist is intended as a tool for corporate governance, including the board of directors and the audit committee, top management, and internal and external auditors. From the external auditor's point of view, these efforts are observable. Determining to what degree the client has taken these steps may help give a clearer picture of fraud risk. Controls to increase fear of detection: - Proper control design - Controls operating as designed - Continuous monitoring - Audit software tools - Punishment protocols - Open communication with employees, vendors, suppliers, and customers - Proper employee activity monitoring - Effective tip hotlines - Whistleblower protections - Monitoring of contractual parties Anti-fraud environment to deflate possible rationalizations: - Proper tone at the top - Strong ethical culture - Workplace integrity - Meaningful code of conduct - Anti-fraud training programs STUDY QUESTION 2. The new fraud diamond posited by Jack Dorminey and his colleagues replaces the classic triangle elements of pressure and rationalization with for the predatory fraud perpetrator. a. Criminal mind-set and arrogance b. Ideology and coercion c. Capability and personal integrity d. Ego and entitlement 1505 MALPRACTICE CLAIMS INVOLVING FRAUD An analysis of recent malpractice insurance claims at a large national insurer during 2010 provides an informative look at some of the common perceptions about auditors and their responsibility for fraud detection. It also suggests actions that auditors might take to enhance their abilities to prevent or detect frauds, and to defend themselves against malpractice claims. 181

183 These claims highlight the wide disparities between the clients' or the public's perceptions of the auditors' responsibilities, and either the requirements of professional standards or the auditors' perceptions of those requirements. It is important to remember that once a malpractice claim gets into the legal system, the narrow definitions of professional standards may not always protect the auditor. In the legal system, the system's perception of those standards, and not the profession's, may govern the outcome of a claim. Public Perceptions The public, including individual clients, tends to have a vastly wider view of the auditor's responsibilities than professional standards actually require. These views seem to regard auditors as guarantors of financial statements. They include perceptions that: Auditors are responsible for detecting all frauds. Auditors examine all transactions and detect all misstatements regardless of materiality. By issuing a "clean" audit opinion, the auditor indemnifies the client for undetected losses due to fraud. Auditors are "deep pockets" for loss recovery, regardless of their degree of responsibility, because they tend to be well insured. Auditor Perceptions Auditors, on the other hand, have a far narrower view of their role in fraud detection. This view includes perceptions that: Following minimum audit standards absolves them from responsibility for detecting fraud. Materiality is primarily a quantitative concept in which qualitative aspects are either absent or of secondary importance. Communicating internal control deficiencies absolves them from further responsibility. Details of Claims The largest groups of claims cluster around embezzlements and Ponzi schemes. Each of these illustrates divergent perceptions of auditor responsibility. Embezzlements. Almost 20 percent of these claims involved defalcations in which the auditor allegedly failed to detect an embezzlement. These cases are largely linked by issues of communication between the auditor and the client. In about a third of the cases, the clients allege that the auditor did not inform them of inadequacies in internal control. In about two-thirds of the cases, the auditors assert that they warned the clients, even repeatedly, about internal control deficiencies. Ponzi schemes. In another 25 percent of the claims, the auditor is being sued for losses sustained in Madoff or other Ponzi schemes. These cases turn primarily around questions about confirmation of the clients' investments in these schemes. In some of the cases, the clients allege that the auditor did not confirm the investment. The auditors in these cases respond that confirmation would have been beyond the standard of care and that they would, in any case, have been ineffective as a means of detecting Madoff's fraud. In others of the cases, the auditors are being sued even though they confirmed the investments, because they did not warn the client of the fraudulent nature of the investment scheme. In these cases, the auditors assert that they have met the standard of care for auditors, and that the responsibility for due diligence regarding the investments in any case lies with the clients' investment managers, not the audit firm. This set of cases illustrates, if nothing else, that an auditor can get sued even when there is nothing wrong with 182

184 the audit and the auditor has fulfilled their professional responsibilities. Implications for Audit Practice Apparent misunderstandings, or at least divergent views, seem to be at the root of many malpractice claims related to an auditor's failure or alleged failure to detect a fraud. In a proactive sense, then, having clear communication between the auditor and the client from the beginning is one of the best preventative measures. Malpractice claims, however, usually do not arise until well after the actual engagement. Memory is likely to fail either party to a claim over this interval. This is one reason why as a defensive measure clear and complete documentation, particularly of relevant communications between auditor and client, is critical. Have a clear, well-written engagement letter. - Make sure that management understands where its responsibilities lie, and where the auditor's responsibilities begin and end. - Have a meeting to discuss the engagement letter, and document who attended, when, and where. - When those charged with governance are not the same as management, send them a copy of the engagement letter. Communicate internal control-related matters clearly. - Under SAS 115, all significant deficiencies and material weaknesses should be communicated in writing. - Communication of other matters that do not rise to the significant deficiency level should be documented, clearly as to the matter itself, and when and to whom it was communicated. Have documented communications of the following: - Instances of fraud to the appropriate level of management on a timely basis. Instances of fraud involving management, employees with significant roles in internal control, or others, when the fraud involves a material misstatement to the financial statements, to those charged with governance on a timely basis. Communications with those charged with governance, to include a clear understanding of the auditor's responsibilities, and communication of SAS 115 matters. Have complete management representations. - Ensure that the representations address management's responsibilities with respect to fraud. - Have a meeting with the client to make sure they understand what they are signing. - Document the meeting. Meet with management and those charged with governance to go over the audit report. Make sure that they understand what it means. The new auditor's report under the Clarified Standards goes to considerable length to distinguish what is and what is not the auditor's responsibility. The implementation of this new report should serve as an opportunity to meet with both the client and the board to update this understanding. Do not rely solely on management's assertions or representations, whether written or oral. Obtain and document corroborative evidence from other sources. Many of the procedures performed in the ordinary course of an audit can reveal fraud risks. Auditors should perform these procedures with fraud risk in mind, and should document in those procedures their considerations relative to fraud. Some of these procedures include: - Reading of minutes - Correspondence with attorneys - Confirmations with third parties - Review of legal and regulatory correspondence - Understandings and, where applicable, tests of internal control 183

185 STUDY QUESTION - Related party procedures - Review of legal expense - Analytical procedures - Tests of cash receipts, disbursements, and revenue recognition. 3. Recent malpractice claims involving fraud at a large national insurer highlight the truth of all of the following statements except: a. There are differences in the public's perception versus the auditor's perception of the auditor's responsibilities for fraud detection. b. Auditors indemnify their clients against losses from fraud by issuing an unqualified audit opinion. c. Clear communication between the auditor and the client regarding the auditor's responsibilities for fraud detection is necessary. d. Strict adherence to professional standards does not guarantee that an auditor will not be sued for malpractice. CPE NOTE: When you have completed your study and review of chapters 14-15, which comprise Module 4, you may wish to take the Quizzer for this Module. Go to CCHGroup.com/PrintCPE to take this Quizzer online. 184

186 10,100, Answers to Study Questions 10,101 MODULE 1 CHAPTER 1 1. a. Incorrect. Existence, rights and obligations, completeness, and valuation and allocation are the assertions listed by AU-C Section 315 under the broad category of account balances at period end. b. Correct. AU-C Section 315 groups the financial statement assertions into three broad categories: account balances at period end, classes of transactions and events, and presentation and disclosure. c. Incorrect. Occurrence, rights and obligations, completeness, classification, understandability, accuracy and valuation are the assertions listed by AU-C Section 315 under the broad category presentation and disclosure d. Incorrect. Occurrence, completeness, accuracy, cutoff, and classification are the assertions listed by AU-C Section 315 under the broad category of classes of transactions and events. 2. a. Incorrect. AU-C Section 315 states that determination of whether an assertion is relevant is made without regard to the effect of internal controls. b. Correct. According to AU-C Section 315, a relevant assertion is a financial statement assertion that has a reasonable possibility of containing one or more misstatements that would be material to the financial statements. c. Incorrect. An assertion is a representation by management that is embodied in the financial statements, whether explicit or otherwise. Not all explicit assertions are necessarily relevant assertions. d. Incorrect. Under AU-C Section 315's definition, auditors would not ordinarily consider an assertion that had only a remote possibility of containing one or more material misstatements to be a relevant assertion. 3. a. Incorrect. According to AU-C Section 300, a description of the characteristics that define the scope of the engagement is a component of the audit strategy, rather than the audit plan. b. Incorrect. The audit plan should describe the nature and extent of planned further audit procedures down to the relevant assertion level, rather than at the financial statement level. c. Correct. AU-C Section 300 requires the audit plan to describe the planned risk assessment procedures. d. Incorrect. Consideration of knowledge obtained on other engagements performed for the entity is a part of the audit strategy, rather than the audit plan. 4. a. Correct. Certain risks have inherent properties that cannot be mitigated by internal controls. Therefore, AU-C Section 315 requires auditors to consider whether identified risks represent significant risks without regard to the effects of internal control. b. Incorrect. Fraud carries with it inherent risks due to its covert nature. For this reason, when significant fraud risk exists, it should enter into consideration of whether a particular identified risk is a significant risk. c. Incorrect. Significant economic developments may form a part of an entity's environment, and are important to an auditor's understanding of an entity and may be relevant to risk assessment. For these reasons, they should be considered when considering whether an identified risk is significant. d. Incorrect. Related party transactions are usually regarded as having heightened risk for misstatement. Auditors should, therefore, take into consideration whether a transaction involves related parties in determining if 185

187 it represents a significant risk. 5. a. Correct. AU-C Section 315 requires auditors to identify and assess risks of material misstatement at both the financial statement and the relevant assertion levels. b. Incorrect. In identifying and assessing risks of material misstatement, auditors consider the financial statement assertions that are relevant to significant transaction classes, account balances and disclosures. They make their assessments at the relevant assertion level, rather than for the transaction class, balance or disclosure itself. c. Incorrect. While it is true that auditors are required to assess the risks of material misstatement at the financial statement level, they are also required to make this assessment at another level. d. Incorrect. It is correct that auditors are required to assess the risks of material misstatement at the relevant assertion level. They are, however, also required to make this assessment on another level. 6. a. Incorrect. AU-C Section 320 makes a number of assumptions about the competence and diligence of financial statement users, one of which is their willingness to study the statements with appropriate diligence. b. Incorrect. AU-C Section 320 assumes that financial statement users have appropriate knowledge of business and economic activities and accounting. c. Correct. AU-C Section 320 states that auditors do not consider the individual needs of specific individual financial statement users, because their needs may vary so greatly. d. Incorrect. Under AU-C Section 320, financial statement users are assumed to recognize that there are uncertainties inherent in the measurement of financial statement amounts, such as accounting estimates and judgments used in preparing the statements. 7. a. Correct. When substantive procedures do not by themselves provide sufficient appropriate evidence at the relevant assertion level auditors should test controls. A frequently cited example is when large volumes of transactions are recorded in electronic form only and are either not economically testable or are unavailable for testing after a certain time. b. Incorrect. If controls are not expected to be operating effectively, as for example when they are improperly designed or implemented, it usually serves no purpose to test them. c. Incorrect. Auditors should test each control that they plan to rely on at least once every three years. Under certain circumstances, however, such as when there is a significant risk of material misstatement at the relevant assertion level, or when there is a weak control environment, more frequent testing may be necessary. d. Incorrect. Auditors need test only those controls that they plan to rely on. Therefore, if a significant assessed risk of material misstatement at the relevant assertion level can be adequately and efficiently addressed by substantive procedures alone, tests of related controls are not necessary. 8. a. Incorrect. There is no requirement to apply substantive procedures to immaterial classes of transactions, account balances or disclosures. b. Correct. AU-C Section 330 states that substantive procedures should be performed in all audits for all relevant assertions related to each material class of transactions, account balance, and disclosure regardless of the assessed risk of material misstatement. c. Incorrect. Substantive procedures performed on each material class of transactions, account balance, and 186

188 disclosure may include tests of details and substantive analytical procedures. There is no requirement, however, that both be performed when only one is necessary to provide sufficient appropriate evidence. d. Incorrect. Substantive procedures are performed to detect material misstatements down to the relevant assertion level, which is below the transaction class, account balance and disclosure level. 9. a. Incorrect. A type 1 report does not contemplate a service auditor testing controls at a service organization. Therefore it does not provide evidence about the operating effectiveness of the service organization's controls. b. Incorrect. Evaluating the design and implementation of user entity controls related to the transactions processed and services provided by a service organization is in itself a risk assessment procedure rather than a response to an assessed risk. c. Incorrect. Obtaining an understanding of the nature and significance of the services provided by a service organization to the user entity's operations is in itself a risk assessment procedure rather than a response to an assessed risk. d. Correct. As part of their response to assessed risks related to a user entity's use of a service organization, user auditors should determine whether sufficient appropriate evidence concerning the relevant assertions is available from the user entity's records. If it is not, they should perform, or use another auditor to perform further audit procedures at the service organization. 10. a. Incorrect. The AOEM is explicit in stating that the terms "clearly trivial" and "immaterial" are not synonymous. b. Incorrect. Other criteria in addition to size enter into the determination of whether a misstatement is clearly trivial. c. Incorrect. Misstatements should be evaluated in light of their aggregate effects with other misstatements in determining whether they can be considered clearly trivial. d. Correct. Many factors, both quantitative and qualitative, enter into the determination of whether a misstatement is clearly trivial. For this reason, a misstatement cannot be considered clearly trivial if there is any doubt about whether it is. 10,102 MODULE 1 CHAPTER 2 1. a. Incorrect. Nothing prohibits a firm from specifying as a matter of its own quality control policies and procedures that the documentation completion date be the same as the report release date. However, nothing in professional standards requires this. As a practical matter, it would be unusual not to allow for time after the report release date to complete the assembly of the audit file. b. Incorrect. The documentation completion date may be no later than 45 days after the report release date under PCAOB Auditing Standards. The AU-C Section 230 requirement is 60 days. c. Correct. AU-C Section 230 requires that the documentation completion date occur no later than 60 days after the report release date. This is less stringent than the PCAOB requirement, which is 45 days. d. Incorrect. The date on which the auditor obtained sufficient appropriate audit evidence to support the opinion is the earliest date permissible for the report date. 2. a. Correct. AU-C Section 230 defines the report release date as the date that the auditor grants permission for the audit report to be used in connection with the financial statements. b. Incorrect. Under AU-C Section 230, as well as under PCAOB standards, the documentation completion date 187

189 is determined with reference to the report release date. For AU-C Section 230 purposes, that is no later than 60 days after the report release date. The PCAOB standards require a shorter 45 day period. The report release date, however, is not determined with reference to the documentation completion date. c. Incorrect. Under AU-C Section 230, the last date of audit field work is of little relevance for purposes of audit documentation. d. Incorrect. AU-C Section 230 defines report date as the date on which the auditor obtained sufficient appropriate audit evidence to support the opinion, not the report release date. 3. a. Incorrect. For observation procedures, acceptable identifiers should include both when and where the observation was made as well as the process or subject of the observation, persons involved and their responsibilities. b. Incorrect. For inquiry procedures, acceptable identifiers should include the date and subject matter of the inquiry and the positions of the persons inquired of, as well as their names. c. Incorrect. For systematic samples, an acceptable document identifier should include the starting point, such as "the 5 th item," as well as the population of documents and interval. d. Correct. Unique item numbers, for example invoice, purchase order or check numbers are acceptable document identifiers according to AU-C Section a. Incorrect. Audit plans (also known as audit programs) are a required element of all audit documentation. b. Incorrect. AU-C Section 230 lists summaries of significant findings or issues as one of the elements ordinarily included in audit documentation. c. Correct. It is not necessary to keep complete copies of all contracts or agreements that are inspected during an audit. It is, however, required that abstracts or copies of important documents such as contracts or agreements be retained if they are necessary for an experienced auditor to understand the work performed and the conclusions reached. d. Incorrect. Representation letters are a required element of all audit documentation. 5. a. Correct. AU-C Section 320 contains a requirement for auditors to document the factors considered determining materiality, including, when applicable, materiality at the transaction class, account balance and disclosure level. b. Incorrect. Auditors are required to document performance materiality, which is less than materiality for the financial statements as a whole. c. Incorrect. Auditors are required to document changes made to materiality levels during the audit. d. Incorrect. AU-C Section 320 does not contain a specific requirement to document uncorrected misstatements from prior periods. However, AU-C Section 450 requires auditors to consider the effects of uncorrected prior periods' misstatements on the current financial statements, transaction classes, account balances and disclosures. 6. a. Incorrect. AU-C Section 600 requires documentation of the written communication to the component auditors of the group engagement team's requirements. b. Correct. Only when the component auditor's report does not state that the audit was performed in 188

190 accordance with either PCAOB standards or GAAS, is the group auditor required to document the basis for the determination that the component auditor's report meets GAAS requirements. c. Incorrect. AU-C Section 600 states that the audit documentation should indicate significant components and the type of work performed on their financial information. d. Incorrect. If a group auditor assumes responsibility for a component auditor's work, the audit documentation should include the nature, timing and extent of the group engagement team's involvement in that work. 10,103 MODULE 2 CHAPTER 3 1. a. Incorrect. FRF for SMEs would be appropriate when owners and managers are essentially the same group. b. Correct. One indication when the framework is appropriate is the entity's lenders are able to contact owners/managers directly. c. Incorrect. When an entity operates in an industry with specialized accounting principles, FRF for SMEs would not be appropriate because those principles would not be addressed in the framework. d. Incorrect. There is not a specific list of requirements that must be met in order to use the framework. 2. a. Correct. The framework indicates the time horizon is 12 months from the statement of financial position date for considering the impact of known and available information. b. Incorrect. If an entity is not a going concern, the framework indicates that FRF for SMEs is not appropriate. c. Incorrect. The level of analysis to assess going concern depends on the circumstances. A brief analysis is needed when the organization has a series of profitable years and access to alternative sources of financing. If the entity finds itself with poor results or limited financing sources, then a detailed analysis would be indicated. d. Incorrect. Management of the entity and not the external accountant is responsible for assessing going concern issues. 3. a. Incorrect. Regardless of the titles used for the financial statements, notes must prominently state that FRF for SMEs is the financial reporting framework used for preparing the financial statements. b. Incorrect. The framework does allow a single financial statement, such as either a statement of financial position or a statement of activity. If both a statement of financial position and statement of activity are presented, then the financial statements should include a statement of cash flows. c. Incorrect. The framework does not require a description of the differences between FRF for SMEs and GAAP. When the financial statements are being audited, it would be the audit standards which indicate the auditor should assess whether principal differences are explained, not the framework itself. d. Correct. Where there is an option between several alternatives, the notes do need to explain which option management is applying. 10,104 MODULE 2 CHAPTER 4 1. a. Incorrect. The framework does not allow amortizing any gain or loss on a restructuring of debt. b. Correct. The new debt is recognized based on the terms of the instrument. This is compared to the carrying value of the extinguished debt with any difference recognized as again the loss in the current period. c. Incorrect. While there are many options within the FRF for SMEs framework, this is not one. There is no concept of other comprehensive income in the framework. There is no explicit discussion of extraordinary item 189

191 treatment. d. Incorrect. There are no present value concepts used in determining the gain or loss in a restructuring of debt. 2. a. Incorrect. Disclosing the amount and maturity dates beyond the one-year timeframe for financial assets is required under the framework. b. Incorrect. This is the extent of specific guidance in the framework for financial instruments with liability and equity components. They are classified based on the substance of the contract. c. Correct. Unlike the extensive guidance for derivatives in GAAP, the extent of guidance for derivatives in the FRF for SMEs framework is a comment that derivatives are recognized in the financial statements based on the net cash paid or received at settlement. d. Incorrect. Both investment assets and investment income need to have separate disclosure of the following: Nonconsolidated subsidiaries and non-proportionally consolidated joint ventures Investments valued using the cost method Investments valued using the equity method Investments valued using market values. 3. a. Incorrect. The threshold for a voluntary change in accounting principle is the financial statements will provide reliable and more relevant information. A clear preference criterion is not stated as part of the framework. b. Correct. Adjusting the opening balance of equity is one component of a change in accounting principle. In addition, other items the financial statements should be restated as if the new accounting policy had been applied for each year that is presented in the financial statements. c. Incorrect. Material accounting errors should be corrected on a retrospective basis that is correcting the financial statements of previous periods as if the accounting had been performed correctly. d. Incorrect. The threshold for not restating the earliest period presented is impracticable, not a measure of efficiency. The framework provides a description of what would be impracticable. 10,105 MODULE 2 CHAPTER 5 1. a. Incorrect. The method described, debiting the full amount paid to a contra account, is referred to as the cost method. A different accounting treatment is applied under the constructive retirement method. b. Incorrect. Although state law may direct a particular accounting treatment, the framework provides two different methodologies that an entity may use for reacquisition of shares, assuming state law is silent. c. Correct. The framework does not require recognition of options under a stock-based compensation plan to be recognized in the statement of financial position. Certain matters need to be disclosed, but the options are not recognized until the shares are issued. This is a significant difference between the framework and GAAP. d. Incorrect. There are very significant differences between how the framework and GAAP address stock-based compensation plans. 2. a. Incorrect. Guarantees are recognized based on the criteria spelled out for loss contingencies, specifically the likelihood of a future payment is probable and amount is subject to reasonable estimation. 190

192 b. Correct. The first step in recognizing increase in an asset retirement obligation is to determine the amount of increase due to passage of time. Although this may appear analogous to interest expense, the framework specifies this increase should be recognized as an operating expense in the current period and not categorized in the statement of operations as interest expense. c. Incorrect. The framework does not allow recognition of gain contingencies, even if the likelihood is probable and amount can be estimated. d. Incorrect. If an entity is exposed to a greater loss than the amount accrued, it is necessary to disclose that fact. 3. a. Incorrect. FRF for SMEs does not require an assessment of long-lived asset impairment. This is a significant difference from GAAP, in the author's assessment. b. Incorrect. Under FRF for SMEs stock-based compensation is not recognized until the stock is issued. This is a significant difference from GAAP. c. Incorrect. The other comprehensive income concept does not exist in the FRF for SMEs framework. d. Correct. If discontinued operations are present, FRF for SMEs requires such items to be presented as a separate component on a statement of operations between the captions of income before discontinued operations and net income. The same presentation is required under GAAP. 10,106 MODULE 2 CHAPTER 6 1. a. Incorrect. Investments are presented on a statement of financial position or notes in three categories: those accounted for under equity method, those at cost, and debt and equity investments held for sale. Presentation on the statement of operations or notes is the same way. This allows analysis of how each category of investments is performing. b. Incorrect. Entities can make an accounting policy choice between accounting for controlled subsidiaries on the equity method or consolidating them. c. Incorrect. If entity chooses to consolidate its subsidiaries, the threshold is 50% of equity interest to determine whether there is control. d. Correct. Those investments are accounted for at market value, not fair value. 2. a. Incorrect. There are some exceptions, but the general concept is assets and liabilities are measured at market value. b. Incorrect. One of the many places where the framework allows latitude is in the recognition of intangible assets acquired in a business combination. An entity is allowed to make an accounting policy choice between recognizing those intangible assets or not. This option may be exercised on an item by item basis. c. Incorrect. Previously deferred items, such as those mentioned in the answer do not roll into the recognition of retirement and other postemployment benefits. Any unamortized transition obligations or assets are also excluded. This results in the accrued benefit asset or accrued benefit liability being the difference between plan assets and accrued benefit obligation. d. Correct. If there is a bargain purchase it is recognized as gain a statement of operations. It is not used to reduce any assets. It is not deferred. 3. a. Correct. Any changes to the provisional amounts during the measurement period will flow into the residual amount which was either goodwill or gain on bargain purchase. In addition, any changes to 191

193 provisional amounts are made on a retrospective basis as of the acquisition date. b. Incorrect. The measurement period provides an acquirer the opportunity to revise any amounts that were recorded on a provisional basis. Any revisions should be performed retrospectively. c. Incorrect. The measurement period ends when the entity has gathered all information it was seeking in order to correctly identify and recognize all of the amounts correctly. This period of time may not exceed one year from the acquisition date. d. Incorrect. All costs such as advisory, legal, accounting, or any other acquisition-related costs should be expensed as they are incurred. 10,107 MODULE 2 CHAPTER 7 1. a. Incorrect. To recognize an intangible asset the items must be specifically identifiable which means it is separable or arises from legal rights or by contract. b. Correct. This is not one of the criteria to recognize an intangible asset. Not only that, the framework indicates intangible assets have a finite life. c. Incorrect. An entity needs to be able to obtain the future economic benefits for an item to be considered an intangible asset. d. Incorrect. Whether the future economic benefits are revenues, cost savings or something such as a production process, there needs to be a future economic benefit to recognize and intangible asset. 2. a. Correct. These costs should not be capitalized because they are not a part of the development phase. b. Incorrect. Salaries and wages to develop an intangible asset during the development phase are capitalizable. c. Incorrect. Cost of materials and services to develop an intangible asset are capitalizable d. Incorrect. If it is appropriate to register an item based on its nature, fees to do so are capitalizable. 3. a. Incorrect. In contrast to GAAP, which requires scheduled increases in lease payments to be adjusted to a straight-line basis, the FRF for SMEs framework provides an accounting policy choice for entities. They may choose to adjust the payments to a straight-line basis, or they may expense increase as incurred. b. Correct. These concessions should be adjusted to a straight-line basis over the term of the lease. c. Incorrect. Unless there is a reasonable assurance that ownership will transfer by the end of the lease, a lease for land should be accounted for as an operating lease. d. Incorrect. The transfer of substantially all the benefits and risks of ownership is considered by the framework to be a capital lease which consists of acquiring an asset and a related liability for future payments. 10,108 MODULE 2 CHAPTER 8 1. a. Incorrect. Determination of the expense is this simple. It is determined by calculating the net of two items. First, changes in the accrued benefit obligation excluding payments to plan members and employee contributions. Second actual return on plan assets which is changes in market value of plan assets net of payments to plan members and contributions to the plan. b. Incorrect. Recognition in the statement of financial position is this simple. The plan assets less accrued benefit obligation is the amount to recognize either as either an accrued benefit asset or an accrued benefit liability. c. Incorrect. The concept of fair value does not exist in the framework. Plan assets are valued at market value. 192

194 The framework specifies that if market values are not readily available, management needs to determine the amount that is approximation of market value. d. Correct. The actuarial valuation report needs to be prepared at least every three years. In the intervening years management needs to roll the evaluation forward using available information and assumptions. 2. a. Incorrect. An actuarial calculation only needs to be prepared every three years. In the intervening years management needs to roll the evaluation forward using available information and assumptions. b. Incorrect. The discount rate should be revised as of each measurement date. The discount rate should be changed as long-term interest rates fluctuate. c. Incorrect. The FRF for SMEs framework does not make use of fair value. Instead, plan assets should be measured at market value. d. Correct. Determining the expected return on plan assets is one of the steps necessary in applying this approach. 3. a. Correct. The income tax rates and laws used to measure income tax liabilities and assets should be those which are in effect as of the date of the statement of financial position, not the laws and rates expected to be in effect sometime in the future. b. Incorrect. If a deferred tax asset that was not otherwise realizable before the business combination becomes realizable, it should not become a part of the accounting for the business combination. Instead, it would flow into the current year tax determination. c. Incorrect. If there are different tax rates involved, the appropriate rate to use is based on how the underlying asset will be taxed d. Incorrect. The tax impact related to discontinued operations should be presented in the separate section for discontinued operations. 10,109 MODULE 3 CHAPTER 9 1. a. Incorrect. Monitoring is an ongoing process, while inspection is a retrospective evaluation. b. Incorrect. It is monitoring, not inspection, that is designed to provide the firm with reasonable assurance that its QC system is appropriately designed and properly functioning. c. Correct. According to the definition in SQCS 8, monitoring is an ongoing process that considers and evaluates a firm's QC system. Monitoring includes inspection or periodic review of completed engagements. Inspection is a retrospective process, which includes review of completed engagements, and evaluates the adequacy of QC policies and procedures. d. Incorrect. Neither inspection nor monitoring is designed to provide assurance to outside parties. Monitoring, of which inspection is a component, is an internal process. 2. a. Incorrect. SQCS 8 indicates that deficiencies in individual engagements do not necessarily mean that the firm's QC system is inadequate. b. Correct. According to SQCS 8, a non-systemic deficiency is not an indicator of an inadequacy in the QC system. c. Incorrect. SQCS 8 states that repetitive or systemic deficiencies require prompt corrective action. 193

195 d. Incorrect. SQCS 8 notes that all QC systems are subject to inherent limitations that can reduce their effectiveness. 3. a. Incorrect. Evaluation of the firm's compliance with its own QC policies and procedures is considered to be a monitoring activity. b. Incorrect. Monitoring activities include evaluating the relevance, adequacy and operating effectiveness of the firm's QC policies and procedures. c. Incorrect. Evaluating the appropriateness of the firm's practice aids and guidance materials is listed as a monitoring activity. d. Correct. There is no requirement to have all complaints or allegations investigated by outside persons. Firms may, however, decide to engage a suitably qualified outside firm or person to investigate complaints or allegations when, for example, it is not practicable to have a partner not involved with the engagement to supervise the investigation. 10,110 MODULE 3 CHAPTER a. Correct. SQCS 8 requires engagement reviews to be completed prior to the report release date. b. Incorrect. SQCS 8 does not allow EQCRs to be conducted after the report has been issued. c. Incorrect. SQCS 8 does not allow EQCRs to be conducted by the engagement partner, or by any person on the engagement team. d. Incorrect. SQCS 8 allows EQCRs to be conducted by suitably qualified persons, either within or outside of the firm. 2. a. Incorrect. SQCS 8 requires a reviewing of selected, but not all engagement documentation concerning only the significant judgments made by the engagement team. b. Incorrect. SQCS 8 permits, but does not require consultation with the engagement partner during the conduct of the engagement. It further notes that firms should establish policies and procedures to establish the degree to which the EQCR reviewer can consult on the engagement without losing objectivity. c. Incorrect. SQCS 8 requires the EQCR reviewer and the engagement partner to discuss significant issues and findings. This requirement does not extend to the entire engagement team. d. Correct. SQCS 8 requires that EQCR include reading the financial statements or other subject matter of the engagement, including the draft report. 3. a. Incorrect. There is no requirement that all A&A engagements be subjected to EQCR. Except in firms with very few A&A engagements, such a requirement would likely lead to inefficiencies and compliance difficulties. b. Incorrect. Professional standards do not specify which types of engagements should undergo EQCR. c. Correct. SQCS 8 requires that EQCR be conducted by persons having no previous connection to the engagement. d. Incorrect. It is legitimate for engagements to be selected for EQCR at the engagement partners' discretion, however this cannot be the sole selection criterion. 194

196 10,111 MODULE 3 CHAPTER a. Incorrect. At present, only AICPA member firms are able to use PRISM. The AICPA envisions that this system will eventually include all firms undergoing peer reviews. b. Correct. Because they will be required to respond to any MFC forms through PRISM, firms required to use PRISM should assure that they are registered and have a valid user name and password at least 24 hours before the planned date of the peer review. Firms that have recently interacted with the AICPA or CPA2Biz Web sites, as for example to purchase a product, should be able to use the same user name and password. c. Incorrect. The AICPA envisions that the PRISM system will, in the future, enable peer reviewers to file all peer review documentation on-line. At present, its capacities are limited to the MFC and DMFC forms. d. Incorrect. The PRISM system introduces important procedural changes to the peer review process, but does not entail any substantive changes. 2. a. Incorrect. The Review Captain Checklist for engagement reviews has been renamed as the Review Captain Summary, but has not been deleted. b. Incorrect. Peer reviewers are still required to fill out the Team Captain checklist for system reviews, but are no longer required to submit it to the administering entity. c. Incorrect. Peer reviewers may submit the Summary Review Memorandum for system reviews in either the new Microsoft Exceltrade; format, or in the Adobe Acrobattrade; format. d. Correct. The April 2014 revision of the PRPM introduced a requirement for peer reviewers to file the firm's representation letter as a part of the peer review documentation submitted to the administering entity. Previously, reviewers were required to obtain, but not to submit this letter. 3. a. Incorrect. In order to qualify as a peer reviewer, a person is required to be associated with a firm that has received a peer review rating of pass on its most recent system or engagement review, which is ordinarily within the last three years and six months. b. Incorrect. In order to qualify as a peer reviewer, a person is required to be currently active in public practice. This may be either as a partner of a firm enrolled in the program, or as a person at a supervisory level in the accounting or auditing function as a manager or with equivalent supervisory responsibilities. c. Incorrect. The PRPM requires at least five, rather than three years of recent experience in public accounting in the accounting or auditing function in order to qualify for service as a peer reviewer. d. Correct. The PRPM requires AICPA membership in good standing as a qualification for serving as a peer reviewer. 10,112 MODULE 3 CHAPTER a. Correct. The impact on efficiency is not discussed anywhere in the standard, let alone whether it is a factor to use in considering whether to rely on work performed by the internal audit function. b. Incorrect. The level of competency is a factor in considering whether to rely on the internal audit function. c. Incorrect. A specific factor to consider is whether the internal audit function uses a systematic and disciplined approach. This would also include whether they apply quality control. d. Incorrect. The external auditor should consider several factors that support the objectivity of the internal auditors, including organizational status of the function and its policies and procedures. 195

197 2. a. Incorrect. If the objectivity of the internal audit function is impaired, the external auditor would not be using the function to gather audit evidence. b. Incorrect. Reperformance of work performed by the internal audit function is not based on an assessment of competency. If the competency were impaired, it is unlikely the external auditor would even be using the function to gather audit evidence. c. Incorrect. Reperformance is not required in every area where the internal audit function has performed work. d. Correct. When the internal audit function has gathered audit evidence, the external auditor is required to reperform some portion of the work. The extent and areas are not specified in the standard. 3. a. Incorrect. No such requirement exists. In addition the portion of work performed by the internal audit function is not addressed as an issue in the standard. b. Correct. When the internal audit function is involved to gather audit evidence or when internal auditors provide direct assistance, the external auditor is required to document that the level of involvement does not affect the external auditor's ability to conclude. The phrasing used in the standard is what's described in the question: the left in the position of being sufficiently involved in the audit. c. Incorrect. Evaluating adequacy of disclosures is explicitly mentioned as a task which could not be assigned to the internal audit function. This is a significant judgment which the external auditor should carry out. d. Incorrect. The requirement to document that were performed by the internal audit function together evidence or provided by internal auditors in direct assistance applies any time that involvement exists. There is no threshold where the requirement comes into play. The phrasing used in the standard is the external auditor must document he or she is left in the position of being sufficiently involved in the audit. 10,113 MODULE 3 CHAPTER a. Incorrect. This is reversed. Although attention will be paid to both user-relevance and cost, the priority will be given to user-relevance. b. Incorrect. In general display requirements will be the same for private companies and public companies. If a matter is considered to be important enough for a display requirement that information will generally be useful for all users of financial statements. c. Incorrect. Following the pattern already set by FASB, pronouncements of the PCC will generally allow an additional year for private companies to apply new requirements. This could be extended if the matter is more complex or shortened if the information is needed quickly. d. Correct. As a general matter, there are a smaller number of users for financial statements of private companies and those users would generally have better access to management than in the public company environment. This will be a factor considered for disclosures. 2. a. Correct. The ASU allows private companies to choose either of these options, which provide substantial latitude. b. Incorrect. Prospective application is not allowed. c. Incorrect. The accounting alternative allows other approaches in addition to full retrospective. d. Incorrect. The accounting alternative may be applied on a swap-by-swap basis, not to all swaps that meet the criteria. 196

198 3. a. Correct. All three of the accounting alternatives approved to date have an effective date of December 15, For most private companies this will apply to fiscal years ending December 31, b. Incorrect. All three of the approved alternative accounting treatments allow for early application. c. Incorrect. The goodwill alternative is applied prospectively. The interest rate swap alternative may be applied either on a modified retrospective approach or full retrospective approach. The VIE for leases is applied retrospectively. d. Incorrect. Only the goodwill alternative is applied prospectively and that is required, not an option. 10,114 MODULE 4 CHAPTER a. Incorrect. There is no requirement for auditors to independently develop a valuation model. Although this is a possible audit procedure, most auditors would consider it either inefficient or unnecessary under most circumstances. b. Correct. AU-C Section 501 states that when securities or derivatives are measured or disclosed at fair value, auditors should, when applicable, gain an understanding of valuation models used by brokerdealers or other third party sources used in making the fair value estimation. c. Incorrect. Employing a specialist to assess valuation model might be an appropriate audit procedure, but it is not explicitly required. d. Incorrect. Tracing stated values to prices on publicly traded exchanges would be an effective procedure, when such quotes are available. However, because they may not always be available, such as when the investment is not publicly traded, this is not listed as a requirement by AU-C Section a. Incorrect. The auditor's determination that a written response is necessary is, in effect, a determination that sufficient appropriate audit evidence cannot be obtained through other sources. b. Incorrect. AU-C Section 505 states that alternative procedures are not acceptable when the auditor has already determined that a written response is necessary. c. Correct. When a written response that the auditor has determined to be necessary is not received, AU- C Section 505 requires the auditor to determine the implications for the audit, and for his or her opinion. d. Incorrect. Under these circumstances, auditors may consider whether a modified opinion is necessary. However, there is no automatic requirement to modify the opinion. 3. a. Incorrect. AU-C Section 510 requires successor auditors to determine whether opening balances reflect appropriate application of accounting policies. b. Correct. According to AU-C Section 510, successor auditors are required to evaluate whether current period audit procedures provide evidence about opening balances either by performing specific procedures related to those balances or reviewing the predecessor's audit documentation. This section does not require them to do both. c. Incorrect. AU-C Section 510 requires successor auditors to determine whether the prior period's closing balances have been brought forward correctly. d. Incorrect. AU-C Section 510 requires that the successor auditor request management to authorize the predecessor auditor to allow a review of his or her audit documentation. 197

199 4. a. Correct. Scanning of untested expense balances is a commonly-performed analytical procedure. When it is performed it should be documented. It is not, however, required. b. Incorrect. It is not sufficient simply to compare expectations to recorded amounts or ratios, such as by "eyeballing" them without documenting the results. Those results should be recorded in the audit documentation. c. Incorrect. When further auditing procedures are applied in response to significant unexpected differences identified by an analytical procedure, those procedures should be documented. d. Incorrect. Audit documentation should record the factors considered in developing the expectations used in substantive analytical procedures, unless those expectations are readily discernible from the audit documentation. One example of a "readily discernible expectation" is a simple trend analysis, in which there is usually an implicit expectation of consistency, unless there are known conditions that indicate otherwise. 5. a. Incorrect. AU-C Section 530 applies to both statistical and nonstatistical sampling. b. Correct. AU-C Section 530 requires auditors to project sample results to the entire population from which the sample was drawn. Failure to do so is one of the most common departures from professional standards that the AICPA practice monitoring programs cite in audit sampling. c. Incorrect. According to AU-C Section 530, tolerable misstatement is a monetary amount set by the auditor. The auditor seeks to obtain an appropriate level of assurance that the actual misstatement in the population the actual misstatement in the population does not exceed this amount. d. Incorrect. When a planned substantive test is not applicable to a selected item, auditors are required to select a replacement item. 6. a. Incorrect. The reestimation in the current period of a prior period's accounting estimate does not call into question the auditor's professional judgment made based on available information in prior periods. It may, rather, be the result of estimation uncertainty. b. Incorrect. The difference between the outcome of an accounting estimate and the amount originally recognized or disclosed does not necessarily indicate a misstatement in the prior period's financial statements. It may, rather, be the result of estimation uncertainty. c. Correct. The definitions in AU-C Section 540 state that both accounting estimates and their related disclosures are subject to an inherent lack of measurement precision. This inherent lack of precision is known as estimation uncertainty. d. Incorrect. The reestimation in the current period of a prior period's accounting estimate does not necessarily indicate a management bias, but may rather be the result of estimation uncertainty. 7. a. Incorrect. AU-C Section 550 requires auditors to obtain evidence that significant related party transactions outside the normal course of business have been properly authorized and approved. b. Correct. Auditors have a responsibility under AU-C Section 550 to communicate to those charged with governance significant findings and issues concerning related parties. However, this communication would seldom be made immediately upon discovery of such a transaction. Auditors would ordinarily perform further audit procedures on the transaction before concluding that this communication was appropriate. c. Incorrect. AU-C Section 550 requires auditors to inspect underlying contracts or agreements to evaluate whether the business rationale for such a transaction suggests that it may have been entered into for fraudulent purposes. 198

200 d. Incorrect. AU-C Section 550 states that significant related party transactions outside the normal course of business should be treated as giving rise to significant risks. 8. a. Incorrect. The absence of a reference in an auditor's report to substantial doubt about going concern is not a guarantee of the entity's ability to continue as such. This is so because auditors cannot always predict future events or conditions that may cause going concern problems. b. Incorrect. AU-C Section 570 contains no requirement for auditors to design special procedures to detect conditions that indicate substantial doubt about going concern. Risk assessment procedures and the further audit procedures designed to gather evidence in response to them are normally expected to be sufficient for this purpose. c. Incorrect. AU-C Section 570 defines a reasonable period of time as a period not to exceed one year after the date of the financial statements, rather than the date of the auditor's report date. d. Correct. AU-C Section 570 applies to audits of financial statement audits prepared using special purpose frameworks such as the cash or tax basis, as well as to general purpose frameworks such as GAAP. 9. a. Correct. Auditors have grounds for either withdrawing from an audit engagement or disclaiming an opinion when they have sufficient doubt about management's integrity to conclude that their written representations are not reliable. b. Incorrect. For purposes of AU-C Section 580, the financial statements, the assertions therein, and supporting books and records are defined as being outside of management's written representations. c. Incorrect. When management does not provide written representations, auditors can either withdraw from the engagement or disclaim an opinion. d. Incorrect. The representations should be dated as of the date of the auditor's report. 10,115 MODULE 4 CHAPTER a. Incorrect. The classic triangle is not designed with collusive fraud schemes in mind. b. Correct. The classic fraud triangle was designed to model the thought process of individual perpetrators, many of whom are first-time perpetrators. c. Incorrect. Two of the classic triangle's elements, pressures and rationalizations, may not be readily observable by auditors. For this reason, it does not always do well in explaining the "predatory" or career criminal type of perpetrator. d. Incorrect. The Wal-Mart case highlights the fact that frauds perpetrated by highly compensated senior management may often lack the element of non-shareable financial pressure. 2. a. Correct. The new fraud diamond holds that predators do not require pressure, only a proclivity to commit fraud, or a "criminal mind-set." Similarly, such people are typically arrogant and require no rationalization for their actions. b. Incorrect. Ideology and coercion are elements of the "MICE" model. Neither figures explicitly in the new fraud diamond. c. Incorrect. Capability is the fourth element in the original fraud diamond. Personal integrity is one of the elements of the fraud scale. Neither figures explicitly in the new fraud diamond. 199

201 d. Incorrect. Ego and entitlement is one of the elements of the "MICE" model. It does not figure explicitly in the new fraud diamond. 3. a. Incorrect. Recent malpractice claims illustrate that the public tends to hold a much more inclusive view of the auditor's responsibilities for fraud detection than is either prescribed by professional standards or perceived by the auditor. b. Correct. Recent malpractice claims suggest that the public, or at least some members of the public, think that an unqualified audit opinion is an indemnification against losses from fraud. This perception must often be addressed within the legal system even though it is clearly not supported by the requirements of professional standards. c. Incorrect. As both a proactive measure to avert misunderstandings, and as a defensive measure when misunderstandings nevertheless arise, clear communication between the auditor and the client regarding the auditor's responsibilities for fraud detection is essential. The communication needs to be documented as well. d. Incorrect. Claims arising from the Madoff case illustrate that auditors sometimes get sued even when they have adhered strictly to professional standards. 200

202 10,200, CPE Quizzer Instructions This CPE Quizzer is divided into four Modules. To obtain CPE Credit, go to CCHGroup.com/PrintCPE to complete your Quizzers online for immediate results and no Express Grading Fee. There is a grading fee for each Quizzer submission. Processing Fee: Recommended CPE: $56.00 for Module 1 4 hours for Module 1 $56.00 for Module 2 4 hours for Module 2 $42.00 for Module 3 3 hours for Module 3 $28.00 for Module 4 2 hours for Module 4 $ for all Modules 13 hours for all Modules Instructions for purchasing your CPE Tests and accessing them after purchase are provided on the CCHGroup.com/PrintCPE website. To mail or fax your Quizzer, send your completed Answer Sheet for each Quizzer Module to CCH Continuing Education Department, 4025 W. Peterson Ave., Chicago, IL 60646, or fax it to (773) Each Quizzer Answer Sheet will be graded and a CPE Certificate of Completion awarded for achieving a grade of 70 percent or greater. The Quizzer Answer Sheets are located at the back of this book. Express Grading: Processing time for your mailed or faxed Answer Sheet is generally 8-12 business days. To use our Express Grading Service, at an additional $19 per Module, please check the "Express Grading" box on your Answer Sheet and provide your CCH account or credit card number and your fax number. CCH will fax your results and a Certificate of Completion (upon achieving a passing grade) to you by 5:00 p.m. the business day following our receipt of your Answer Sheet. If you mail your Answer Sheet for Express Grading, please write "ATTN: CPE OVERNIGHT" on the envelope. NOTE: CCH will not Federal Express Quizzer results under any circumstances. Recommended CPE credit is based on a 50-minute hour. Participants earning credits for states that require selfstudy to be based on a 100-minute hour will receive 1/2 the CPE credits for successful completion of this course. Because CPE requirements vary from state to state and among different licensing agencies, please contact your CPE governing body for information on your CPE requirements and the applicability of a particular course for your requirements. Date of Completion: If you mail or fax your Quizzer to CCH, the date of completion on your Certificate will be the date that you put on your Answer Sheet. However, you must submit your Answer Sheet to CCH for grading within two weeks of completing it. Expiration Date: December 31, 2015 Evaluation: To help us provide you with the best possible products, please take a moment to fill out the course Evaluation located after your Quizzer. A copy is also provided at the back of this course if you choose to mail or fax your Quizzer Answer Sheets. 201

203 Wolters Kluwer, CCH is registered with the National Association of State Boards of Accountancy (NASBA) as a sponsor of continuing professional education on the National Registry of CPE Sponsors. State boards of accountancy have final authority on the acceptance of individual courses for CPE credit. Complaints regarding registered sponsors may be submitted to the National Registry of CPE Sponsors through its website: One complimentary copy of this course is provided with certain copies of CCH publications. Additional copies of this course may be downloaded from CCHGroup.com/PrintCPE or ordered by calling (ask for product ). 202

204 10,301, Quizzer Questions: Module 1 1. A business risk could arise from any of the following except: a. A significant condition that adversely affects an entity's ability to achieve its objectives b. Significant events that adversely affect an entity's ability to execute its strategies c. Material weakness in internal control that adversely affect an entity's ability to present financial statements that conform with the requirements of the applicable financial reporting framework d. Failure to take an action that would prevent the entity from setting inappropriate objectives 2. The term performance materiality is best defined as an amount set by the auditor: a. To assess the effects of detected misstatements in the aggregate for the financial statements taken as a whole b. For purposes of selecting items for detail tests or tests of controls when statistical sampling is employed c. Below which misstatements are considered to be clearly trivial and need not be aggregated d. At less than materiality for the financial statements as a whole, to reduce the likelihood that the aggregate of undetected and uncorrected misstatements will exceed materiality for the statements as a whole 3. Which of the following statements about the requirements of AU-C Sections 300 and 315 for the discussion among the audit team in planning the audit is correct? a. This discussion should include the engagement partner and key members of the audit team. b. This discussion should include the engagement partner and all members of the audit team. c. Fraud risk must be discussed separately from other risks of material misstatement. d. All matters discussed should be communicated to the members of the audit team. 4. When establishing an overall audit strategy, AU-C Section 300 requires auditors to: a. Establish an understanding of the terms of the engagement b. Consider the results of preliminary engagement activities c. Evaluate compliance with relevant ethical requirements d. Evaluate whether the client and engagement should be continued 5. An auditor's evaluation of the design and implementation of internal controls should: a. Be limited to inquiries of the entity's IT personnel b. Be based on procedures in addition to inquiries c. Include tests of controls over financial reporting for all material transaction classes, account balances and disclosures d. Include the auditor's observation of the performance of control procedures 6. Which of the following sets of assertions, according to AU-C Section 315, would most likely be considered 203

205 relevant assertions for inventory balances at the end of the audit period? a. Existence, rights and obligations, completeness, and valuation and allocation b. Occurrence, rights and obligations, completeness, classification, understandability, accuracy and valuation c. Occurrence, completeness, accuracy, cutoff, and classification d. Understandability, occurrence and classification 7. Which of the following statements about high-volume transaction classes with highly automated processing and little human intervention is correct? a. It is most effective to obtain sufficient appropriate audit evidence from substantive procedures alone. b. Auditors should obtain an understanding of controls over the risks related to these transactions. c. Controls over the risks related to these transactions are not relevant to the audit. d. Auditors must apply analytical procedures to these classes of transactions. 8. AU-C Section 320 recognizes that: a. Financial statement users are not reasonably expected to have an understanding of accounting. b. Misstatements are considered material if they could reasonably be expected, either individually or in the aggregate, to influence the economic decisions of financial statement users. c. Auditors' judgments about materiality are affected by both the size and nature of a misstatement, and are made without regard to surrounding circumstances. d. Auditors make materiality judgments based on a consideration of the financial information needs of individual users of the statements. 9. According to AU-C Section 320, materiality determined in planning the audit: a. Establishes an amount below which uncorrected misstatements will ordinarily be evaluated as immaterial b. Should remain the same throughout the audit c. Is valid in determining the nature and extent of further audit procedures even though a smaller amount may subsequently be determined d. Should be revised during the audit if auditors become aware of information that would have caused them to determine different amounts initially 10. Auditors should perform tests of controls: a. When the assessment of the risk of material misstatement at the relevant assertion level is based on knowledge that the controls are improperly designed b. When they plan to rely on the operating effectiveness of controls in determining the nature, timing and extent of substantive procedures c. During every period audited d. Every three years 11. When an auditor's response to a significant risk of material misstatement at the relevant assertion level consists only of substantive procedures, those should include: 204

206 a. Substantive analytical procedures b. A summary of the auditor's understanding of relevant internal controls c. Tests of details d. Confirmations 12. When the overall accounts receivable balance is material to the financial statements, an auditor might justify the decision not to use external confirmations under which of the following circumstances? a. The auditor's assessed level of control risk is low. b. Experience shows that confirmations would receive a low rate of response, or that responses would be unreliable. c. The assessed level of risk of material misstatement at the relevant assertion level is high, but other planned substantive procedures address the assessed risk. d. Management requests the auditor not to undertake external confirmation procedures. 13. AU-C Section 402 lists which of the following as an appropriate response to assessed risks associated with a user entity's employment of a service organization? a. The user auditor should request the service auditor to perform further audit procedures at the service organization. b. The user auditor should determine whether sufficient appropriate evidence concerning the relevant assertions is available from a subservice organization's records. c. The user auditor should engage another auditor to perform tests of controls at the service organization. d. The user auditor should obtain evidence about the operating effectiveness of service organization controls by reading a type 2 service auditor's report when the risk assessment includes an expectation of their effectiveness. 14. AU-C Section 450 states that auditors: a. Should timely communicate all misstatements accumulated during the audit to the appropriate level of management b. Should timely communicate all misstatements accumulated during the audit to those charged with governance c. May require management to correct misstatements accumulated during the audit d. May elect to perform additional procedures to determine if misstatements remain, when management has, at the auditor's request, examined an account balance and corrected misstatements that were detected 15. According to AU-C Section 450, which of the following statements about uncorrected misstatements is correct? a. Auditors should evaluate current period uncorrected misstatements without regard to the effect of uncorrected misstatements from prior periods. b. Auditors should consider the size of uncorrected misstatements independently from the circumstances of their occurrence. c. Auditors should reassess materiality before evaluating the effects of uncorrected misstatements. d. Auditors should determine whether uncorrected misstatements are material only in the aggregate. 205

207 16. The date that the auditor grants permission for the audit report to be used in connection with the financial statements is known as the: a. Field work completion date b. Report date c. Documentation completion date d. Report release date 17. An example of an unacceptable document identifier for specific items tested is: a. Every 15 th item from the May cash disbursements journal b. All invoices over $15,000 from the June 2015 accounts payable detail c. Checks numbered from to d. For an inventory observation, descriptions of the counting procedures and goods observed, the persons involved and their responsibilities, and the location, date and time of the observation 18. Audit documentation should enable another experienced auditor with no previous connection to the audit to understand the nature, timing, extent, and results of the audit procedures: a. When allowed contact with the client b. When combined with oral clarifications c. Without additional oral explanation d. When the other auditor re-performs significant audit procedures 19. Which of the following statements applies to the documentation retention period under AU-C Section 230? a. The documentation retention period runs for seven years after the report date. b. The documentation retention period may run for more than five years after the report date, if required by law or regulation. c. The documentation retention period runs for seven years after the balance sheet or period end date. d. The documentation retention period runs for five years after the report date. 20. After the report date, but before the document completion date, the auditor: a. May delete incorrect or superseded information from the audit documentation b. May make changes to the audit documentation without the need to document the reason for the change c. May not add information to the audit documentation d. May not sign off on file completion checklists 21. AU-C Section 240 requires which of the following specific fraud-related items to be recorded in the audit documentation? a. The fraud risk discussion at the conclusion of the audit b. The nature of fraud-related communications made to management, the audit committee, or others c. Results of procedures performed to address the risk of design deficiencies in internal control 206

208 d. The auditing procedures used to gather the information needed to identify and assess the risk of material misstatement caused by error 22. AU-C Section 265 requires auditors to: a. Communicate only material weaknesses in internal control to the client in writing b. Communicate only significant deficiencies in internal control to the client in writing c. Make the written communication of significant deficiencies and material weaknesses in internal control no later than 45 days following the report release date d. Make written communication of significant deficiencies and material weaknesses in internal control no later than 60 days following the report release date 23. According to AU-C Section 450, audit documentation should record all of the following except: a. All misstatements that have been identified by the auditor and corrected by management, except for trivial amounts b. Consideration of the aggregate effects of misstatements c. A statement as to the basis for determining that certain misstatements are trivial d. Separate consideration of known and likely uncorrected misstatements 24. Which of the following statements, according to AU-C Section 450, best applies to "clearly trivial" misstatements? a. Immaterial misstatements are considered clearly trivial. b. A threshold amount below which a misstatement would be considered clearly trivial should be documented. c. Clearly trivial misstatements are determined solely with reference to their size. d. A misstatement may be considered clearly trivial individually, without regard to its effects when aggregated with other misstatements. 25. When a group auditor assumes responsibility for a component auditor's work, AU-C Section 600 requires the group auditor's documentation to include: a. The component auditor's audit file b. The nature, timing and extent of the group engagement team's involvement in the work of the component auditor c. Review of all of the component auditor's audit documentation d. The component auditor's licensing information within the component's jurisdiction 207

209 10,302, Quizzer Questions: Module All of the following financial reporting frameworks are acceptable as an other comprehensive basis of accounting except: a. Cash basis b. Pronouncements of the Government Accounting Standards Board c. Tax basis accounting d. Financial reporting framework for small and medium-sized enterprises 27. Which of the following statements about FRF for SMEs is correct? a. The framework does not have a stated effective date. b. The AICPA expects to update the framework annually. c. The AICPA retains authority to specify what companies or industries will be required to follow the framework. d. The framework may only be applied to financial statements with fiscal years ending on or after December 15, 2014, with early application not permitted. 28. Which of the following statements about FRF for SMEs is correct? a. To recognize an item as an asset under FRF for SMEs that item must be legally enforceable. b. FRF for SMEs allows presenting financial statements on either the accrual basis or cash basis, providing the appropriate basis is prominently disclosed. c. Fair value, replacement cost, and historical cost are the primary measurement methodologies used in FRF for SMEs. d. Expenditures and assets are recognized as an expense when there is no future economic benefit. 29. Which of the following statements about disclosures under the FRF for SMEs is correct? a. Notes to the financial statements need to disclose management's choice when there are alternative accounting principles available under FRF for SMEs. b. Disclosure of accounting principles and methods should be spread between the notes providing quantitative data for the item disclosed. c. If an entity discloses the principal differences between FRF for SMEs and accounting principles generally accepted in the United States of America, then the notes must quantify each of those differences. d. Accounting principles and methods unique to a specific industry and generally applied by all entities within that industry do not need to be disclosed since the entity may assume that all readers of the financial statements are aware of those industry wide accounting policies. 30. All of the following comments about a transition to applying FRF for SMEs are correct except: a. An entity should prepare an opening statement of financial position as of the first day of the earliest year presented. b. The impact of changes made to measurement of assets and liabilities on the opening statement of financial position should be reflected in opening equity. 208

210 c. Estimates necessary to prepare the opening statement of financial position should reflect known information as of the date of the most recent statement of financial position. d. The nature and amount of each adjustment to equity in the opening statement of financial position should be disclosed in the notes. 31. All of the following statements concerning debt that is in default or with covenant violations is correct except: a. If a creditor has the unilateral right to demand repayment of a loan, the loan should be classified as current unless certain conditions are met. b. For a loan with a covenant violation as of the financial statement date, the loan may be classified as long term if the creditor has verbally agreed to waive the right to demand repayment through the date the financial statements are available for issue. c. A loan in default as of the financial statement date may be classified as long-term if it has been refinanced on a long-term basis prior to the date the financial statements are available to be issued. d. Prior to the financial statements being available to be issued, the entity and creditor have a noncancelable agreement for refinancing the short-term debt on a long-term basis and there is no impediment to actual completion of the refinancing. 32. Which of the following statements about financial assets and liabilities are correct? a. Financing fees and transaction costs should be added to the transaction amount when measuring financial liabilities. b. Financial assets and financial liabilities may not be offset in a statement of financial position. c. Unlike GAAP, under FRF for SMEs financial assets may not be derecognized until they have been paid in accordance with the terms of the agreement or the remaining balance is written off. d. FRF for SMEs contains extensive guidance for the recognizing financial assets upon transfer, roughly comparable to the guidance found in GAAP. 33. The FRF for SMEs framework indicates all of the following items should be disclosed for financial assets and liabilities except: a. The amounts and maturity dates of financial assets maturing beyond one year. b. The carrying amount of any assets that are collateral for debt. c. Any financial liabilities that were in default as of the statement of financial position date. d. The interest rate sensitivity of floating rate financial liabilities. 34. Which of the following comments on accounting and disclosure for derivative instruments is correct? a. Derivatives should be measured at net cash paid or received at settlement. b. Since there is a large body of established accounting requirements for derivatives under GAAP, if an entity has derivatives other than "plain vanilla" interest rate swaps, use of FRF for SMEs framework is not indicated. c. Recognition, measurement, and disclosure of derivatives in the framework are substantively less descriptive than GAAP but, in the author's perspective, are roughly comparable to the requirements of GAAP. d. Accounting and disclosure requirements under FRF for SMEs are substantively less descriptive than GAAP, yet contain guidance for a several of the most commonly used 209

211 types of derivatives. 35. In general, how do the disclosures for risks and uncertainties under the FRF for SMEs framework compare to the disclosures under GAAP? a. FRF for SMEs only requires disclosure of material risks and uncertainties with greater than remote likelihood of occurring. b. Disclosures of risks and uncertainties are more detailed and quantified under the FRF for SMEs framework than under GAAP. c. Disclosures of risks and uncertainties are roughly comparable under FRF for SMEs and GAAP. d. In contrast to GAAP, disclosures of risks and uncertainties under the FRF for SMEs framework are principles based without any specific requirements. 36. Which of the following statements about PP&E is correct? a. The framework does not require impairment testing for long-lived assets. b. Improvements, which are expenditures which increase an item's physical output or service capacity, are expensed in the period incurred. c. To simplify accounting for PP&E only straight line depreciation or amortization is allowed under the framework. d. Unlike GAAP, the FRF for SMEs framework does not indicate the useful lives of PP&E need to be reviewed after the life is established at acquisition or construction. 37. Which of the following statements about long-lived assets held for sale is correct? a. Such assets may be reclassified to a separate category on the statement of financial position if management believes such presentation is more informative for users. b. Such assets should continue to be depreciated or amortized during the period of time they are held for sale. c. If a long-lived asset no longer meets the criteria to be categorized as held for sale, it should be reclassified back to its previous presentation with additional depreciation or amortization recorded that would have otherwise been recorded while it was categorized as held for sale. d. If a long-lived asset no longer meets the criteria to be categorized as held for sale, it should be reclassified back to its previous presentation with future depreciation or amortization resumed at the point it no longer met the criteria to be so categorized over the then revised remaining life. 38. Which of the following statements about stock-based compensation plans are correct? a. Accounting recognition and disclosures for stock-based compensation plans are at the discretion of management since the framework is silent. b. Certain details of stock-based compensation plans need to be disclosed, however options do not need to be recognized in the statement of financial position. c. Recognition of stock-based compensation in the statement of financial position under the framework is substantively different than GAAP since there is a specific, simplified calculation for all options specified in the FRF for SMEs framework. d. Accounting recognition and disclosures for stock-based compensation plans are substantively similar under FRF for SMEs and GAAP. 39. Which of the following statements about the definitions of probable, reasonably possible, and remote is 210

212 correct? a. The definitions of those terms under the FRF for SMEs framework are close to identical to GAAP. b. The definitions of those terms under FRF for SMEs framework are essentially the same as GAAP. c. The definitions of those terms as used for loss contingencies are different than similar terms used elsewhere in the FRF for SMEs framework. d. The FRF for SMEs and GAAP frameworks have methodologically different approaches for recognizing contingencies and therefore the terms have a different orientation and definition under each framework. 40. Which of the following comments about contingencies are correct? a. The framework allows recognition in the statement of financial position for gain contingencies with a probable likelihood of occurring for which the amount of the gain can be reasonably estimated. b. Gain contingencies with a likelihood of probable or reasonably possible may be disclosed in the notes to the financial statements, if management believes such information is necessary to prevent the financial statements from being misleading. c. Loss contingencies with a likelihood of either probable or reasonably possible should be disclosed in the notes to the financial statements. d. If the amount for a possible loss contingency is best estimated in terms of a range of possible losses, the maximum amount in the range should be used for accrual, assuming the likelihood of the loss is probable. 41. Which of the following statements about accounting for subsidiaries is correct? a. The percentage threshold for evaluating whether an entity should consolidate another entity is 75 percent of equity interests. b. An entity is not allowed to present parent-company-only financial statements. c. An entity should present parent-company-only financial statements since investors in the parent entity are primarily concerned about the performance and security for their investment. d. An entity has the choice of consolidating subsidiary entities or using the equity method to account for them. 42. An entity should account for debt or equity securities that are held for sale under which of the following methods? a. Fair market value using level I inputs b. Cost c. Market value d. An entity has two options to account for such investments 43. All of the following statements about consolidated financial statements are correct except: a. When a parent ceases to have control of a subsidiary, financial statements are restated on a nonconsolidated basis to exclude the entity which is no longer consolidated. b. An entity can make an accounting policy choice between consolidating all controlled entities or accounting for them under the equity method. 211

213 c. Income from a controlled subsidiary is included in consolidated income only after the time control is gained until the time that control is lost. d. When an entity controls subsidiaries, the financial statements should identify whether they are prepared on a consolidated or nonconsolidated basis. 44. All of the following statements about business combinations are correct except: a. The general concept in a business combination is that all assets acquired and liabilities assumed should be measured at their fair value as of the date of acquisition. b. Retirement and other postemployment benefits are recognized using only the plan assets and accrued benefit obligation; previously deferred items such as unamortized actuarial gain or loss and unamortized prior service cost are not recognized. c. The framework indicates that if it seems a bargain purchase exists on a business combination, the entity should reassess all the components in the calculation leading to determining there was a bargain purchase. d. If a business combination results in a bargain purchase, the amount should be recognized in the statement of operations as of the acquisition date. 45. All the following statements about disclosures for a business combination are correct except: a. For each material business combination, the disclosure should include the market value of consideration transferred as of the acquisition date. b. For each material business combination, the disclosure should include the name, description of the acquiree, and acquisition date. c. The total gain from bargain purchase for the period should be disclosed. It is optional to disclose the amount for each material business combination. d. For business combinations that are collectively material but individually immaterial, the market value of total consideration transferred should be disclosed. 46. All of the following are accurate descriptions of recognizing and measuring intangible assets except: a. Internally-generated goodwill should be recognized as an intangible asset. b. During the research phase of developing internally-generated intangible assets all expenditures should be expensed. c. Entity can choose to either capitalize expenditures during the development phase or expense them. d. One example of the types of activities that could take place during the development process is the design of tools, dies, or jigs using a new technology. 47. All of the following are accounting policy choices are available within the framework except: a. For startup costs, an entity can either expense start-up costs as incurred or capitalize them and amortized over 15 years. b. For internally-generated intangible assets, costs incurred during the development phase can either be expensed as incurred or capitalized as an intangible asset. c. Increasing costs during the term of an operating lease, such as step increases to approximate inflationary escalation, may be either expensed as incurred or adjusted to a straight-line over the term of the lease. d. Leases that meet certain criteria for possible accounting as a capital lease may be either capitalized or treated as an operating lease, assuming appropriate disclosures are included in the notes to the financial statements. 212

214 48. Which of the following statements about intangible assets and goodwill is correct? a. An entity should regularly review the amortization method and estimated useful life of intangible assets other than goodwill. b. Entity should regularly review goodwill for impairment. c. Goodwill is not amortized. d. At an overall level, the accounting for goodwill under the FRF for SMEs framework and GAAP are roughly comparable. 49. All of the following comments about revenue recognition are correct except: a. Completed contract method of accounting is not allowed. b. If there are multiple deliverables, it is necessary to recognize revenue for each identifiable component separately. c. Revenue from interest, dividends, and royalties should be recognized when the transaction is measurable and collectible with reasonable assurance. d. Under percentage of completion method, revenue is recognized proportionally based on the performance of each act that constitutes performance. 50. Which of the following general characterizations of the accounting for leases is most accurate? a. Lease accounting under the FRF for SMEs framework is roughly comparable to GAAP as it exists in b. All leases, including operating and capital leases, should be reflected on an entity's financial statements. c. The framework allows an entity to either capitalize or expense those leases for which meet certain criteria for potential capitalization. d. To simplify accounting for leases, the framework calls for treating all leases in the manner as what would be an operating lease within GAAP. 51. All of the following generalizations about accounting for pensions and income tax are correct except: a. Entities can choose between several accounting policy choices for retirement plans, one of which could be characterized as a very simple methodology. b. Entities can choose between two accounting policy choices for income taxes, one of which could be characterized as a very simple methodology. c. The valuation of an accumulated benefit obligation for a retirement or other postemployment benefit plan is only required to be prepared every three years. d. The taxes payable method of accounting for income tax under the FRF for SMEs framework could be characterized as roughly comparable to the required accounting for income tax under GAAP. 52. All of the following statements about when different retirement plans may be netted or aggregated are correct except: a. Unfunded plans administered by the same Third Party Administrator may be aggregated for measurement, presuming those plan assets are managed by the same investment manager b. Unfunded plans providing different benefits to the same group of employees may be aggregated for measurement. c. Unfunded plans providing the same benefits to different groups of employees may be 213

215 aggregated for measurement. d. An overfunded plan may be netted against an underfunded plan only if the entity has the right to use one plan's assets to pay benefits for another plan and intends to exercise that right. 53. All of the following statements about applying the deferred income tax method are correct except: a. Differences between the carrying amount and tax basis of an asset are temporary differences, which could be either taxable or deductible. b. To simplify accounting for income taxes, the deferred income tax method does not allow use of tax planning strategies to determine whether tax benefits are realizable. c. Temporary differences can arise from the carrying amount of a subsidiary in the consolidated financial statements being different from the tax basis that exists at the level of the subsidiary entity. d. As of each financial reporting date, a deferred income tax asset or liability should be recognized for all of the deductible and taxable temporary differences. 54. All of the following statements about income tax accounting are correct except: a. Current tax liabilities of one entity in a consolidated financial statement may be offset against the current tax asset of another entity. Likewise a deferred income tax assets and liabilities may be offset between different entities that are components of the consolidated financial statements. b. On the statement of financial position, income tax assets and liabilities should be presented separately from other assets and liabilities. Likewise, the current portion of income tax assets and liabilities should be presented separately from the deferred portion. c. Under the taxes payable method, the only comments recognized on a statement of financial position is the current income tax assets or liabilities, to the extent they are unpaid or refundable. d. The cost or benefit of current and deferred income taxes that are related to discontinued operations are presented on a statement of operations with the results of discontinued operations. 55. All of the following statements are a general description of an accounting policy choice available for retirement and other postemployment benefits except: a. One accounting policy choice is somewhat similar to the requirements of GAAP. b. On the statement of operations, one of the accounting policy choices recognizes a current expense equal to the current year contribution plus a straight-line amortization of the amount by which the accumulated benefit obligation exceeded the plan assets at market value at the initiation of the plan. c. On a statement of financial position, one of the accounting policy choices recognizes only the net amount of plan assets and accumulated benefit obligation. There's no recognition of any deferred items. d. One accounting policy choice merely requires recognized a liability for the required contribution for the current year. 214

216 10,303, Quizzer Questions: Module According to the definitions in SQCS 8, which of the following statements is correct? a. The purpose of inspection is to provide the firm with reasonable assurance that its QC system is appropriately designed, and is operating effectively. b. One of the purposes of monitoring is to provide the firm with reasonable assurance that its QC system is appropriately designed, and is operating effectively. c. One of the purposes of monitoring is to provide outside parties with reasonable assurance that a firm's QC system is appropriately designed, and is operating effectively. d. The purpose of inspection is to provide the firm with reasonable assurance that its QC system is operating effectively. 57. According to SQCS 8, systemic or repetitive deficiencies: a. Need not be summarized in the monitoring report b. May not in themselves indicate that the QC system is inadequate c. Require prompt corrective action d. Should be evaluated on a partner-by-partner basis 58. Inspections primarily include: a. Evaluating the appropriateness of the firm's guidance materials b. Evaluating the documentation related to the firm's process for assuring the independence of its professional personnel c. Following up on corrective actions taken as a result of monitoring d. An after-the-fact review of selected engagements 59. This course suggests that effective selection criteria for engagements to be subjected to inspection should include all of the following except: a. Low-risk engagements b. Initial engagements c. Engagements involving specialized industries d. A representative cross-section of compilations, reviews and audits, when applicable to the firm's practice 60. Monitoring procedures at the broad functional level may ordinarily include review of: a. Client and engagement acceptance and continuation documentation b. Selected personnel records pertaining to the QC element of human resources c. Documentation of consultation with outside parties concerning the application of accounting principles d. Resolution of independence matters 61. Which of the following statements applies to EQCR under the definitions of SQCS 8? a. It is a part of the monitoring element of quality control. b. It is a retrospective evaluation of a firm's QC policies and procedures that includes reviews of specific engagements. 215

217 c. It should be conducted by the engagement team. d. It is designed to provide an objective evaluation, prior to the report release, of the engagement team's significant judgments, and its conclusions in writing the report. 62. Properly designed EQCR policies and procedures include: a. Reading the draft report and the financial statements or other subject matter of the engagement b. Provisions for waiving the independence requirement for the EQCR reviewer under certain circumstances c. Selection criteria that a majority of the firm's A&A engagements are expected to meet d. A requirement for the EQCR reviewer to discuss the subject matter of the engagement with the client's management 63. Common shortcomings in the design of EQCR policies and procedures include which of the following? a. Failing to write specific and objective criteria for engagements to be subjected to EQCR b. Including both subjective and objective criteria for engagements to be subjected to EQCR c. Prohibiting the EQCR reviewer from making decisions for the engagement team d. Requiring the EQCR reviewer to be appointed by a person other than the engagement partner 64. To maintain the objectivity of the EQCR reviewer, the firm's policies and procedures should: a. Require evaluation of the EQCR reviewer's objectivity by a suitably qualified external person b. Require the engagement partner to determine the EQCR reviewer's objectivity c. Provide for replacement of the EQCR reviewer when his or her objectivity is likely to have been impaired d. Provide for oversight of the EQCR reviewer by a committee of the firm's management 65. The commentary to this chapter notes that in a stable firm with a specialty practice, the firm's EQCR selection criteria: a. Should include all of the specialty engagements b. Might safely adopt criteria that it only rarely expects an engagement to meet c. May exclude the specialty engagements d. May substitute inspection procedures for EQCR 66. Which of the following is an accurate statement about PRISM? a. This system enables MFC and DMFC forms for AICPA member firms to be filed on-line. b. All firms required to use PRISM have been automatically registered with the system by the AICPA. c. The PRISM system currently enables peer reviewers to file peer review engagement checklists on-line. d. To date, the PRISM system has yielded significant statistical data about areas of frequent noncompliance with professional standards. 67. The AICPA envisions that PRISM will in the future do all of the following except: a. Encompass peer reviews performed for both AICPA member and non-member firms 216

218 b. Capture and analyze data from MFC forms in an electronic database c. Enable peer reviewers to submit all required peer review forms and documentation through the PRISM system d. Enable the AICPA's peer review program to interface with State Boards of Accountancy 68. Which of the following represents a change to previous practice created by the April 2014 revision of the PRPM? a. The Summary Review Memorandum for system reviews has been deleted. b. Peer reviewers are no longer required to submit the Team Captain checklist for most system reviews to the administering entity. c. Peer reviewers must submit the Review Captain Summary for engagement reviews in Adobe Acrobattrade; format. d. Peer reviewers are no longer required to obtain a firm representation letter on engagement reviews. 69. In addition to the general qualifications for a peer reviewer, a system review team captain must: a. Be active in the practice of public accounting at the supervisory level b. Complete at least 50 percent of their AICPA required continuing professional education in subjects related to auditing, accounting and quality control c. Be a partner or owner in a firm that has passed its most recent peer review d. Complete at least 20 hours of continuing education every year 70. Which of the following represents the minimum training requirements necessary to initially qualify as a review captain for an engagement review? a. Complete the AICPA introductory reviewer training course, "How to Conduct a Review Under the AICPA Practice Monitoring Program" b. Meet all of the initial training requirements for a system review team captain c. Complete the live seminar "How to Perform an Engagement Review Under the AICPA Practice Monitoring Program" d. Complete Day 1 of the AICPA introductory reviewer training course, "How to Conduct a Review Under the AICPA Practice Monitoring Program" plus participate in the mentoring program 71. Which of the following statements best describes SAS 128? a. The standard contains a number of presumptively mandatory requirements indicating the accountant must comply with each of those requirements in situations for which that requirement applies. b. An external auditor must follow the required provisions of the standard, including documentation matters, any time an audit is performed. c. The standard will be effective for audits of financial statements for periods beginning on or after December 15, 2015, which means for most CPA firms the first time the standard will applies to audits will be for engagements with December 31, 2016 fiscal year ends. d. The standard allows external auditors to delegate to the internal audit function specific responsibilities regarding the audit opinion in certain circumstances. 72. Which of the following judgments does the standard allow external auditors to delegate to internal auditors when the internal audit function is used to obtain audit evidence? 217

219 a. Assess significant accounting estimates b. Evaluate sufficiency of tests performed c. Develop appropriate audit programs d. Evaluate management's assessment of going concern assumptions 73. Which of the following statements about the standard is most correct? a. When the internal audit function is gathering audit evidence, the external auditor should reperform some work completed when the external auditors combined assessment of objectivity and independence of the internal audit function is at a low yet marginally acceptable level. b. The external auditor should consider reperforming work completed by the internal audit function when gathering audit evidence with the decision to reperform based on the professional judgment of the external auditor in the circumstances. c. The external auditor should reperform some portion of the work completed by the internal audit function when the function is gathering audit evidence. d. When internal auditors are providing direct assistance, the external auditor should test some of the work performed in every area completed by the internal auditors. 74. Which of the following statements about using internal auditors to provide direct assistance is correct? a. The external auditor should supervise and review the work performed by internal auditors when the work performed is in areas that are considered material to the financial statements taken as a whole. b. When internal auditors provide direct assistance, the external auditor should not only review the work performed but should also test some portion of that work. c. Testing of direct assistance provided is performed by the external auditor when it is warranted based on the external auditors assessment of competency and level of independence of the internal auditors. d. The standard comments in an engagement letter typically used by an external auditor for all of his or her audit engagements are sufficient to obtain the acknowledgments necessary when internal auditors will be providing direct assistance. 75. Which of the following statements about SAS 128 is most correct? a. Maintaining a system of quality control is a factor for the external auditor in applying this standard but is not a part of the consideration of whether to use the internal audit function for obtaining audit evidence. b. When assessing whether to use the internal audit function to gather audit evidence, the primary factor for the external auditor to consider is the impact of such reliance on the effectiveness of the audit, which does not include efficiency factors. c. The standard does not contain any presumptively mandatory requirements, which the accountant has to comply with in those situations for which the presumptively mandatory requirement applies. d. The external auditor should reperform some portion of the work performed by the internal audit function when gathering audit evidence and should test some portion of the work performed when internal auditors provide direct assistance. 218

220 76. Which of the following is a differential factor FASB and PCC will consider in evaluating accounting alternatives? a. Volume of external financing a private company has raised through loans b. Whether the SSARS literature will be sufficient to provide sufficient comfort for the needs of primary users c. Relative complexity of transactions typical for private companies d. Whether users of financial statements of private companies have better access to management than users of financial statements of public companies 77. Which of the following statements about goodwill under this accounting alternative is correct? a. Stakeholders of private companies suggested goodwill accounting after initial recognition provides decision-useful information for most users. b. Goodwill is amortized over 10 years unless a shorter timeframe is more appropriate. c. Goodwill should be tested for impairment on an annual basis. d. After a private company incurs a goodwill impairment loss, it will become necessary to evaluate impairment of the remaining goodwill on an annual basis. 78. Which of the following statements best describes the accounting alternative for interest rate swaps? a. The alternative applies to all types of interest rate swaps entered into by a private company. b. The alternative applies only to specific swaps, which are generally characterized as "plainvanilla" receive-variable, pay-fixed swaps. c. Documentation under this accounting alternative is the same as otherwise required under GAAP and must also be completed at the time of initiation of the interest rate swap. d. Valuation of the interest rate swap is at fair value as otherwise required under GAAP with specific simplifying assumptions. 79. Which of the following comments about the VIE for lessor entities is most correct? a. The accounting alternative applies to private companies under common control that have any leasing activity between them. b. The primary driver for PCC taking action on this issue is the cost involved for private companies since users of their financial statements provided little feedback of the impact consolidated VIEs have on their analysis. c. This ASU does not change the accounting disclosures for private companies that supply it; the disclosures are the same with and without this accounting alternative. d. One of several of the conditions to apply this accounting alternative is that substantially all of the activity between the two entities is leasing from one to the other. 80. Which of the following statements about accounting alternatives approved by PCC is most correct? a. When addressing implementation approaches, PCC will consider simpler approaches for private companies, including considering a modified retrospective approach when full retrospective is required for public companies, or even considering prospective approach. b. If a private company elects any one of the accounting alternatives approved by FASB and PCC, the company must follow all of the approved alternatives then in effect. c. When considering the cost and difficulty of an accounting issue under consideration compared to the relevance to the users, PCC will place more emphasis on the cost and 219

221 difficulty. d. The accounting alternatives are generally available to non-publicly traded companies which typically would include private companies, not-for-profit organizations and employee benefit plans of private companies. 220

222 10,304, Quizzer Questions: Module AU-C Section 500 defines the term sufficiency of audit evidence as: a. A qualitative measure of the relevance of evidence b. A measure of the reliability of evidence c. A measure of the competence of evidential matter d. A quantitative measure 82. Which of the following statements about the auditor's responsibilities to communicate with legal counsel is correct according to AU-C Section 501? a. Direct communication with in-house legal counsel may be substituted for communication with external counsel. b. Auditors may choose not to seek direct communication with external legal counsel when no actual or potential litigation, claims or assessments that may give rise to risk of material misstatement exist. c. Auditors should avoid discussing matters pertaining to litigation directly with legal counsel. d. Auditors should ask management to send letters of inquiry directly to external legal counsel. 83. If management refuses to allow external confirmations, and the auditor is unable to obtain relevant, reliable audit evidence through alternative audit procedures, the auditor should first: a. Determine the implications for the audit and the auditor's opinion, including whether a modified opinion is necessary b. Issue an adverse opinion c. Disregard the refusal and proceed with the external confirmation process d. Withdraw from the engagement 84. AU-C Section 510 defines the term predecessor auditor as: a. A different auditor from same audit firm who was engaged to perform but did not complete the audit b. An auditor from the same or a different audit firm who has reported on the most recent audited financial statements, or who was engaged to perform but did not complete the audit c. A different auditor from same audit firm who has reported on the most recent audited financial statements d. An auditor from a different audit firm who has reported on the most recent audited financial statements, or who was engaged to perform but did not complete the audit 85. Each of the following auditing procedures is required with respect to opening balances in an initial audit except: a. Obtaining written representations from the predecessor auditor b. Evaluating whether accounting policies have been consistently applied with respect to opening balances c. Reading the predecessor's report on the most recent financial statements 221

223 d. Reading the most recent financial statements 86. Documentation requirements for substantive analytical procedures in an audit of financial statements include requirements to document which of the following? a. Calculation of the debt-to-equity ratio when a balance sheet is presented b. Narrative explanations of the nature and objectives of each analytical procedure c. Evaluation of each difference between recorded amounts and expectations d. The factors considered in developing the expectations used, unless those expectations are otherwise readily discernible from the audit documentation 87. According to AU-C Section 530, nonstatistical sampling is: a. Any sampling approach that does not use both random selection and statistical evaluation techniques b. An unacceptable technique for large populations c. A sampling approach in which auditors select sample items without regard to the characteristics of the population d. Unlikely to provide the auditor with a reasonable basis for conclusions about the population 88. When management is not able to locate an invoice that an auditor has selected as part of a sample for a test of controls, the auditor should: a. Perform the planned procedures on a replacement invoice b. Regard the invoice as a deviation from the prescribed control c. Regard the invoice amount as a monetary misstatement d. Project the monetary amount of the invoice to the population 89. Which of the following statements about management bias in making accounting estimates is incorrect? a. Auditors should include indicators of management bias in the formulation of accounting estimates, if any, in the audit documentation. b. Auditors should review management's judgments in formulating accounting estimates to identify whether indications of bias exist. c. Identified indicators of management bias in making accounting estimates constitute misstatements. d. A difference between an original accounting estimate and its outcome does not necessarily indicate a management bias. 90. In considering the adequacy of related party disclosures for financial statements prepared based on a special purpose framework (i.e., a basis of accounting other than GAAP) that does not contain specific related party disclosure requirements, auditors should: a. Request management to provide a disclosure detailing all material related party transactions b. Consider what disclosures, if any, are reasonable under the circumstances for material related party transactions c. Evaluate whether related party disclosures are comparable to GAAP d. Request management to provide a detailed listing of material related party transactions as supplementary information 222

224 91. When a fact that may have caused revision to the auditor's report is discovered after the release of that report, auditors should first: a. Recall and reissue the affected report b. Determine whether this fact requires revision of the financial statements and, if so, inquire how management intends to address the matter c. Extend their subsequent events procedures to the date the fact was discovered d. Request management disclose the fact in revised financial statements 92. Which of the following is appropriate language for an emphasis-of-matter-paragraph about going concern? a. Significant net capital deficiencies create substantial doubt about the Company's ability to continue as a going concern. b. If the Company continues to experience losses from operations, there may be substantial doubt about its ability to continue as a going concern. c. Unless the Company is able to sell its Singapore division, there is substantial doubt about its ability to continue as a going concern. d. When the Company obtains additional financing as discussed in Note X, doubt about its ability to continue as a going concern will be alleviated. 93. Which of the following statements about the auditor's reporting responsibilities related to substantial doubt about going concern is correct? a. Auditors are prohibited from reissuing an audit report to remove a previously expressed emphasis-of-matter paragraph related to substantial doubt about going concern. b. A substantial doubt as to going concern arising in the current period may affect the auditor's report on prior periods that are presented on a comparative basis. c. A substantial doubt as to going concern existing in a prior period that is presented on a comparative basis does not necessarily imply a similar doubt in the current period. d. Auditors are required to communicate requests to remove a previously expressed emphasis-of-matter paragraph related to substantial doubt about going concern to those charged with governance. 94. Which of the following statements about management's written representations is correct, according to AU- C Section 580? a. Those representations in the current audit should cover all financial statement periods presented in a comparative presentation. b. They need not address matters previously covered in the engagement letter. c. They constitute sufficient appropriate audit evidence about the matters that they cover. d. Those representations can, under certain circumstances, be relied upon to reduce the extent of other audit procedures. 95. When auditors become aware of an omitted auditing procedure after the release of the audit report that impairs their ability to support that report, and they believe that users are currently relying, or likely to rely on the report, they should do all of the following except: a. Promptly perform the omitted procedure or alternate procedures b. Determine whether there is satisfactory basis for the previously expressed opinion c. Record those procedures in the audit documentation 223

225 d. Inform users who are known to be relying or are likely to rely on the report 96. The primary inadequacy of the classic fraud triangle cited by the authors of "Beyond the Fraud Triangle" is that it: a. Lacks objective criteria for identifying incentives or pressures and rationalizations b. Applies only to management fraud c. Does not consider opportunities for fraud d. Applies better to predatory, career-criminal perpetrators than to accidental fraudsters 97. The fraud scale is particularly applicable to: a. Tax evasion schemes b. The first-time "accidental fraudster" c. Fraudulent financial reporting d. Misappropriation of assets by employees 98. Which of the following is a key conceptual element of the fraud diamond? a. The perceived financial pressure element of the classic triangle is modified to consider such other motivators as stock options or bonuses. b. Perpetrators are most often motivated by a combination of money and ego or entitlement. c. Fraud could not occur without the right person with the right capabilities to implement its details. d. The perpetrator believes that the perceived greater good of his or her ideological cause justifies the means. 99. Fraud deterrence depends on reducing which elements of the classic triangle? a. Incentives/pressures and opportunities b. Entitlement/ego and incentives/pressures c. Capability and rationalization d. Rationalization and opportunity 100. Malpractice claims involving embezzlements highlight the need for auditors to: a. Confirm material investments with third parties who are the custodians of the investments, not the investment manager b. Document the communication of internal control weaknesses to management c. Withdraw from audit engagements involving verified embezzlements d. Apply auditing procedures specifically designed to detect material embezzlements 224

226 10,401, Top Auditing Issues for 2015 CPE Course: MODULE 1 ( ) Please go to CCHGroup.com/PrintCPE to complete your Quizzer online for instant results and no Express Grading Fee. A $56.00 processing fee will be charged for each user submitting Module 1 for grading. If you prefer to mail or fax your Quizzer, remove both pages of the Answer Sheet from this book and return them with your completed Evaluation Form to: CCH Continuing Education Department, 4025 W. Peterson Ave., Chicago, IL or fax your Answer Sheet to CCH at You must also select a method of payment below. NAME COMPANY NAME STREET CITY, STATE, & ZIP CODE BUSINESS PHONE NUMBER ADDRESS DATE OF COMPLETION METHOD OF PAYMENT: Check Enclosed Visa Master Card AmEx Discover CCH Account* Card No. Exp. Date Signature EXPRESS GRADING: Please fax my Course results to me by 5:00 p.m. the business day following your receipt of this Answer Sheet. By checking this box I authorize CCH to charge $19.00 for this service. Express Grading $19.00 Fax No. * Must provide CCH account number for this payment option Please answer the questions by indicating the appropriate letter next to the corresponding number Please complete the Evaluation Form (located after the Module 4 Answer Sheet) and return it with this Quizzer Answer Sheet to CCH at the address on the previous page. Thank you. 225

227 10,402, Top Auditing Issues for 2015 CPE Course: MODULE 2 ( ) Please go to CCHGroup.com/PrintCPE to complete your Quizzer online for instant results and no Express Grading Fee. A $56.00 processing fee will be charged for each user submitting Module 2 for grading. If you prefer to mail or fax your Quizzer, remove both pages of the Answer Sheet from this book and return them with your completed Evaluation Form to: CCH Continuing Education Department, 4025 W. Peterson Ave., Chicago, IL or fax your Answer Sheet to CCH at You must also select a method of payment below. NAME COMPANY NAME STREET CITY, STATE, & ZIP CODE BUSINESS PHONE NUMBER ADDRESS DATE OF COMPLETION METHOD OF PAYMENT: Check Enclosed Visa Master Card AmEx Discover CCH Account* Card No. Exp. Date Signature EXPRESS GRADING: Please fax my Course results to me by 5:00 p.m. the business day following your receipt of this Answer Sheet. By checking this box I authorize CCH to charge $19.00 for this service. Express Grading $19.00 Fax No. * Must provide CCH account number for this payment option Please answer the questions by indicating the appropriate letter next to the corresponding number Please complete the Evaluation Form (located after the Module 4 Answer Sheet) and return it with this Quizzer Answer Sheet to CCH at the address on the previous page. Thank you

228 10,403, Top Auditing Issues for 2015 CPE Course: MODULE 3 ( ) Please go to CCHGroup.com/PrintCPE to complete your Quizzer online for instant results and no Express Grading Fee. A $42.00 processing fee will be charged for each user submitting Module 3 for grading. If you prefer to mail or fax your Quizzer, remove both pages of the Answer Sheet from this book and return them with your completed Evaluation Form to: CCH Continuing Education Department, 4025 W. Peterson Ave., Chicago, IL or fax your Answer Sheet to CCH at You must also select a method of payment below. NAME COMPANY NAME STREET CITY, STATE, & ZIP CODE BUSINESS PHONE NUMBER ADDRESS DATE OF COMPLETION METHOD OF PAYMENT: Check Enclosed Visa Master Card AmEx Discover CCH Account* Card No. Exp. Date Signature EXPRESS GRADING: Please fax my Course results to me by 5:00 p.m. the business day following your receipt of this Answer Sheet. By checking this box I authorize CCH to charge $19.00 for this service. Express Grading $19.00 Fax No. * Must provide CCH account number for this payment option Please answer the questions by indicating the appropriate letter next to the corresponding number Please complete the Evaluation Form (located after the Module 4 Answer Sheet) and return it with this Quizzer Answer Sheet to CCH at the address on the previous page. Thank you. 227

229 10,404, Top Auditing Issues for 2015 CPE Course: MODULE 4 ( ) Please go to CCHGroup.com/PrintCPE to complete your Quizzer online for instant results and no Express Grading Fee. A $28.00 processing fee will be charged for each user submitting Module 4 for grading. If you prefer to mail or fax your Quizzer, remove both pages of the Answer Sheet from this book and return them with your completed Evaluation Form to: CCH Continuing Education Department, 4025 W. Peterson Ave., Chicago, IL or fax your Answer Sheet to CCH at You must also select a method of payment below. NAME COMPANY NAME STREET CITY, STATE, & ZIP CODE BUSINESS PHONE NUMBER ADDRESS DATE OF COMPLETION METHOD OF PAYMENT: Check Enclosed Visa Master Card AmEx Discover CCH Account* Card No. Exp. Date Signature EXPRESS GRADING: Please fax my Course results to me by 5:00 p.m. the business day following your receipt of this Answer Sheet. By checking this box I authorize CCH to charge $19.00 for this service. Express Grading $19.00 Fax No. * Must provide CCH account number for this payment option Please answer the questions by indicating the appropriate letter next to the corresponding number Please complete the Evaluation Form (located after the Module 4 Answer Sheet) and return it with this Quizzer Answer Sheet to CCH at the address on the previous page. Thank you. 228

230 10,500, Top Auditing Issues for 2015 CPE Course: Evaluation Form ( ) Please take a few moments to fill out and mail or fax this evaluation to CCH so that we can better provide you with the type of self-study programs you want and need. Thank you. About This Program 1. Please circle the number that best reflects the extent of your agreement with the following statements: Strongly Agree Strongly Disagree a. The Course objectives were met b. This Course was comprehensive and organized. c. The content was current and technically accurate. d. This Course was timely and relevant e. The prerequisite requirements were appropriate. f. This Course was a valuable learning experience. g. The Course completion time was appropriate. 2. This Course was most valuable to me because of: Continuing Education credit Convenience of format Relevance to my practice/employment Timeliness of subject matter Price Reputation of author Other (please specify) 3. How long did it take to complete this Course? (Please include the total time spent reading or studying reference materials and completing CPE Quizzer). Module 1 Module 2 Module 3 Module 4 4. What do you consider to be the strong points of this Course? 5. What improvements can we make to this Course? 229

231 General Interests 1. Preferred method of self-study instruction: Text Audio Computer-based/Multimedia Video 2. What specific topics would you like CCH to develop as self-study CPE programs? 3. Please list other topics of interest to you _ About You 1. Your profession: Accountant Controller Enrolled Agent Other (please specify) 2. Your employment: Self-employed Service Industry Banking/Finance Education 3. Size of firm/corporation: Auditor CPA Risk Manager Public Accounting Firm Non-Service Industry Government Other Your Name Firm/Company Name Address City, State, Zip Code Address THANK YOU FOR TAKING THE TIME TO COMPLETE THIS SURVEY! 230

232 10,600, CCH Learning Center At Wolters Kluwer, CCH we recognize the value of Continuing Professional Education to educate and train your workforce, bring added value to your clients or organization, and gain a competitive edge in the marketplace. But keeping up with legislative and regulatory changes and industry developments can be a fulltime job. Let CCH and the CCH Learning Center serve as your gateway to compelling self-study CPE courses and research resources. With the CCH Learning Center you get: More Than 300 Up-To-Date Courses: The CCH Learning Center offers more than 300 informative courses covering tax, financial and estate planning, and accounting/auditing issues, with new courses being added all the time. Go to the Course Catalog at CCHGroup.com/CPE to see descriptions of all the courses you can take. Expert Authors And Superior Content: Our team of professional analysts, editors, and contributing authors has more experience and more expertise than any other tax publisher in the country, which ensures you get current, reliable, real-world insights to help you handle the toughest topics and issues. Approved CPE: CCH is an approved QAS (Quality Assurance Service) provider with NASBA one of the first CPE sponsors to be approved under the rigorous new CPE requirements. 24/7 Access: CCH Learning Center courses are available online 24 hours a day, seven days a week and you get immediate Quizzer results and certification, so you can make sure you hit your CPE deadlines. Opportunities To Apply Knowledge: CCH Learning Center courses provide integrated learning activities, study questions, client letters, checklists, and other resources that let you apply what you learn. Convenient Print Formats: CCH Learning Center lets you print out hard copies of the courses, giving you a quick and easy way to take the course whenever you want away from the computer at home, on the plane, wherever! Links to CCH INTELLICONNECT TM and Accounting Research Manager TM : For additional research, guidance, and access to late breaking developments, CCH Learning Center's tax courses include links to sources of additional explanation and authority within Intelliconnect TM and the accounting and auditing courses include links to authoritative and proposed literature within Accounting Research Manager TM. To purchase a subscription or learn more about the CCH Learning Center, contact your CCH Representative at CCH-REPS or visit the Online Store at Customer Support: If you have any questions about or need assistance with the CCH Learning Center or have any account related issues, CCH Customer Support is readily available at W. Peterson Ave. Chicago, IL CCHGroup.com 231

233 CCH LEARNING CENTER At Wolters Kluwer, we recognize the value of Continuing Professional Education to educate and train your workforce, bring added value to your clients or organization, and gain a competitive edge in the marketplace. But keeping up with legislative and regulatory changes and industry developments can be a full-time job. Let Wolters Kluwer and the CCH Learning Center serve as your gateway to compelling self-study CPE courses and research resources. With the CCH Learning Center you get: n More Than 300 Up-To-Date Courses: The CCH Learning Center offers more than 300 informative courses covering tax, financial and estate planning, and accounting/auditing issues, with new courses being added all the time. Go to the Course Catalog at CCHGroup.com/CPE to see descriptions of all the courses you can take. n Expert Authors And Superior Content: Our team of professional analysts, editors, and contributing authors has more experience and more expertise than any other tax publisher in the country, which ensures you get current, reliable, real-world insights to help you handle the toughest topics and issues. n Approved CPE: CCH is an approved QAS (Quality Assurance Service) provider with NASBA one of the first CPE sponsors to be approved under the rigorous new CPE requirements. n 24/7 Access: CCH Learning Center courses are available online 24 hours a day, seven days a week and you get immediate Quizzer results and certification, so you can make sure you hit your CPE deadlines. n Opportunities To Apply Knowledge: CCH Learning Center courses provide integrated learning activities, study questions, client letters, checklists, and other resources that let you apply what you learn. n Convenient Print Formats: CCH Learning Center lets you print out hard copies of the courses, giving you a quick and easy way to take the course whenever you want away from the computer at home, on the plane, wherever! n Links to CCH INTELLICONNECT and Accounting Research Manager TM : For additional research, guidance, and access to late breaking developments, CCH Learning Center s tax courses include links to sources of additional explanation and authority within Intelliconnect and the accounting and auditing courses include links to authoritative and proposed literature within Accounting Research Manager. To purchase a subscription or learn more about the CCH Learning Center, contact your Wolters Kluwer Representative at CCH-REPS or visit the Online Store at Customer Support: If you have any questions about or need assistance with the CCH Learning Center or have any account related issues, CCH Customer Support is readily available at W. Peterson Ave. Chicago, IL CCHGroup.com