Lecture 18 Notes

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Accounting & Financial Management
AFM 451
James Wainberg

Lecture 18: Going Concern, Auditing of Accounting Estimates, and other Assurance Services (Ch. 17 & 19) Going Concern – Auditor’s Responsibility  CAS 570 "Going Concern":  Under the going concern assumption, an entity is viewed AS CONTINUING IN BUSINESS FOR THE FORESEEABLE FUTURE (at least 1 year)  GAAP are based on the going-concern concept so when an auditor says “F/S are in conformity with GAAP” it means that continued existed may be presumed for a REASONABLE TIME (at least 1 yr)  The auditor's responsibility is to obtain SAAE about the appropriateness of management's use of the going concern assumption in the preparation of the financial statements and to conclude whether THERE IS A MATERIAL UNCERTAINTY about the entity's ability to continue as a going concern Going Concern – Risk Assessment  According to CAS 570, when performing the risk assessment procedures, the auditor shall consider whether there are events or conditions that may cast significant doubt on the entity's ability to continue as a going concern i. Negative trends in operating results ii. Loan defaults iii. Denial of supplier credit iv. Uneconomical long-term commitments (bad deals) v. Legal proceedings  In practice, audit firms may employ BANKRUPTCY PREDICTION MODELS as an analytical procedure for risk assessment i. Example: Altman Z-score  The auditor should also consider of MITIGATING FACTORS: i. Line-of-Credit availability, ii. Debt extension, iii. Reduction of dividend payments, iv. Anything they can do to keep afloat  ***FACTORS which would REDUCE financial difficult problems Going Concern-Auditing Reporting  If the auditor concludes that THE USE OF GOING CONCERN ASSUMPTION IS APPROPRIATE BUT A MATERIAL UNCERTAINTY EXISTS, then: o If adequate disclosure is made, the auditor shall express an unqualified opinion and include an EMPHASIS OF MATTER PARAGRAPH in the auditor's report (to highlight the issue and draw attention to the note in the financial statements) o If adequate disclosure is not made, the auditor shall express a qualified or adverse opinion  If the financial statements have been PREPARED ON A GOING CONCERN BASIS, but the auditor believes that the use of that assumption is inappropriate, the auditor shall express an adverse opinion o The enterprise must switch to a different basis of accounting (i.e., liquidation values) Keval Shah Chapters 17 & 19 – AFM 451 1 Difficult With Auditing the Going Concern Assumption  CAS 200 emphasizes that the potential effects of inherent limitations on the auditor's ability to detect material misstatements are greater for future events. CAS 570 therefore states that: o The absence of any reference to going concern uncertainty in an auditor's report CANNOT GUARANTEE the entity's ability to continue as a going concern Five Types of Audit Reports that may be used when going-concern problems exist: 1. Standard Report with NO additional explanatory paragraphs 2. Standard report with an unmodified opinion paragraph and an additional explanatory paragraph to direct attention to mgmt.’s disclosures about the problems  included in the notes 3. Adverse opinion  arises from a failure to disclose substantial doubts or when it is virtually certain that the company will fail to continue as a going concern and GAAP no longer applies Keval Shah Chapters 17 & 19 – AFM 451 2 4. Qualification for a GAAP departure if the auditor believes the company’s disclosures about financial difficulties and going-concern problems are inadequate 5. Qualified for SCOPE limitation if evidence that might or might not exist is NOT made available to the auditors, leading to the “except for adjustments, if any” type of audit opinion Auditing Accounting Estimates  Recall: Accounting Risk = The part of INFORMATION RISK due to incorrectly predicting future events, especially in accounting estimates  CAS 540 "Auditing Accounting Estimates" states that certain financial statement items cannot be measured precisely, but can only be estimated. Examples include: o Financial instruments o Pension liabilities o Goodwill impairment charges o Warranty Reserves  Many accounting estimates are calculated using models which rely on various assumptions and input parameters o Timing and amounts of future cash flows o Growth rates o Discount rates, etc. Accounting Estimates – Auditor’s Objective  The objective of the auditor is to obtain SAAE about whether, (in the context of the applicable financial reporting framework): o Accounting estimates are REASONABLE o Related DISCLOSURES are adequate Key Definitions  Accounting estimate is an APPROXIMATION OF A MONETARY AMOUNT in the absence of precise means of measurement  Auditor's point estimate or auditor's range is the amount or range of amounts, respectively, DERIVED FROM AUDIT EVIDENCE for use in evaluating management's point estimate  Estimation uncertainty is the SUSCEPTIBILITY OF AN ACCOUNTING ESTIMATE TO AN INHERENT LACK OF PRECISION in its measurement  Management bias is the lack of neutrality in management estimates  Management’s Point Estimate: The amount selected by mgmt. in the preparation and presentation of information  Outcome of An Accounting Estimate: The actual monetary amt which results from the RESOLUTION of the UNDERLYING TRANSACTION(S), EVENT(S), or CONDITION(S) addressed by the accounting ESTIMATE Why Management Accounting Estimates May Be Unreasonable:  Inherent difficulty in developing the estimate (i.e., HIGH ESTIMATION UNCERTAINTY)  LACK OF TECHNICAL EXPERTISE by management to develop and use appropriate methods and models to determine the value of an accounting estimate Keval Shah Chapters 17 & 19 – AFM 451 3  Deliberate MANAGEMENT BIAS when developing accounting estimates o Typically manipulated to increase net income and net assets Risk Assessment Procedures  When performing the risk assessment procedures for auditing of accounting estimates, the auditor shall understand: I. The REQUIREMENTS of the applicable financial reporting framework II. How management identifies transactions and events that may give rise to the need for accounting estimates to be recognized or disclosed (i.e., controls) III. How management makes the accounting estimates and the data on which they are based Discussion of CAS 540  Estimation uncertainties incorporate all 3 types of misstatements: o FACTUAL AND PROJECTED MISSTATEMENTS related to SAMPLING theory and the traditional Audit Risk Model with its focus on PLANNING AUDIT EVIDENCE-GATHERING PROECDURES  Sampling risk and confidence intervals can be reduced by increasing the sample size – by gathering more evidence o JUDGMENTAL MISSTATEMENTS: Differences arising from mgmt.’s judgments concerning ACCOUNTING ESTIMATES that the auditor CONSIDERS UNREASONABLE, or the selection or application of accounting policies that the auditor considers INAPPROPRIATE  Includes NONSAPLING ERRORS  INACCURACIES in forecasting of future events  Accounting Risk = Risk of material forecasting errors in the developing the accounting estimates  The factual and projected misstatements can be treated as part of AUDIT RISK  ACCOUNTING RISK CANNOT be reduced by gathering more evidence  they can only be controlled through proper accounting disclosure and are a part of financial reporting judgment  Acc
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