Learning Objectives

Partnership Review and Rotation
Audits should be reviewed by partners in the accounting firm not connected with the audit and should rotate their audit partners every five years. Under SOX, section 103, auditors should provide a concurring or second partner review by a qualified person associated with the public accounting firm, other than the person in charge of the audit, or by an independent reviewer. SOX, section 303 makes it unlawful for a registered public accounting firm to provide audit services to an issuer if the lead audit partner having primary responsibility for the audit, or the audit partner responsible for reviewing the audit, has performed audit services for that issuer in each of the five previous fiscal years of that issuer. Section 103 also states the quality control standards that were discussed in
11.3 Quality Control, above.
Audit Committee Review of Auditors
Under SOX, section 301, ¹⁵ public company audit committees are directly responsible for the appointment, compensation, and oversight of the work of any registered public accounting firm employed by their company (including resolution of disagreements between management and the auditor regarding financial reporting). Each such registered public accounting firm reports directly to the audit committee. Auditors may also have to discuss accounting complaints with the audit committee. Each audit committee must have

established procedures for the receipt, retention, and treatment of complaints regarding accounting, internal accounting controls, or auditing matters.

Evaluate Governance Evidence


There is important governance evidence that may be acquired any time during the audit, but definitely has to be done before the final judgment and evaluation phase (Phase IV of the Audit Process Model). The important governance information to be gathered from the client includes: a legal letter, a management representations letter, information about contingent liabilities and commitments, and identification of related parties. The auditor must review legal documents, contracts, board of directors meeting notes and manage- ment communication to determine if contingent liabilities exist. A search for unrecorded liabilities, discussed in Chapter 10 Substantive Testing and Evidence is also routine. Because of the numerous international (and generally local) standards requiring dis- closure for related parties, evaluating the existence of related parties and transactions with related parties is an important part of the final review.

• 
  Obtain Evidence and Letters Concerning Litigation, Claims and Assessments
  

To discover litigation, claims and assessments that affect the client, the auditor relies on both his own field procedures and a letter from the client’s legal counsel.
Field Procedures
The field procedures to discover claims against the client are:

• 
  read the corporate meetings’ minutes and notes of other appropriate meetings;
  
• 
  read contracts, leases, correspondence, and other similar documents;
  
• 
  review guarantees of indebtedness disclosed on bank confirmations;
  
• 
  inspect other documents for possible client-made guarantees;
  
• 
  determine if there are any side letters.
  

The auditor will ask management about the policies and procedures adopted for identifying, evaluating and accounting for contingencies; and obtain a description and evaluation of all pending contingencies (before or at balance sheet date). The auditor will obtain written assurance from the client that all unasserted claims that require disclosure are disclosed.
Legal Letter
The primary procedure that auditors rely on for discovering litigation, claims and assess- ments that affect the client is a letter from the client’s legal counsel called a legal letter or inquiry of client’s attorneys. Auditors analyze client legal expense for the present year and sometimes the prior years. The auditor requires that the client send a standard attorney letter to every legal adviser. The letter goes to both outside counsel (independent law firms) and inside general counsel (lawyers that are employees of the client). The standard

letter from the client’s attorney is prepared on the client’s letterhead and signed by one of the client company’s management. The desired date of the letter from the attorney is close to the date of the auditor’s report.

A sample request for such a legal letter (or inquiry of client’s attorneys letter) from the client is shown in Illustration 11.4.
For all litigation, claims and assessments, the inquiry of client’s attorneys letter should request evidence relating to:

• 
  existence of conditions or circumstances indicating a possible loss from litigation, claims or assessments;
  
• 
  the period in which the underlying cause occurred;
  
• 
  likelihood of an unfavorable outcome;
  
• 
  amount of potential loss, including court costs.
  

Letter from Client’s Legal Counsel
The letter from client’s legal counsel informs the auditor of pending legislation and other information involving legal counsel that is relevant to the financial statements. It should include the following:

1. 
   Identification of the client and the date of the audit.
   
2. 
   A list, prepared by management, of material pending or threatened litigation, claims or assessments for which the lawyer has been engaged. The management may also request that its lawyer prepare this list.
   
3. 
   A list, prepared by management, of unasserted claims and assessments which manage- ment considers probable of assertion, and that, if asserted, ¹⁷ would have a reasonable possibility of an unfavorable outcome. There should also be a request that the lawyer indicate any disagreements with the evaluation.
   
4. 
   A request that the lawyer furnish information or comment about the nature and progress to date of each listed claim or assessment. If possible, the attorney would provide an evaluation of the likelihood and amount of potential losses.
   
5. 
   A request for the identification of any unlisted pending or threatened legal actions, or a statement that the client’s list is complete.
   
6. 
   A statement by the client informing the lawyer of his responsibility to inform manage- ment whenever, in the lawyer’s judgment, there is a legal matter requiring disclosure in the financial statements.
   

ILLUSTRATION 11.4

Legal Letter

Shoun Company 888 24 ^th Street

Lubbock, Texas 79410-1894
January 26, 20x8
Duey Cheattham & Howe 69 Swindle Road
Bamboozle, Texas 78602–3847

Gentlemen:

Our auditors, Kusuda & Gasan, are now engaged in an audit of our financial statements as of December 31, 20X7 and for the year then ended. In connection with the audit, management has furnished Kusuda & Gasan with information concerning certain contingencies involving matters with respect to which you have been engaged and to which you have devoted substantive attention on behalf of the Company. These contingencies individually represent a maximum potential loss exposure in excess of $230,000.
Pending or Threatened Litigation, Claims, and Assessments
We have furnished our auditors with the following information relation to the only pending or threatened litigation, claim, or assessment your firm is handling on our behalf and to which you have devoted substantive attention in the form of legal consultation or representation:

1. 
   Description of the nature of the case – Antitrust complaint filed against the company by the US Department of Justice for discriminatory pricing policies.
   
2. 
   Process of case to date – Case is in the discovery phase.
   
3. 
   Response to the case – Management intends to contest the case vigorously.
   
4. 
   Evaluation of the likelihood of an unfavorable outcome and an estimate, if one can be made, of the amount or range of potential loss – Management believes that the probability of an unfavorable outcome is remote. No estimate of loss can be made.
   

Please furnish to Kusuda & Gasan such explanation, if any, that you consider necessary to supplement the foregoing information, including an explanation of those matters as to which your views may differ from those stated and an identification of the omission of any pending or threatened litigation, claim, or assessment, or a statement that the list of such matters is complete.
Unasserted Claims and Assessments
We understand that whenever, in the course of performing legal services for us with respect to a matter recognized to involve an unasserted possible claim or assessment that may call for financial statement disclosure, if you have formed a professional conclusion that we must disclose or consider disclosure concerning such possible claim or assessment, as a matter of professional responsibility to us, you will so advise us and will consult with us concerning the question of such disclosure and the applicable requirements of International Financial Reporting Standard IAS

37. 
    Please specifically confirm to Kusuda & Gasan that our understanding is correct.
    

We will be representing to Kusuda & Gasan that there are no unasserted possible claims or assessments that you have advised are probable of assertion and must be disclosed in accordance with International Financial Reporting Standard IAS 37 in the financial statements currently under audit.
Other Matters
Your response should include matters that existed at December 31, 20X7 and for the period from that date to the date of your response. Please make your response effective as of February 8 20X7, and specifically identify the nature of and reasons for any limitation on your response.
Also, please furnish Kusuda & Gasan with the amount of any unpaid fees due you as of December 31, 20X7 for services rendered through that date. Please mail your reply directly to Kusuda & Gasan, 3012 24th Street, Lubbock, Texas 79410-1894. A stamped, addressed envelope is enclosed for your convenience. Also, please furnish us a copy of your reply.
Sincerely,
Ken McPhail, President

7 A request that the lawyers identify and describe the nature of any reasons for any limitations on the response.

• 
  Obtain Management Representation Letter
  

During the course of an audit, management makes many representations to the auditor, either unsolicited or in response to specific inquiries. When these representations relate to matters that are material to the financial statements, the auditor must seek corroborative audit evidence, evaluate whether the representations made by management appear reason- able and consistent with other audit evidence, and consider whether the individuals making the representations are competent to do so. International Standard on Auditing 580 ¹⁸ states: “The auditor should obtain evidence that management acknowledges its responsibility for the fair representation of the financial statements in accordance with the relevant financial reporting framework, and has approved the financial statements.”
The auditor can obtain this evidence from relevant minutes of meetings of board of directors, a signed copy of the financial statements, or by obtaining a written represent- ation from management.
Written Representations from Management
In instances when other sufficient appropriate audit evidence cannot reasonably be expected to exist, “the auditor should obtain written representations from management on matters material to the financial statements.” ¹⁹ The auditor may document in his working papers evidence of management’s representations by summarizing oral dis- cussions with management or by obtaining written representations from management. The possibility of misunderstandings between the auditor and management is reduced when oral representations are confirmed in writing by management.
Form and Content of Representations Letter
Written representations can take the form of a representation letter from management, or a letter from the auditor outlining his understanding of management’s representation, duly acknowledged and confirmed by management. ²⁰ The management representation letter should be addressed to the auditor or to the shareholders in an annual report. It

should contain the information requested by the auditor, be appropriately dated with the same date as the auditor’s report on the financial statements, ²¹ and signed. The members of management who have primary responsibility for the entity and its financial aspects, usually the senior executive officer and the chief financial officer, should sign the letter.

Matters that are ordinarily included in a management representation letter are:

• 
  management’s acknowledgement of its responsibility for the fair presentation of finan- cial statements;
  
• 
  availability of all financial records and related data;
  
• 
  information regarding related party transactions;
  
• 
  plans or intentions that may affect the carrying value or classification of assets;
  
• 
  disclosure of compensating balances and other arrangements involving restrictions on cash balances.
  

A sample of a management representation letter to the auditor is shown in Illustration 11.5.


Concept and a Company 11.1
Universal Health Services and KPMG – “I am neither a certified public accountant nor a securities lawyer.”

Concept Story