Learning Objectives
Management representation
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11-сhapter (COMPLETING THE AUDIT)
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Management representation letter and responsibility for financial statements.
Universal Health Services, Inc. (UHS) is a hospital company operating acute care and behavioral health hospitals, ambulatory surgery and radiation centers in the USA, Puerto Rico and France. UHS owns 25 acute-care and 39 behavioral health hospitals in these three countries. In February 2003, UHS’s CFO Kirk Gorman, a company veteran of 16 years, was asked to resign at the urging of its auditor, KPMG LLP. KPMG were doing their first audit for the company, having just replaced the prior auditor Arthur Andersen. According to UHS, there was a dispute related to Gorman’s theoretical views about the split of duties and responsibilities between the CFO and the auditor. (Gallaro 2003) Gorman wrote a letter to the Philadelphia office of KPMG explaining that, while he was willing to sign the management representation letter (attesting that the financial statements he submitted for audit were, to the best of his knowledge, accurate), he was relying on KPMG to ensure that the accounting treatment was in accordance with GAAP. (Leone 2003) He asked if KPMG would be willing to sign a similar statement vouching for the accu- racy of its work. (Corporate Finance 2003) Furthermore, the letter released by UHS, stated that, “I do review and analyze the financial statements and disclosures in our 10-Q and 10- K filings, but I can’t personally verify that all of our accounts are in accordance with GAAP.” Because he was “neither a certified public accountant nor a securities lawyer” that lead him to “rely upon KPMG to ensure that our financial statements ... are in compliance with (generally accepted accounting principles) and securities regulations.” (UHS 2002) In a letter dated February 10 (UHS 2003), Gorman sought to clarify his position. He wrote that he had not intended to leave the impression that he doubted the veracity of the company’s financial statements or that he wanted to shift responsibility for the statements’ accuracy to KPMG. (Gallaro 2003)
If management refuses to provide representations that the auditor considers necessary, this will be considered a limitation on scope under international standards. It is also a limitation on scope if management has provided an oral representation but refuses to confirm it in writing. This scope limitation would mean that the auditor should express a qualified opinion or a disclaimer of opinion. Review for Contingent Liabilities and Commitments Contingent liability is a potential future obligation to an outside party for an unknown amount resulting from the outcome of a past event, for example an adverse tax court decision, lawsuit, and notes receivable discounted. Footnote disclosure is ordinarily required if there are probable losses. Conditions for Existence of a Contingent Liability Three conditions are required for a contingent liability to exist: There is a potential future payment to an outside party or potential future assets impairment. There is an uncertainty about the amount of payment or asset impairment. The outcome will be resolved by some future event. Procedures to Test for Contingencies Audit procedures that test for contingencies are not just done in the last days of the audit, but from the beginning. Income tax disputes, investigations by government or industry authorities, and the amount of unused bank lines of credit are generally known from the start of the audit. Procedures such as reviews of contracts, correspondence, credit agree- ments and inquiries of management should point out possible contingencies. One audit procedure for finding contingencies is the legal letter already discussed where the auditor analyzes legal expenses and statements from legal counsel and obtains a letter from each major lawyer as to the status of pending litigation. Three other common procedures are to: review working papers; examine letters of credit to confirm used and unused balances; and evaluation of known contingent liabilities. ILLUSTRATION 11.5 Management Representation Letter 22 The following letter is not intended to be a standard letter. Representations by management will vary from one entity to another and from one period to the next. Although seeking representations from management on a variety of matters may serve to focus management’s attention on those matters, and thus cause management to specifically address those matters in more detail than would otherwise be the case, the auditor needs to be cognizant of the limitations of management representations as audit evidence as set out in this ISA. Shoun Company 888 24 th Street Lubbock, Texas 79410-1894 January 26, 20x8 Kusuda & Gasan, CPAs 3012 24th Street Lubbock, Texas 79410-1894. Dear Ms. Kusuda, This representation letter is provided in connection with your audit of the financial statements of ABC Company for the year ended December 31, 20X7 for the purpose of expressing an opinion as to whether the financial statements give a true and fair view of (present fairly, in all material respects,) the financial position of Shoun Company as of December 31, 20X7 and of the results of its operations and its cash flows for the year then ended in accordance with (indicate relevant financial reporting framework). We acknowledge our responsibility for the fair presentation of the financial statements in accordance with (indicate relevant financial reporting framework). We confirm, to the best of our knowledge and belief, the following representations: Include here representations relevant to the entity. Such representations may include: There have been no irregularities involving management or employees who have a significant role in the accounting and internal control systems or that could have a material effect on the financial statements. We have made available to you all books of account and supporting documentation and all minutes of meetings of shareholders and the board of directors (namely those held on March 15, 20X7 and September 30, 20X7, respectively). We confirm the completeness of the information provided regarding the identification of related parties. The financial statements are free of material misstatements, including omissions. The Company has complied with all aspects of contractual agreements that could have a material effect on the financial statements in the event of noncompliance. There has been no noncompliance with requirements of regulatory authorities that could have a material effect on the financial statements in the event of noncompliance. The following have been properly recorded and when appropriate, adequately disclosed in the financial statements: The identity of, and balances and transactions with, related parties. Losses arising from sale and purchase commitments. Agreements and options to buy back assets previously sold. Assets pledged as collateral. We have no plans or intentions that may materially alter the carrying value or classification of assets and liabilities reflected in the financial statements. We have no plans to abandon lines of product or other plans or intentions that will result in any excess or obsolete inventory, and no inventory is stated at an amount in excess of net realizable value. The Company has satisfactory title to all assets and there are no liens or encumbrances on the company’s assets, except for those that are disclosed in Note X to the financial statements. Contingencies that are of concern to the auditor, among others, are: pending litigation for patent infringement, product liability or other actions; guarantees of obligations of others; product warranties; income tax disputes; and notes receivable discounted. Commitments Similar to contingent liabilities are commitments. Commitments are agreements that the entity will hold to a fixed set of conditions, such as the purchase or sale of merchandise at a stated price, at a future date, regardless of what happens to profits or to the economy as a whole. Examples are commitments to purchase raw materials, lease premises, royalty agreements, licensing agreements and agreements to sell merchandise or services at a fixed price. There may be commitments to employees in the form of profit sharing, stock options, health benefits and pension plans. All material commitments are ordinarily either described together in a separate footnote or combined in a footnote related to contingencies. Related Parties Parties are considered to be related if one party has the ability to control the other party or exercise significant influence over the other party in making financial and operation decisions. A related party transaction is a transfer of resources or obligations between related parties, regardless of whether a price is charged. Two aspects of related party transactions of which an auditor must be aware is adequate disclosure of related party transactions and the possibility that the existence of related parties increases the risk of management fraud. International Financial Reporting Standards (IAS 24) 23 requires disclosure of the nature and volume of transactions with related parties. There are many legitimate reasons for significant transactions with related parties but the risk for an auditor is that management will conceal transactions between related parties causing the disclosures to be misstated, i.e. the related party disclosures are not complete. Procedures to Discover Related Party Transactions Because of the possibility of related party transactions, the auditor should perform audit procedures designed to obtain sufficient appropriate audit evidence regarding the identi- fication and disclosure by management of related parties and the effect of related party transactions. However, an audit cannot be expected to detect all related party trans- actions. 24 Audit procedures must identify circumstances that increase the risk of mis- statement or that indicate material misstatement regarding related parties has occurred. If these circumstances exist, the auditor should perform modified, extended, or additional procedures. Illustration 11.6 shows examples of circumstances and may indicate the existence of previously unidentified related parties. Concept and a Company 11.2 Adelphia Communications |
