Paragraph A2 of AU-C 500 of the Clarified Auditing Standards reads:
Most of the auditor's work in forming the auditor's opinion consists of obtaining and evaluating audit evidence. Audit procedures to obtain audit evidence can include inspection, observation, confirmation, recalculation, re-performance, and analytical procedures, often in some combination, in addition to inquiry. Although inquiry may provide important audit evidence and may even produce evidence of a misstatement, inquiry alone ordinarily does not provide sufficient audit evidence of the absence of a material misstatement at the assertion level, nor is inquiry alone sufficient to test the operating effectiveness of controls. [italics ours]
Inquiries are recognized in the auditing standards along with other types of tests and are normally the most cost efficient of all auditing procedures. Management and accounting personnel's responses to auditors' inquiries provide information that will be used in the evidence collection process from the start to the finish of an audit.
The use of inquiries on an audit engagement will usually begin during the pre-engagement planning phase with the client acceptance and/or continuance decision-making and the delivery of an engagement letter by the engagement leader. Continuing into the planning phase, inquiries and other procedures will be the heart of an auditor's risk assessment process that leads to the design of a cost-beneficial audit strategy and an audit plan. Evidence collected from the detailed tests of balances will also arise from a combination of inquiries and other procedures.
Making Inquiries on Audits of Special Purpose Frameworks
The engagement leader should make the first and perhaps the most important audit inquiry. Clarified auditing standards require an auditor to determine if an entity's applicable reporting framework is an appropriate presentation of its financial position and results of operations. If the applicable framework is not appropriate, the auditor will be required to issue a qualified or adverse audit opinion.
When a reporting entity is using a special purpose framework such as cash, modified cash, income tax, or the FRF for SMEs basis, the auditor should discuss the appropriateness of the framework with management well in advance of the entity's reporting date. If necessary to prohibit a qualified or adverse opinion, an appropriate framework can be selected and financial statements adjusted accordingly.
Using the FRF for SMEs basis as an example, the following are some of the audit inquiries that may be necessary:
- Has the accrual basis of accounting been used except where the FRF for SMEs requires different methods?
- Will any fair value accounting requirements of a previously used U.S. GAAP framework require adjustment to "market values" under the FRF for SMEs?
- Because management can elect the equity method of accounting for greater than 50%-owned subsidiaries, variable interest entities and other investments over which it has significant influence, what is the most appropriate method for reporting any 50+%-owned subsidiaries?
- Is the cost or equity method of accounting the most appropriate for other investments?
- Inventories are valued at the lower of cost or the ceiling of net realizable value under the FRF for SMEs. Are any inventory adjustments necessary to convert from a U.S. GAAP valuation range of the ceiling and floor of net realizable value?
- Goodwill and all other intangible assets are amortized and no tests for impairment are required for any intangible or other long-lived assets. Are restatements necessary for these FRF for SMEs principles?
- Lease accounting requirements are similar to traditional U.S. GAAP, even if new lease accounting standards become applicable for GAAP. Are any adjustments necessary for capitalized leases?
- Management can elect the income taxes payable method instead of the deferred taxes method. Which method is most appropriate for the entity?
- Accounting for pension and post-employment plans under a current contribution payable method can simplify accounting, save financial statement preparation time and reduce auditor's time charges and the use of costly specialists. On the other hand, it also removes pension obligations from the statement of financial position. Is the contribution payable method the most appropriate for the entity?
- With only footnote disclosures required for such items as derivatives and stock-based compensation plans, costly accounting methods under U.S. GAAP can be avoided. Are the disclosures required under the FRF for SME sufficient information for users of the financial statements?
- While the acquisition method required for business combinations is similar to U.S. GAAP, push-down (new basis) accounting is permitted for acquired entities, resulting in similar values being recorded in the acquired entity's financial statements. Will this new basis accounting facilitate future consolidations and is it appropriate for an entity's subsidiaries?
AU-C 230, Audit Documentation, indicates that all substantive evidence used to reach audit conclusions must be documented in engagement files. Paraphrasing, the documentation must be sufficient to enable an experienced reviewer to determine what the auditor did, what the auditor found and what the auditor did about what was found.
My next article will focus on efficient ways to document inquiries made throughout an audit engagement.