You are auditing the balance sheet section of a client\'s balance sheet as of 12

Question

You are auditing the balance sheet section of a client's balance sheet as of 12/31/2011. You see that there is a $1,000,000 long-term debt outstanding to Sturdy Savings Bank which is due on 12/15/2016. You read the loan agreement and see that there is an acceleration clause . The clause reads that the borrower cannot borrow more than $10,000 from any other entity during the term of the $1,000,000 without prior approval of Sturdy Savings Bank. If your client violates this clause, the $1,000,000 becomes due and payable upon demand of the lender. Assume that you client had violated the acceleration clause on 11/1/2011. Discuss how you would handle this situation and how it might affect your client's financial statements for the year ended 12/31/11.

Explanation / Answer

A variety of situations might exist at a client for whom the auditor is asked to prepare the financial statements. In analyzing these situations, it is important to consider: • The effectiveness of the entity’s internal control apart from what the auditor does or is being asked to do. • Why the auditor is being asked to perform certain task such as preparing adjusting entries, notes to the financial statements, or even the financial statements • The ability of client personnel (staff accountant, bookkeeper, management) to understand and evaluate the work performed by the auditor The following are examples of those situations and the applicable analysis. . Situation A: Client’s Accountant is Capable of Preparing Financial Statements The client’s accountant is capable of preparing the financial statements. The auditor knows that the accountant is capable of preparing the financial statements because he/she prepared the financial statements last year and did a good job. Iteration A1: The auditor is being asked to draft the financial statements this year because the client’s accountant is busy installing a new computer system. Consequently, the client’s accountant doesn’t have enough time to carefully prepare the financial statements this year. The client’s accountant submits an adjusted trial balance to the auditor along with the notes to the financial statements with indicators of where the notes should go and asks the auditor to complete the task of drafting the financial statements. The auditor drafts the financial statements using the accountant’s materials and recommends no additional adjusting or correcting entries. After the auditor has drafted the financial statements, the accountant reviews the auditor-drafted financial statements for accuracy and traces everything back to the adjusted trial balance Analysis of A1: The accountant has done 90% of the work required to prepare the financial statements. The accountant’s adjusted trial balance and notes reflect all of the requirements of GAAP except for presenting them in the proper format. Based on the facts presented, there is no identified control deficiency. 1 Iteration A2: Assume the same scenario as described in Iteration A1 except the accountant does not have enough time to prepare year end closing entries (e.g. adjustments to depreciation based on client’s depreciation schedules, year end payroll accruals based on client’s payroll journal), draft the financial statements and the accompanying notes and asks the auditor to perform these tasks. After the auditor prepares all necessary year end adjustments and drafts the financial statements and footnotes, the accountant reviews all the auditor-prepared documents for accuracy and traces adjusting entries back to all source documents. Analysis of A2: This situation, like many, will require professional judgment. Although the accountant is capable of doing all this work and seems to have controls in place to prevent and detect misstatements, it could be argued that the client does not take the closing process seriously. If preparing the financial statements is a low priority to this entity, it could be argued that this situation is an indicator of an ineffective control environment. Paragraph 19 of SAS 112 identifies the following as at least a significant deficiency and a strong indicator of a material weakness: • An ineffective control environment. Control deficiencies in various other components of internal control could lead the auditor to conclude that a significant deficiency or material weakness exists in the control environment. Situation B: Client’s Accountant is Not Capable of Preparing the Financial Statements The client has a staff accountant who is able to accurately keep the books and records on the cash basis and to prepare an unadjusted trial balance but cannot compute the accruals or prepare the financial statements. Iteration B: Because of the client’s inability, the auditor computes all year end accruals which the client’s accountant posts to the trial balance. The accountant is very careful and posts the accruals to the correct accounts. He thanks the auditor for providing him with the accruals and tells the auditor that he could not have prepared them himself. Using last year’s adjusted trial balance and financial statements as a template, the staff accountant codes the accounts in the adjusted trial balance, combines the accounts with the same code, formats the financial statements and substitutes this year’s numbers for last year’s numbers. Finally he inserts the same notes that were included in last year’s financial statements attaching them to the line items they were attached to last year. When he has completed the financial statements, he explains to the auditor how he prepared the financial statements and gives the financial statements to the auditor. Analysis B The staff accountant is unable to either adjust the cash basis trial balance or evaluate the auditor’s adjustments. Neither he nor anyone else within the client organization is capable of evaluating whether the financial statements are fairly presented in accordance with GAAP. As a result, the auditor has identified a control deficiency and evaluates the deficiency as a material weakness because the client has no controls which would prevent or detect material misstatements in the audited financial statements. An entity’s system of internal control over financial reporting should include controls over the prevention, detection and correction of misstatements in the audited financial statements. If an entity/government has not designed controls to prevent or detect misstatements in their audited accrual basis financial statements, then they have a control deficiency that must be evaluated if identified by the auditor

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