Auditors Should Perform Audit Procedures Relating To Subsequent Events

Auditors play a crucial role in ensuring the reliability and fairness of financial statements. One of the key areas where auditors must exercise due diligence is in considering subsequent events. These are events that occur after the balance sheet date but before the financial statements are issued. Understanding and appropriately addressing subsequent events is vital for providing reasonable assurance that the financial statements present a true and fair view of the company's financial position and performance. This article delves into the specific audit procedures auditors should perform related to subsequent events, providing a comprehensive guide for practitioners and a clear explanation for those seeking a deeper understanding of the auditing process.

Understanding Subsequent Events

Before diving into the specific audit procedures, it's essential to clearly define what constitutes a subsequent event and the different types that exist.

A subsequent event is defined as an event occurring between the date of the financial statements (the balance sheet date) and the date the financial statements are issued (or available to be issued). These events can have a significant impact on the financial statements, potentially requiring either:

• Adjustment of the financial statements: If the event provides evidence of conditions that existed at the balance sheet date.
• Disclosure in the notes to the financial statements: If the event provides evidence of conditions that arose after the balance sheet date.

There are two main types of subsequent events:

• Type 1: Adjusting Events: These events provide additional evidence relating to conditions that existed at the balance sheet date. They require an adjustment to the amounts recognized in the financial statements. Examples:
  • Settlement of a lawsuit after the balance sheet date, where the lawsuit existed at the balance sheet date.
  • Bankruptcy of a major customer after the balance sheet date, indicating that the accounts receivable balance at the balance sheet date was overstated.
  • Sale of inventory after the balance sheet date for less than its carrying value, suggesting that the inventory was overvalued at the balance sheet date.
• Type 2: Non-Adjusting Events: These events provide evidence about conditions that arose after the balance sheet date. They do not require adjustments to the financial statement amounts, but they may require disclosure in the notes to the financial statements if they are material. Examples:
  • A major fire or natural disaster that destroys a significant portion of the company's assets after the balance sheet date.
  • Issuance of a significant amount of debt or equity after the balance sheet date.
  • A major acquisition or disposal of a business segment after the balance sheet date.
  • Significant changes in market prices or exchange rates after the balance sheet date.

Auditor's Responsibility for Subsequent Events

The auditor's responsibility regarding subsequent events extends from the balance sheet date to the date of the auditor's report. The auditor is responsible for obtaining sufficient appropriate audit evidence regarding events occurring during this period that may require adjustment of, or disclosure in, the financial statements. This responsibility is clearly defined in auditing standards, such as those issued by the Public Company Accounting Oversight Board (PCAOB) and the Auditing Standards Board (ASB) of the American Institute of Certified Public Accountants (AICPA).

It's important to note that the auditor does not have a responsibility to actively search for subsequent events after the date of the auditor's report. However, if the auditor becomes aware of a fact after the date of the report that, had it been known at that date, may have caused the auditor to amend the report, the auditor should take appropriate action, as discussed later in this article.

Audit Procedures Related to Subsequent Events

To fulfill their responsibility regarding subsequent events, auditors must perform specific audit procedures designed to identify and evaluate these events. These procedures are not performed as a separate, isolated audit step. Rather, they are integrated into various phases of the audit, particularly near the completion of fieldwork. The following outlines the key audit procedures auditors should perform:

1. Reviewing Management's Procedures

• Objective: To understand and evaluate management's procedures for identifying and accounting for subsequent events.
• Procedures:
  • Inquiry of Management: The auditor should inquire of management about any procedures they have in place to identify subsequent events. This includes asking about:
    • How management identifies potential subsequent events.
    • Who is responsible for monitoring subsequent events.
    • The process for evaluating the impact of subsequent events on the financial statements.
  • Review of Documentation: Review any documentation related to management's procedures, such as written policies or checklists.
  • Evaluation of Effectiveness: Assess the effectiveness of management's procedures. Are they comprehensive and consistently applied? Are they likely to identify material subsequent events? If management's procedures are inadequate, the auditor will need to perform more extensive procedures themselves.

2. Reading Minutes of Meetings

• Objective: To identify potential subsequent events discussed in meetings of shareholders, directors, and committees.
• Procedures:
  • Obtain Minutes: Obtain and read the minutes of meetings of shareholders, directors, and relevant committees (e.g., audit committee, finance committee) held after the balance sheet date.
  • Focus on Key Issues: Pay particular attention to discussions about:
    • Significant transactions or events.
    • Litigation or claims.
    • Changes in business strategy.
    • Financial performance and forecasts.
    • Regulatory matters.
  • Follow-Up: If the minutes mention potential subsequent events, follow up with management to obtain more information and evaluate the impact on the financial statements.

3. Reviewing Legal Counsel Inquiries

• Objective: To identify potential litigation, claims, and assessments that could constitute subsequent events.
• Procedures:
  • Obtain Legal Counsel Inquiry Letter: Obtain a legal counsel inquiry letter, which is a letter from the company's legal counsel to the auditor summarizing the status of pending or threatened litigation, claims, and assessments.
  • Review the Letter: Carefully review the letter, paying attention to:
    • The nature of the litigation, claim, or assessment.
    • The period in which the underlying cause for legal action occurred.
    • Management's and legal counsel's evaluation of the likelihood of an unfavorable outcome.
    • An estimate of the potential loss or range of loss.
  • Follow-Up: If the letter identifies any significant litigation, claims, or assessments, follow up with management and legal counsel to obtain more information and evaluate the impact on the financial statements. This may include obtaining an updated legal opinion.

4. Performing Analytical Procedures

• Objective: To identify significant changes or trends that could indicate the occurrence of subsequent events.
• Procedures:
  • Compare Financial Data: Compare the company's financial data for the period after the balance sheet date to comparable data for prior periods and to budgeted or forecasted amounts.
  • Analyze Key Ratios: Analyze key financial ratios and trends to identify any unusual or unexpected fluctuations.
  • Consider External Factors: Consider external factors, such as changes in the industry, economy, or regulatory environment, that could impact the company's financial performance.
  • Investigate Anomalies: Investigate any significant changes, trends, or anomalies identified during the analytical procedures. Inquire of management about the reasons for these fluctuations and obtain supporting documentation.

5. Obtaining a Representation Letter

• Objective: To obtain written representations from management regarding subsequent events.
• Procedures:
  • Include Subsequent Events Representation: The auditor should obtain a representation letter from management that specifically addresses subsequent events.
  • Specific Representations: The representation letter should include representations that:
    • Management has disclosed to the auditor all subsequent events that require adjustment of or disclosure in the financial statements.
    • Management has properly accounted for and disclosed such events.
  • Evaluate Reasonableness: While the representation letter provides evidence, it is not a substitute for performing other audit procedures. The auditor must evaluate the reasonableness of management's representations based on the other audit evidence obtained.

6. Inquiry of Management

• Objective: To obtain information from management about any subsequent events that may have occurred.
• Procedures:
  • Inquire about Specific Areas: The auditor should inquire of management about specific areas that are likely to be affected by subsequent events, such as:
    • Changes in the company's operations or business strategy.
    • New contracts or agreements.
    • Significant changes in sales or order backlog.
    • Losses of major customers or suppliers.
    • Litigation or claims.
    • Changes in debt agreements or financing arrangements.
    • Governmental regulations.
  • Document Responses: Document management's responses to the inquiries.
  • Corroborate Information: Corroborate management's responses with other audit evidence.

7. Examining Underlying Documentation

• Objective: To verify the information provided by management and to obtain additional evidence about subsequent events.
• Procedures:
  • Review Supporting Documents: Examine supporting documents related to potential subsequent events, such as:
    • Contracts and agreements.
    • Invoices and sales records.
    • Bank statements.
    • Correspondence with customers or suppliers.
    • Legal documents.
  • Assess Accuracy and Completeness: Assess the accuracy and completeness of the information contained in the documents.
  • Relate to Financial Statements: Relate the information to the financial statements to determine the appropriate accounting treatment and disclosure.

Evaluating and Reporting on Subsequent Events

After performing the audit procedures, the auditor must evaluate the identified subsequent events to determine their impact on the financial statements. This evaluation involves:

• Determining the Type of Event: Is it an adjusting event (Type 1) or a non-adjusting event (Type 2)?
• Quantifying the Impact: Estimate the financial impact of the event. This may require obtaining additional information from management, legal counsel, or other experts.
• Assessing Materiality: Determine whether the event is material to the financial statements. Materiality is a matter of professional judgment, considering both quantitative and qualitative factors.
• Ensuring Proper Accounting and Disclosure: Verify that the event has been properly accounted for and disclosed in the financial statements in accordance with the applicable financial reporting framework (e.g., GAAP or IFRS).

Based on the evaluation, the auditor will determine the appropriate course of action, which may include:

• Requiring Adjustment of the Financial Statements: If the event is an adjusting event and is material, the auditor will require management to adjust the financial statements.
• Requiring Disclosure in the Notes to the Financial Statements: If the event is a non-adjusting event and is material, the auditor will require management to disclose the event in the notes to the financial statements.
• Modifying the Auditor's Report: If management refuses to adjust the financial statements or disclose a material subsequent event, the auditor may need to modify the auditor's report. This could involve issuing a qualified opinion, an adverse opinion, or a disclaimer of opinion, depending on the severity of the issue.

Subsequent Events After the Date of the Auditor's Report

As mentioned earlier, the auditor does not have a responsibility to actively search for subsequent events after the date of the auditor's report. However, if the auditor becomes aware of a fact after the date of the report that, had it been known at that date, may have caused the auditor to amend the report, the auditor should:

• Discuss the Matter with Management: Discuss the matter with management and determine whether the financial statements need to be revised.
• Take Action if Financial Statements are Revised: If management revises the financial statements, the auditor should perform the necessary audit procedures on the revised financial statements and issue a new auditor's report. The new report should include an emphasis-of-matter paragraph describing the reason for the revision and the date of the original report.
• Take Action if Financial Statements are Not Revised: If management refuses to revise the financial statements when the auditor believes they should be, the auditor should notify management that they will take steps to prevent future reliance on the auditor's report. This may involve notifying the company's board of directors and regulatory authorities.

Documentation

Proper documentation of the audit procedures performed in relation to subsequent events is crucial. The auditor's documentation should include:

• A description of the procedures performed.
• The results of the procedures.
• The auditor's conclusions regarding the impact of subsequent events on the financial statements.
• Any significant matters discussed with management or legal counsel.
• A copy of the management representation letter.

Conclusion

Auditing for subsequent events is a critical aspect of the audit process. By performing the audit procedures outlined in this article, auditors can obtain sufficient appropriate audit evidence regarding events occurring after the balance sheet date that may require adjustment of, or disclosure in, the financial statements. This helps to ensure that the financial statements present a true and fair view of the company's financial position and performance, providing valuable information to investors, creditors, and other stakeholders. A thorough and diligent approach to auditing subsequent events is essential for maintaining the integrity and reliability of financial reporting.