Scope and objectives
The Scope of Auditing standards and its effective date. SA 501 deals with specific considerations by the auditor in obtaining sufficient appropriate audit evidence with respect to inventory, litigation and claims involving the entity, and segment information in an audit of financial statements.
The SA 501 applies to audits of financial statements for periods beginning on or after April 1, 2010, and its objective is to enable the auditor to obtain sufficient appropriate audit evidence to evaluate the existence and condition of inventory, the completeness of litigation and claims involving the entity, and the presentation and disclosure of segment information in accordance with the applicable financial reporting framework.
In SA 501 provides guidance to auditors on how to effectively and appropriately evaluate inventory, litigation and claims, and segment information in financial statements during an audit to obtain sufficient and appropriate audit evidence.
Inventory
The specific considerations that an auditor needs to take into account while conducting an audit of financial statements with respect to inventory, litigation and claims involving the entity, and segment information. The summary specifically relates to the audit standard SA 501 – Audit Evidence – Specific Considerations for Inventory, Litigation, and Segment Information.
The auditor’s objective for the audit, which is to obtain sufficient appropriate audit evidence regarding the existence and condition of inventory, completeness of litigation and claims involving the entity, and the presentation and disclosure of segment information in accordance with the applicable financial reporting framework.
The specific procedures that an auditor must perform while auditing inventory when it is material to the financial statements. These procedures include attending the physical inventory counting, evaluating management’s instructions and procedures for recording and controlling the results of the physical inventory counting, observing the performance of management’s count procedures, inspecting the inventory, and performing test counts. The text provides additional guidance and considerations for each of these procedures.
Finally, they mention that the auditor must perform audit procedures over the entity’s final inventory records to determine whether they accurately reflect actual inventory count results.
Physical Inventory Counting Conducted Other than At the Date of the Financial Statements
The guidance for auditors on how to perform inventory observations or physical counts during an audit. It explains that physical inventory counting may be conducted at a date other than the date of the financial statements, and if this is the case, the auditor should perform additional procedures to obtain evidence about any changes in inventory between the count date and the date of the financial statements.
The effectiveness of the design, implementation, and maintenance of controls over changes in inventory determines whether conducting physical inventory counting at a date other than the date of the financial statements is appropriate for audit purposes. If attendance at physical inventory counting is impractical, alternative audit procedures should be performed to obtain sufficient appropriate audit evidence about the existence and condition of inventory. However, if it is not possible to obtain sufficient evidence, the auditor must modify the opinion in the auditor’s report according to SA 705(Revised).
The guidance also notes that when a perpetual inventory system is maintained, management may perform physical counts or other tests to ascertain the reliability of inventory quantity information included in the entity’s perpetual inventory records. The guidance also lists relevant matters for consideration when designing audit procedures to obtain audit evidence about whether changes in inventory amounts between the count date and the final inventory records are properly recorded.
Inventory under the Custody and Control of a Third Party
The auditors should approach verifying the existence and condition of inventory that is held by a third party but belongs to the entity being audited. This situation can arise when a company has outsourced the storage or handling of its inventory to a third-party provider such as a warehouse or logistics company.
When inventory held by a third party is material to the financial statements, the auditor must obtain sufficient and appropriate evidence about its existence and condition. This can be achieved in two ways:
Requesting confirmation from the third party: The auditor can ask the third party to confirm the quantities and condition of inventory held on behalf of the entity. This confirmation can be obtained through an external confirmation procedure, which is governed by SA 5058. External confirmation procedures involve obtaining information from third parties to corroborate assertions made by management. In this case, the auditor would be seeking confirmation from the third party about the inventory held.
Performing inspection or other audit procedures: Depending on the circumstances, the auditor may consider it appropriate to perform other audit procedures instead of, or in addition to, confirmation with the third party. For example, if the auditor has reason to doubt the integrity or objectivity of the third party, they may perform other audit procedures to verify the existence and condition of the inventory. Examples of other audit procedures that the auditor could perform include attending the third party’s physical counting of inventory (if practicable), obtaining a report from another auditor or a service auditor on the adequacy of the third party’s internal control, inspecting documentation regarding inventory held by the third party (such as warehouse receipts), or requesting confirmation from other parties when inventory has been pledged as collateral.
When inventory is held by a third party, the auditor must obtain sufficient and appropriate evidence about its existence and condition. This can be achieved through confirmation from the third party or other audit procedures, depending on the circumstances.
Litigation and Claims
The auditor’s responsibilities related to identifying and evaluating litigation and claims involving the entity being audited. Litigation and claims can have a significant impact on the financial statements, and it’s important for the auditor to design and perform audit procedures to identify any such risks.
To identify risks related to litigation and claims, the auditor can use a variety of audit procedures. These may include inquiry of management and others within the entity, reviewing minutes of meetings of those charged with governance, and reviewing legal expense accounts. The auditor may also examine related source documents, such as invoices for legal expenses, depending on the circumstances.
It’s worth noting that litigation and claims involving the entity may have a material impact on the financial statements, and thus may be required to be disclosed or accounted for in the financial statements. The auditor must be aware of this and consider it when designing audit procedures to identify risks related to litigation and claims.
Additionally, the evidence obtained for identifying litigation and claims that may give rise to a risk of material misstatement can also provide evidence regarding other relevant considerations, such as valuation or measurement, regarding litigation and claims. SA 540 provides guidance relevant to the auditor’s consideration of litigation and claims requiring accounting estimates or related disclosures in the financial statements.
The auditor’s responsibilities related to litigation and claims include designing and performing audit procedures to identify risks related to litigation and claims, using various audit procedures to obtain evidence, and considering the potential impact of litigation and claims on the financial statements. The evidence obtained for identifying litigation and claims can also provide evidence regarding other relevant considerations, such as valuation or measurement.
Communication with the Entity’s External Legal Counsel
The requirements for auditors to communicate with a company’s external legal counsel when there is a risk of material misstatement regarding litigation or claims. The auditor needs to perform additional procedures to obtain sufficient appropriate audit evidence to assess the reasonableness of management’s estimates of the financial implications, including costs, of such matters.
The auditor must seek direct communication with the entity’s external legal counsel through a letter of inquiry, which should be prepared by management and sent by the auditor. If direct communication is not possible due to legal or regulatory prohibitions, the auditor must perform alternative audit procedures.
Direct communication with external legal counsel assists the auditor in obtaining information about potentially material litigation and claims and management’s estimates of the financial implications. The auditor may seek direct communication through a letter of general inquiry or a letter of specific inquiry.
A letter of general inquiry requests the external legal counsel to inform the auditor of any litigation and claims that the counsel is aware of, together with an assessment of the outcome of the litigation and claims, and an estimate of the financial implications, including costs involved.
A letter of specific inquiry includes a list of identified litigation and claims, management’s assessment of the outcome of each matter, and its estimate of the financial implications, including costs involved. The auditor requests that the entity’s external legal counsel confirm the reasonableness of management’s assessments and provide additional information if the list is considered incomplete or incorrect.
In certain circumstances, the auditor may judge it necessary to meet with the external legal counsel to discuss the likely outcome of the litigation or claims. This may be necessary where the matter is a significant risk, complex, or there is a disagreement between management and external legal counsel. These meetings usually require management’s permission and are held with a representative of management in attendance.
If the auditor is unable to obtain sufficient appropriate audit evidence by performing alternative procedures, or if management or external legal counsel refuses to cooperate, the auditor must modify the opinion in the auditor’s report in accordance with relevant auditing standards.
Written Representations
In the process of conducting an audit, the auditor is responsible for obtaining sufficient appropriate audit evidence to support their opinion on the financial statements. One of the sources of such evidence is written representations from management and those charged with governance, which are written statements provided to the auditor by the management and governance bodies of the audited entity. These statements provide a form of assurance to the auditor that they have disclosed all known information that could impact the financial statements.
In the context of litigation and claims, the auditor must specifically request written representations from management and those charged with governance to confirm that all known actual or potential litigation and claims that could affect the financial statements have been disclosed to the auditor and appropriately accounted for and disclosed in accordance with the applicable financial reporting framework. Obtaining these written representations helps the auditor to ensure that all material risks associated with litigation and claims have been identified and adequately addressed in the financial statements.
Segment Information
In accordance with the applicable financial reporting framework, entities may be required or permitted to disclose segment information in their financial statements. The auditor is responsible for obtaining sufficient appropriate audit evidence regarding the presentation and disclosure of segment information in the financial statements as a whole, but not for expressing an opinion on the segment information presented on a standalone basis.
The auditor must obtain an understanding of the methods used by management to determine segment information, and evaluate whether these methods are likely to result in disclosure in accordance with the applicable financial reporting framework. Examples of matters that may be relevant in understanding the methods used by management include sales, transfers, and charges between segments, comparisons with budgets and expected results, allocation of assets and costs among segments, consistency with prior periods, and adequacy of disclosures with respect to inconsistencies.
The auditor must also perform analytical procedures or other audit procedures appropriate to the circumstances. The goal of these procedures is to provide the auditor with sufficient appropriate audit evidence to support their opinion on the presentation and disclosure of segment information in the financial statements.
Quiz: Audit Evidence—Specific Considerations for Selected Items (SA 501)
1. When does SA 501 – Audit Evidence—Specific Considerations for Inventory, Litigation, and Segment Information apply?
a) Audits of financial statements for periods beginning on or after April 1, 2010
b) Audits of financial statements for periods beginning on or after April 1, 2015
c) Audits of financial statements for periods beginning on or after April 1, 2023
d) Audits of financial statements for any period
Answer: a)
2. What is the objective of SA 501?
a) To evaluate the existence and condition of inventory only
b) To evaluate the completeness of litigation and claims involving the entity only
c) To evaluate the presentation and disclosure of segment information only
d) To obtain sufficient appropriate audit evidence for evaluating inventory, litigation and claims involving the entity, and segment information
Answer: d)
3. What are the specific procedures that an auditor must perform while auditing inventory when it is material to the financial statements?
a) Reviewing management’s instructions and procedures for recording and controlling the results of physical inventory counting
b) Observing the performance of management’s count procedures
c) Inspecting the inventory and performing test counts
d) All of the above
Answer: d)
4. What should the auditor do if physical inventory counting is conducted at a date other than the date of the financial statements?
a) Perform additional procedures to obtain evidence about any changes in inventory between the count date and the date of the financial statements
b) Modify the opinion in the auditor’s report
c) Ignore the physical inventory counting as it is not reliable
d) Skip the physical inventory counting altogether
Answer: a)
5. How can the auditor verify the existence and condition of inventory that is held by a third party?
a) Request confirmation from the third party
b) Perform inspection or other audit procedures
c) Both a) and b)
d) None of the above
Answer: c) Both a) and b)
6. When should the auditor seek direct communication with the entity’s external legal counsel?
a) Only when there is a risk of material misstatement regarding litigation or claims
b) Only when the external legal counsel is known to the auditor
c) Only when litigation or claims are significant to the financial statements
d) Always, regardless of the circumstances
Answer: a)
7. What is the purpose of obtaining written representations from management and those charged with governance?
a) To provide assurance to the auditor that all known information impacting the financial statements has been disclosed
b) To serve as evidence for litigation and claims
c) To determine the inventory valuation method used by management
d) To evaluate the presentation and disclosure of segment information
Answer: a)
8. What is the auditor’s responsibility regarding segment information in the financial statements?
a) To express an opinion on the segment information presented on a standalone basis
b) To obtain an understanding of the methods used by management to determine segment information
c) To evaluate the adequacy of disclosures with respect to inconsistencies
d) All of the above
Answer: b)
9. What are some examples of matters that may be relevant in understanding the methods used by management for segment information?
a) Sales, transfers, and charges between segments
b) Comparisons with budgets and expected results
c) Allocation of assets and costs among segments
d) All of the above
Answer: d)
10. What is the goal of performing analytical procedures or other audit procedures for segment information?
a) To express an opinion on the segment information presented on a standalone basis
b) To identify material risks related to litigation and claims
c) To evaluate the presentation and disclosure of segment information in the financial statements
d) To determine the existence and condition of inventory
Answer: c)
Additional questions:
11. Which specific items are covered under SA 501?
a) Inventory, litigation, and claims
b) Segment information, financial reporting framework, and inventory
c) Litigation, segment information, and financial statements
d) Claims, financial reporting framework, and inventory
Answer: a)
12. SA 501 applies to audits of financial statements for periods beginning on or after which date?
a) April 1, 2010
b) April 1, 2015
c) April 1, 2020
d) April 1, 2023
Answer: a)
13. What is the objective of SA 501?
a) To evaluate the completeness of inventory records
b) To assess the impact of litigation on financial statements
c) To obtain sufficient appropriate audit evidence for inventory, litigation, and segment information
d) To determine the accuracy of segment information disclosures
Answer: c)
14. What specific procedures should an auditor perform when auditing inventory?
a) Attending the physical inventory counting, evaluating management’s instructions, observing performance of count procedures
b) Reviewing legal expense accounts, obtaining written representations, and confirming inventory existence
c) Inspecting the inventory, attending management meetings, and reviewing segment information disclosures
d) Analysing sales trends, conducting external confirmations, and assessing internal control over inventory
Answer: a)
15. When is it necessary to perform additional procedures to obtain evidence about changes in inventory between the count date and the date of the financial statements?
a) When physical inventory counting is not conducted
b) When inventory is significant to the financial statements
c) When there are inconsistencies in inventory records
d) When litigation and claims are involved
Answer: b)
16. How can the auditor verify the existence and condition of inventory held by a third party?
a) Requesting confirmation from the third party or performing inspection or other audit procedures
b) Reviewing management’s inventory records and conducting external confirmations
c) Analysing legal expense accounts and attending physical inventory counting
d) Inspecting documentation related to litigation and claims
Answer: a)
17. What responsibilities do auditors have regarding the evaluation of litigation and claims involving the audited entity?
a) Assessing the adequacy of segment information disclosures
b) Identifying risks related to litigation and claims and designing appropriate audit procedures
c) Determining the inventory valuation method used by management
d) Requesting written representations from management and governance bodies
Answer: b)
18. How can the auditor communicate with the entity’s external legal counsel regarding litigation and claims?
a) Through direct communication in the form of a letter of inquiry
b) By attending management meetings and reviewing legal expense accounts
c) By obtaining external confirmations from legal counsel
d) Through anonymous reporting channels and whistle-blower complaints
Answer: a)
19. What is the purpose of obtaining written representations from management and those charged with governance?
a) To confirm the existence and condition of inventory held by third parties
b) To assess the integrity and objectivity of management and governance bodies
c) To ensure that all known litigation and claims have been disclosed and appropriately accounted for
d) To evaluate the adequacy of segment information disclosures
Answer: c)
20. What is the auditor’s responsibility regarding the presentation and disclosure of segment information in the financial statements?
a) To express an opinion on the segment information presented on a standalone basis
b) To obtain an understanding of the methods used by management and evaluate the adequacy of disclosures
c) To perform analytical procedures to identify material risks related to litigation and claims
d) To request external confirmations from third-party segment information providers
Answer: b)
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