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Fundamentals of Auditing

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Letter of Representation

It is now normal audit practice for the auditor to obtain a letter from the management addressed to the auditor
confirming any representations given by the management to the auditor. This letter is known as the
management letter or the letter of representation.
Representations in this context can be defined as a statement made to convey an opinion.

Reasons why the letter of representation is obtained

Auditors are required to carry out procedures designed to obtain sufficient appropriate audit evidence to
determine with reasonable confidence whether the financial statements are free of material misstatement.
Representations from management are a source of evidence.

Management representations as Audit Evidence

In the course of an audit, numerous questions are asked of the client's management and staff. Replies are
usually verbal. Most of the queries are:
a. Not material to the financial statements. Examples are queries re missing documents or errors in
bookkeeping, or
b. Capable of being corroborated by other evidence. For example, provisions in respect of litigation can
be confirmed by the client's solicitors or the life of plant can be confirmed by examining technical

However, in some cases:

a. Where knowledge of the facts is confined to management, for example, the management's intentions
to close or keep open a material loss-making branch. This would have an affect on the value of the
assets at the branch.
b. Where the matter is principally one of judgment and opinion, for example, the readability of old
stock. Then:
i. The auditor should ensure that there is no conflicting evidence;
ii. The auditor may be unable to obtain corroborating evidence;
iii. The auditor should obtain written confirmation of any representations made;
The auditor must decide for himself whether the total of other evidence and management's written
representations are sufficient for him to form an unqualified opinion.


The following procedures should be adopted:
a. The auditor should summarize in his working papers all matters that are material and also subject to
uncorroborated oral representations by management,
b. In addition these matters should be either.
i. Formally minuted as approved by the Board of Directors at a meeting ideally attended by the
ii. Included in the signed letter of representation.
c. Standard letters should not be used as:
i. Each audit is different;
ii. The letter is important and should receive very careful attention;
iii. The management should participate in its production. There should be much drafting, review
and discussion.
d. The letter should be:
i. Signed at a high level – e.g. chief executive, financial director;
ii. Approved and minuted at a board meeting at which, ideally, the auditor would be present.
e. The preparation of the letter should begin at an early stage, e.g. at the beginning of the final audit in
order to avoid the possibility of the auditor being faced with a refusal to sign by the management. If
there is a refusal by management to cooperate then the, auditor should:
i. do all he can to persuade management to cooperate;

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ii. prepare a statement setting out his understanding of the principal representations made, with
a request that management confirm it;
iii. if management disagree with this statement, discuss and negotiate until a correct
understanding has been reached;
iv. if management refuse altogether to cooperate, either on principle or because the are
themselves uncertain about a particular matter, consider if he has obtained al the
information and explanations he requires and consequently may need to qualify his
report on grounds of limitation of scope.
f. The representation letter or board resolution making representations should be approved as late as
possible in the audit, after the analytical review, but, as it is audit evidence, before the audit report is
prepared. If there is a long delay between the approval of the representation and the audit report, the
auditor may need to do the: audit work/or obtain a supplementary letter of representation. It is
suggested to dating the letter on the day the financial statements are approved.


The contents of the letter of representation should not include routine matters, for example, that all fixed
assets exist and are the property of the company or that stock is valued at the lower of cost and net realizable
The letter should include only matters which:
a. are material to the financial statements, and
b. the auditors cannot obtain independent corroborative evidence.

Example of a Letter of Representation

To ABC & Co.
Chartered Accountants
We confirm that to the best of our knowledge and belief, and, having made appropriate enquiries of other
directors and officials of the company, the following representations given to you in connection with your
audit of the company's financial statements for the year ending 31st December 20x7:
1. We acknowledge as directors our responsibility for the financial statements, which you have prepared for
the company. All the accounting records have been made available to you for the purpose of your audit and all
the transactions undertaken by the company have been properly reflected and recorded in the accounting
records. All other records and related information, including minutes of all management and shareholders'
meetings, have been made available to you.
2. The provision for warranty claims has been estimated at 2% of annual turnover as in previous years. This
amount is in accordance with our opinion of the probable extent of warranty claims. We know of no events
which would materially affect the amount of these claims
3. As stated in Note 12 to the Accounts, there exists a contingent liability in respect of the company's
guarantee of the bank overdraft of NBG Ltd, an associated company now in receivership. In our opinion the
assets of NBG Ltd will realize sufficient to satisfy the bank and no actual liability will arise.
4. It is the intention of the Board of Directors to continue production for at least the next three years so
that valuation of the assets and liabilities of that plant should appropriately be on the going concern basis
Yours Sincerely,
Company Secretary
Signed on behalf of the Board of XYZ Co Ltd
14 March 20x8

Verification of Liabilities

A balance sheet will contain many liabilities grouped under various headings. The headings may include:
Non Current Liabilities
Bank loans
Current Liabilities
Trade creditors
Accrued expenses

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Unearned incomes
Taxation payable
Provision for losses
The auditors’ duty is four-fold:
1. To verify the existence of liabilities shown in the balance sheet
2. To verify the correctness of the money amount of such liabilities
3. To verify the appropriateness of the description given in the accounts and the adequacy of disclosure
4. To verify that all existing liabilities are actually included in the accounts

Verification methods:

It is not possible to detail the procedures for verifying all possible liabilities. However, some general principles
can be discerned, and these should be applied according to the particular set of circumstances met with in
practice or in an examination. These are:


. Request or make a schedule for each liability or class of liabilities. This should show the
make up of the liability with the opening balance, if any, all changes, and the closing balance.


. Verify cut-off. For example a trade creditor should hot be included unless the goods were
acquired before the year end.


. Consider the reasonableness of the liability. Are there circumstances which ought to
excite suspicion?

Internal control

. Determine, evaluate and test internal control procedures. This is particularly important
for trade creditors.

Previous date clearance

. Consider the liabilities at the previous accounting date. Have they all been

Terms and conditions

, this applies principally to loans. The auditor should determine that all terms
and conditions agreed when accepting a loan have been complied with. In recent years many loan
deeds have contained undertakings by the company borrowing the money that it will keep a minimum
proportion of equity (ordinary share capital and reserves) in its total capital (equity and loans). Breach
of this agreement which has occurred frequently in property companies can lead to the appointment
of a receiver.


. The authority for all liabilities should be sought. This will be found in the company
minutes or directors' minutes and for some items the authority of the Memorandum and Articles may
be needed.


. The auditor must see that the description in the accounts of each liability is adequate.


. The auditor must examine all relevant documents. These will include invoices,
correspondence, debenture deeds etc., according to the type of liability.


. Some liabilities are secured in various ways, usually by fixed or floating charges. The auditor
must enquire into these and ensure that they have been registered. The Companies Act requires, for
secured liabilities, that an indication of the general nature of the security be given and also the
aggregate amount of debts included under the item covered by the security.


. The creation of each liability should be vouched, for example the receipt of a loan.
l. Accounting policies. The auditor must satisfy himself that appropriated accounting policies have been
adopted and applied consistently.

Letter of representation

. This has been discussed in detail.

Interest and other ancillary evidence

. The evidence of loans tends to be evidenced by interest
payments and other activities which stem from the existence of the loan.
o. Disclosure. All matters which need to be known to receive a true and fair view from the accounts
must be disclosed. The Companies Acts provisions must be complied with

External verification

. With many liabilities it is possible to verify the liability directly with the
creditor. This action will be taken with short term loan creditors, bank over drafts and, by a similar
technique to that used with debtors, the trade creditors,


. Materiality comes into all accounting and auditing decisions.

Post-Balance sheet events

. These are probably more important in this area than in any other. It is
an independent topic with its details. To understand it the accounting knowledge of “Events
occurring after the Balance Sheet Date - IAS 10” is must.
s. Accounting Standards. Liabilities must be accounted for in accordance with the accounting standards.

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. Assess the risk of misstatement.
Students may well remember these mnemonically. For any given liability all of them will not be required, but
mentally going through them should be an excellent guide to what needs to be done.

Inclusion of all liabilities

(There is no liability remained unrecorded)
It is not enough for the auditor to be satisfied that all the liabilities recorded in the books are correct and are
incorporated in the Final Accounts. He must also be satisfied that no other liabilities exist which are not, for
various reasons, in the books and the accounts. Examples of such unrecorded liabilities are:
a. Claims by employees for injury. Note that these should be covered by insurance under the Employers
Liability (Compulsory Insurance).
b. Claims by ex employees for unfair dismissal.
c. Contributions to superannuation schemes.
d. Unfunded pension liabilities. A company may have a liability to pay past or present employees a
pension in respect of past service and have no funds separated out for this purpose.
e. Liability to 'top-up' pension schemes. When money has been put into separate trusts to pay pensions,
inflation has often meant that the amount is insufficient and the company may have to implement
Clauses in the scheme whereby they have to put in extra money which could run into millions of
f. Bonuses under profit sharing arrangements.
g. Returnable packages and containers.
h. Value added and other tax liabilities. The auditor's special knowledge of tax may lead him to suspect a
liability of which the directors are blissfully ignorant.
i. Claims under warranties and guarantees.
j. Liabilities on debts which have been factored with recourse. To explain: A owes B Rs. 50. B sells
(factors) the debt to C for Rs. 45. Thus B has no debt any more but Rs. 45 in the bank. A fails to pay
C. C can claim Rs. 50 from B (he has recourse).
k. Bills receivable discounted (a special case of j above).
l. Pending law suits.
It is important that the auditor appreciates that such liabilities can exist. He also has a positive obligation to
take reasonable steps to unearth them.

The actions

he would take would include:
a. Enquiry of the directors and other officers.
b. Obtain a letter of representation - see later in the chapter.
c. Examination of post balance sheet events. This will include an inspection of the purchase invoices
and the cash book after date.
d. Examination of minutes where the existence of unrecorded liabilities may be mentioned.
e. A review of the working papers and previous years' working papers
f. An awareness of the possibilities at all times when conducting the audit

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