-
801.1 The primary audit objectives
for commitments and contingencies are discovering their existence,
assessing their financial statement effect, and evaluating the adequacy
of their disclosure. 1 Examples of commitments and contingencies of concern to a CIRA auditor are as follows:
- • Pending or threatened litigation or unasserted claims, including developer lawsuits.• Communications from regulatory agencies regarding violations or possible violations of laws or regulations.• Commitment related to expansion or rehabilitation of facilities.• Possible losses on long-term contracts.• Long-term leases with required fixed payments for several years.•
- Financial transactions or arrangements with financial institutions,
- for example, oral or written guarantees, endorsements, open letters of
- credit, etc.• Other oral or written guarantees.• IRS examinations in progress related to tax elections or taxes on nonmembership/non-exempt functions.•
- Environmental remediation liabilities, including designation as a
- potentially responsible party by the Environmental Protection Agency.• Fraud involving CIRA management or personnel that could affect the financial statements.
-
Audit Procedures801.2
The auditor may be aware of possible commitments or contingencies from
knowledge of the CIRA's activities gained during audit planning and
from reading minutes, contracts, agreements, or other documents. Some
commitments or contingencies may be discovered as a result of audit
procedures applied to specific account balances or transaction classes.
For example,
- lease commitments may be discovered
- during the audit of rent and other lease payments, and compensating
- balance or debt guarantee arrangements may be disclosed on confirmation
- responses received from lenders.
-
801.3 The auditor may decide to
send confirmation letters to financial institutions to confirm or
discover details of financing arrangements, such as
- guarantees or other contingent liabilities. HOA-CL-10.7
- illustrates a “Confirmation of Contingent Liabilities with Financial
- Institutions.” The auditor should specifically question management about
- the possibility of unrecorded contingencies or commitments, such as
- those listed in paragraph 801.1. The management and legal representation letters also provide evidence about commitments and contingencies.
-
Legal Representation Letter801.4 SAS No. 12 (AU 337), Inquiry of a Client's Lawyer Concerning Litigation, Claims, and Assessments, requires the auditor to send a letter of inquiry to the client's legal counsel and evaluate the response.
- The auditor identifies lawyers who were consulted about litigation,
- claims, and assessments and should be inquired of. These lawyers are
- identified by reviewing client legal files, analyzing legal and
- professional fees and invoices, and inquiring of management. (These
- procedures are also performed to identify commitments and
- contingencies.)
-
801.5 Some CIRAs may use more than
one lawyer, and since many lawyers charge for responding to the
inquiries, management often does not want to send requests to lawyers
unless they are helpful to the audit
- Communicating with some lawyers
- may not be necessary. For example, communication is not required with
- lawyers involved only with collections, lawyers representing the CIRA at
- exchanges of ownership interests, lawyers involved with litigation by
- the CIRA, unless counterclaims are involved, or lawyers contacted last
- year who performed no services this year (however, see paragraph 801.7).
- (However, auditors should consider whether, because of the general lack
- of sophistication of many CIRA officers, the CIRA's attorney may be the
- only reliable source of information for discovering litigation in which
- the CIRA is involved.)
-
801.6 If a lawyer on the board of
directors serves as the CIRA's counsel, either a letter should be
obtained from that individual or the individual should sign the
management representation letter
- Signing the representation letter
- normally is appropriate only when there are no pending or threatened
- litigation, claims, or assessments and no unasserted claims that are
- probable of assertion and have a reasonable possibility of an
- unfavorable outcome. In that situation, the authors believe the letter
- should include those specific assertions.
-
801.7 If a lawyer was not
consulted during the period, the auditor may not send a legal letter,
but, according to an auditing interpretation at AU 9337.15-.17,
the authors recommend that the written representation obtained from
management state that management is not aware of any pending
- or threatened litigation, claims, or assessments or unasserted claims or
- assessments and that a lawyer has not been consulted about such
- matters. The “Management Representation Letter” at HOA-CL-3.1 illustrates the wording of such a representation in the practical considerations
-
801.8 Content of the Letter The legal letter asks the lawyer to provide or corroborate information about pending or threatened litigation
- including, for each individual
- case, its nature and progress to date, how the CIRA is responding or
- intends to respond, the likelihood of an unfavorable outcome, and an
- estimate, if one can be made, of the amount or range of potential loss.
- With respect to unasserted claims, the lawyer is asked to comment on any
- possible unasserted claims specifically identified by management and to
- confirm that he or she will notify management of any unasserted claims
- that come to his or her attention that, in his or her judgment, must be
- disclosed in accordance with the requirements of FASB ASC 450 (formerly SFAS No. 5, Accounting for Contingencies).
-
801.11 Evaluating Lawyers' Responses
In reviewing the lawyer's response, the auditor should make sure it
reflects the materiality limit specified, is as of the specified
response date, and contains all items of information requested (if a
short form request was sent). If the date of the response significantly
differs from the date requested, the auditor should obtain an updated
letter
- Also, the auditor should carefully
- evaluate how the lawyer words the assessment of the probability of an
- unfavorable outcome. The auditor should decide whether the response is
- clear regarding a probable or remote outcome. Wording such as “the CIRA
- believes there is absolutely no merit to the litigation,” “the CIRA has a
- substantial chance of prevailing,” or “the CIRA will be able to assert
- meritorious defenses,” are not clear as to likelihood of outcome. In
- addition, lawyers' responses that are unclear or amount to talking
- around the point without taking a solid position should be carefully
- evaluated by the auditor. For example, terms like substantial chance and reasonable opportunity indicate more uncertainty than an opinion that the CIRA will prevail. The term meritorious defenses means only that the defenses will not be summarily dismissed by the court.
-
801.24 Mold
Mold intrusion has become a common environmental concern for CIRAs as a
significant increase in mold remediation expenses has been incurred by
associations in the last few years. Unfortunately for CIRAs, insurance
policies have been rewritten to exclude mold damage
- Attorneys are cautioning CIRA
- boards of directors to be proactive in responding to mold claims. Once
- mold is discovered, repair, remediation, and possibly relocation of the
- unit owners occur as part of the remediation process.
-
801.25 Determining the responsible
party and the extent and/or type of repairs and remediation, as well as
unit owner relocation policies, varies by association and the specific
circumstances encountered. The auditor should inquire of management as
to the association's policy with regards to these matters and the
expected financial impact
- Often, however, the financial
- impact is unknown until the extent of the damage is uncovered and the
- extent of necessary remediation can not be determined until the mold is
- exposed. For mold remediation projects in process, the association
- should consider disclosing a contingency with an undetermined financial
- impact in the notes to the financial statements. An illustrative
- disclosure example follows:
- Mold has been found and remediated in one or more units of the
- Association during the year. Neither the extent of the mold intrusion,
- nor the total financial impact to the Association, can be determined at
- this time.
-
Risks and Uncertainties801.26 FASB ASC 275 (formerly SOP 94-6, Disclosure of Certain Significant Risks and Uncertainties),
requires disclosures about risks and uncertainties that could
significantly affect the amounts or situations reported in the financial
statements. The disclosures are grouped into the following four areas:
• Nature of operations.• Use of estimates in the preparation of financial statements.• Certain significant estimates.• Current vulnerability resulting from certain concentrations.
-
801.27 The first two disclosures
generally are required for all financial statements. The second two are
required only for estimates and concentrations that meet specified
criteria. 2 FASB ASC 275 does not apply to condensed or summarized interim financial statements.
- The first two areas do not require significant additional audit work
- because the disclosures are required in all financial statements and the
- information needed for the disclosures is readily available. However,
- for the other two areas, specific procedures may be necessary to
- determine that all required disclosures have been identified.
-
801.28 Nature of Operations FASB ASC 972-235-50-1
requires CIRA financial statements to disclose the entity for which the
CIRA provides services, the areas it controls, and the number of units
in the CIRA
In most cases, those disclosures will satisfy the requirements of FASB ASC 275 (formerly SOP 94-6) to disclose the nature of operations. If a CIRA has significant revenue from nonmembers, however, FASB ASC 275 (formerly SOP 94-6) also requires disclosure of the relative importance of that segment of the CIRA's operations.
-
801.29 Use of Estimates FASB ASC 275 (formerly SOP 94-6) requires financial statements to disclose that the preparation of financial statements requires the use
of management estimates. That boilerplate disclosure generally is included in the summary of significant accounting policies.
-
801.30 Certain Significant Estimates
Initially, an auditor's objective is to determine whether all
significant estimates have been identified. One way of determining the
existence of a significant estimate that requires disclosure is to
answer the following questions:
- • Was an estimate used in preparing the financial statements?•
- Is there more than a remote possibility that the estimate will change
- by a material amount within one year from the date of the financial
- statements due to a condition that existed at the date of the financial
- statements?
-
801.31 SAS No. 57 (AU 342), Auditing Accounting Estimates,
also provides guidance that is useful. The SAS requires auditors to
determine whether all estimates that could be material to the financial
statements have been identified. It recommends that auditors consider
performing the following procedures to identify circumstances that
require accounting estimates:
- • Consider assertions embodied in the financial statements to determine the need for estimates. An appendix to the SAS (AU 342.16)
- gives numerous examples of accounting estimates included in financial
- statements. These and others are included in the “Significant Estimates
- Identification Checklist” at HOA-CX-16.2, which serves as a memory jogger to assist in determining whether all estimates have been identified.• Evaluate information obtained by reading minutes or performing other procedures about the following:td dl { margin-top: 0px; margin-bottom: 0px; }•• The client's industry and regulatory environment.•• Changes made or planned in the CIRA's activities or operating strategy.•• Changes in methods of accumulating data.•• Litigation, claims, and assessments or other contingencies.• Inquire of management about whether there are circumstances that indicate the need to make an accounting estimate.
-
801.32 The practice aids in this Guide allow auditors to meet that requirement. The “General Auditing and Completion Procedures” audit program (HOA-AP-2 or HOA-AP-2-S) includes a program step to document that the auditor considered whether all
material estimates were identified. The representation letter drafting form at HOA-CL-3.1 includes language for representations the auditor may obtain related to significant estimates and material concentrations.
-
801.33 The next step is
determining whether it is at least reasonably possible that an estimate
will change by a material amount in the near term (that is, within a
year from the audit of the financial statements). The term
- reasonably possible
- encompasses the entire range from “more than remote” to “less than
- likely.” It could be concluded that it is at least reasonably possible
- that almost any estimate could change. To conclude otherwise, auditors
- must conclude that there is only a remote chance of an estimate changing.
-
801.34 Materiality for
disclosure under the SOP does not depend on the amount reported in the
financial statements, but rather on the materiality of the effect that
using a different estimate would have on the financial statements.
Disclosure may be required even if an estimate resulted in the
recognitions of a small financial statement amount or no amount.
- When evaluating the potential
- materiality of a change in an estimate, auditors should use the same
- materiality thresholds used to evaluate uncorrected misstatements at the
- conclusion of the audit. Using planning materiality, which is
- calculated in the planning stage of the audit to establish the extent of
- audit tests, is not necessarily appropriate
-
801.35 The authors believe it will
be good practice to document conclusions about estimates that could
change, particularly if the decisions are difficult or contentious. Such
documentation can be informal and can be done, for example,
- on the relevant workpaper or in a
- separate memo. If more formal documentation is desired, the “Significant
- Estimates Identification Checklist” at HOA-CX-16.2
- can be used. Note that even if it is determined that the chances of an
- estimate changing are more than remote, the remaining criteria—“material
- amount,” “near term,” and “existing conditions”—may still eliminate the
- need for disclosure.
-
801.36 Current Vulnerability Resulting from Certain Concentrations FASB ASC 275 (formerly SOP 94-6)
requires disclosure of current vulnerability from concentrations that
exist at the balance sheet date (a) in the volume of business with a
particular customer, supplier, or lender, (b) in revenue from particular
products or services, (c) in the available sources of supply of
materials, labor, or services, or of licenses or other rights used in
the entity's operations, and (d) in the market or geographic area in
which an entity conducts its operations if the concentrations meet the
following criteria:
- • The concentration makes the entity vulnerable to the risk of a near-term severe impact.•
- It is at least reasonably possible that the events that could cause
- the severe impact will occur in the near term; that is, within one year
- from the date of the financial statements.
-
Vulnerability from concentrations occurs when an entity is exposed to a
greater risk of loss than would have existed if the entity had mitigated
its risk through diversification. A concentration
- of concern when it involves something that cannot be easily replaced,
- for example, if a cooperative purchases most of its heating fuel from a
- single supplier that cannot easily be replaced. Concentrations may
- involve another entity or individual, or they may involve a group of
- counterparties or items that have similar economic characteristics, such
- as a group of homeowners that collectively expose the CIRA to a
- particular kind of risk
-
801.37 The audit approach for
concentrations is similar in many respects to the audit approach for
significant estimates. That is, initially, the auditor's objective is to
determine whether all concentrations have been identified.
- If the auditor identifies
- concentrations, evaluation of disclosure can be documented on the
- relevant workpaper or by memo. One significant difference between
- auditing disclosures of concentrations and auditing disclosures of
- significant estimates is that the threshold for disclosure is different.
- For concentrations, the threshold is severe impact, whereas for
- significant estimates, the threshold is material. (Severe impact refers
- to a significant financially disruptive effect on the normal functioning
- of the association. It is more than material, but less than
- catastrophic.) Auditors may find that fewer concentrations require
- disclosure. That, however, is a matter of professional judgment based on
- the individual circumstances of each client.
-
801.38 The practice aids in this Guide
allow auditors to document procedures related to concentrations. The
“General Auditing and Completion Procedures” audit program (HOA-AP-2 or HOA-AP-2-S) includes a program step to document that the auditors considered whether all concentrations were identified
The example representation letters at HOA-CL-3.1 and HOA-CL-3.3 include language for obtaining management representations related to concentrations.
-
801.39 Wording the Disclosure Applying the requirements of FASB ASC 275 (formerly SOP 94-6) requires significant judgment on the part of both the auditor and the client. However, the FASB ASC 275
contains only disclosure requirements. It does not require amounts to
be recorded in the financial statements. For that reason, an approach of
“when in doubt, disclose” is recommended
- In a sense, by making the disclosure, both the client and the auditor
- transfer some of the risk due to uncertainties in the financial
- statements to the users of the financial statements themselves. By not
- making the disclosures, however, the client and the auditor forego an
- opportunity to reduce the risk that a user may successfully assert in
- litigation that the disclosures should have been made.
-
801.40 CIRAs may have concerns that the disclosures required by FASB ASC 275 (formerly SOP 94-6)
will include information considered by management to be confidential.
That is particularly true for disclosure of certain concentrations.
Other concerns may include that the disclosures are too negative. Some
client resistance may be overcome by carefully wording the proposed
disclosures. For example, when disclosing a concentration
- phrases such as “a significant portion” or “a substantial percentage”
- are appropriate. The guidance does not require disclosure of names or
- percentages.
-
801.41 Reporting Issues FASB ASC 275 (formerly SOP 94-6) only leads to modifying the auditors' report if either—
- • The disclosures are not adequate, in which case the report should be modified for a departure from GAAP, or•
- The auditors are unable to obtain sufficient evidential matter to
- support management's assertion about the nature, presentation, and
- disclosure of an uncertainty, in which case the report should be
- modified for a scope limitation.Report modification just because there is an uncertainty is not required
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