AU-C section 501, Audit Evidence: Specific Considerations for Selected Items, adds requirements to AU-C 500 for three areas that need particular evidence in a GAAS audit of a nonissuer: inventory, litigation and claims, and segment information. It came out of SAS No. 122.
This page paraphrases the standard. The authoritative text is AU-C 501 in AICPA Professional Standards. For general evidence concepts, see AU-C 500.
What is the objective of AU-C 501?
The auditor's objective is to obtain sufficient appropriate audit evidence about 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.
Inventory
When must the auditor attend the count?
If inventory is material to the financial statements, the auditor obtains sufficient appropriate evidence about its existence and condition by attending the physical inventory counting, unless it is impracticable. Attendance allows the auditor to:
- evaluate management's instructions and procedures for recording and controlling the results of the count
- observe the performance of management's count procedures
- inspect the inventory
- perform test counts
- perform audit procedures over the entity's final inventory records, to find out whether they accurately reflect actual inventory count results
See the inventory observation guide.
Counts not on the balance sheet date
If the count takes place at a date other than the date of the financial statements, the auditor performs procedures in addition to the above to obtain evidence about whether changes in inventory between the count date and the financial statement date are properly recorded. Common procedures include roll-forward or roll-back testing of receipts and shipments, and testing of the cutoff around the count date and year end. See cutoff testing.
Unable to attend the count
If attendance is impracticable because of unforeseen circumstances (illness, weather, an unexpected event), the auditor makes or observes some physical counts on an alternative date and performs audit procedures on intervening transactions. If attendance is impracticable for other reasons, such as a risk to the auditor's safety or the location, the auditor performs alternative procedures, such as inspecting documentation of the subsequent sale of specific items acquired or purchased before the count.
Inconvenience and cost do not make attendance impracticable. If the auditor cannot obtain sufficient appropriate evidence by alternative procedures, the auditor modifies the opinion because of a scope limitation, as AU-C 705 explains.
In a first-year audit accepted after the year-end count, one alternative is to observe a count on a later date, test the roll-back to year end, and consider the effect on opening balances under AU-C 510.
Inventory in third-party custody
If inventory is under the custody and control of a third party, and is material, the auditor obtains sufficient appropriate evidence about the existence and condition of that inventory by requesting confirmation from the third party of the quantities and condition, or by performing inspection or other audit procedures appropriate in the circumstances. Examples include public warehouses and goods on consignment. Depending on the risk, the auditor may also consider the reliability of the third party, for example by getting a report on the third party's controls.
Practical points for the count
- Obtain the count instructions before the count, and read them.
- Observe the count in progress, not only the final tags.
- Select test counts from the floor to the sheets, and from the sheets to the floor, to address existence and completeness.
- Note the last receiving and shipping documents and any items moved during the count.
- Look at condition: damaged, obsolete or slow-moving items and any quality problems.
- Keep copies or record the count sheet numbers so the final records can be agreed back.
These are practice points. They are not requirements of the standard. For reserve estimates, see the inventory reserve calculator.
Litigation and claims
Procedures to identify litigation and claims
The auditor designs and performs audit procedures to identify litigation and claims involving the entity that may give rise to a risk of material misstatement, including:
- inquiry of management and, where applicable, others within the entity, including in-house legal counsel
- review of minutes of meetings of those charged with governance and correspondence between the entity and its external legal counsel
- review of legal expense accounts
Communicating with external legal counsel
If the auditor assesses a risk of material misstatement regarding litigation or claims that have been identified, or when audit procedures indicate that other material litigation or claims may exist, the auditor, in addition to the procedures above, seeks direct communication with the entity's external legal counsel. This is done through a letter of inquiry, prepared by management and sent by the auditor, that asks the counsel to communicate directly with the auditor. In certain circumstances, the auditor may also judge it necessary to meet with the counsel to discuss the likely outcome of the matter and estimates of its financial effect. The meeting adds to the letter of inquiry. It does not replace it.
Points to remember:
- The auditor sends the letter, or controls its sending. The client does not.
- Counsel's replies often follow the American Bar Association's statement of policy on lawyers' responses to auditors' requests, and typically limit what they will say. The auditor reads the reply for what it covers and what it does not.
- A letter is not automatic. It depends on the assessed risk and the results of the first procedures.
- Evaluate the response alongside the accounting guidance for contingencies. See ASC 450 loss contingencies.
Refusals and scope limitations
If management refuses to give the auditor permission to communicate or meet with the entity's external legal counsel, or the counsel refuses to respond appropriately or is prohibited from responding, and the auditor cannot obtain sufficient appropriate evidence by performing alternative procedures, the auditor modifies the opinion because of a scope limitation under AU-C 705.
Representations and subsequent events
The auditor asks management and, where appropriate, those charged with governance for written representations that all known actual or possible litigation and claims have been disclosed and accounted for in line with the framework. See AU-C 580. The auditor also considers events after the balance sheet date that bear on litigation under AU-C 560.
Segment information
If the framework requires segment disclosure, the auditor obtains sufficient appropriate evidence about the presentation and disclosure of segment information. The auditor:
- obtains an understanding of the methods used by management in determining segment information
- evaluates whether those methods are likely to result in disclosure in accordance with the framework
- where appropriate, tests the application of those methods
- performs analytical procedures or other procedures appropriate in the circumstances
Segment disclosure under US GAAP applies to public entities, so this part of AU-C 501 often does not apply to a private company. Where the framework does require it, the auditor looks at how the chief operating decision maker reviews results, whether the segments in the disclosure match that view, and whether the numbers reconcile to the consolidated statements.
Management's specialists
The requirements on using the work of a management's specialist are in AU-C 501, as amended by SAS No. 144, and no longer in AU-C 500. They apply to valuation specialists, actuaries and similar experts the client engages. Specialists engaged by the auditor are covered by AU-C 620.
Documentation
The auditor documents the count attendance and procedures (instructions evaluated, test counts, the link to the final records, and the cutoff information), the inquiries and letters on litigation, and the segment procedures. See AU-C 230.
File checks on specific audit evidence
These are practice checks, not requirements of the standard. Weaknesses to look for:
- Material inventory with no count attendance and no alternative procedures
- Test counts recorded without agreeing them to the final listing
- No cutoff work around the count date
- Legal letters sent by the client, or not sent when the risk assessment pointed to a need
- Counsel replies filed without anyone evaluating what they omit
- Litigation inquiries of management documented with the same wording every year
Related
- Inventory observation guide
- ASC 450 loss contingencies
- AU-C 500 audit evidence
- AU-C 330 responding to assessed risks
Sources
- AICPA, AU-C Section 501, Audit Evidence: Specific Considerations for Selected Items (AICPA Professional Standards), as amended by SAS No. 144
- AICPA, SAS No. 142, Audit Evidence, and SAS No. 144, The Auditor's Use of Specialists and Pricing Information From External Information Sources
- AICPA, AU-C Sections 230, 330, 500, 510, 560, 580, 620 and 705 (cross-referenced sections)
- FASB, ASC 280, Segment Reporting (scope); ASC 450, Contingencies
- American Bar Association, Statement of Policy Regarding Lawyers' Responses to Auditors' Requests for Information
Part of CORAA University · Evidence and audit procedures: related guides, calculators and templates.
AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error