From The AICPA Audit Committee Toolkit. Copyright © 2005 by the American Institute of Certified Public Accountants, Inc., New York, New York.

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Communications with the audit committees have engendered more public scrutiny in light of what is considered to be best practices for governance. Independent auditors, in the wake of well-documented audit failures, are required to increase their documentation and communication efforts as they relate to their interactions with the audit committee. The following sections list matters that must be communicated. This list is not meant to indicate that this is all that the auditor is communicating to the audit committee.

Auditor’s Responsibility Under Generally Accepted Auditing Standards

It is important for audit committees to understand what an audit is and what it is not. Usually, audit committees are most concerned about the system of internal control and that the organization's financial statements are free of material misstatement. The auditor should make sure the audit committee understands the level of responsibility that the auditor assumes for the system of internal control and the financial statements under generally accepted auditing standards (GAAS). It is also important that the auditor make sure that the audit committee understands that an audit is designed to obtain reasonable rather than absolute assurance about the financial statements.

Significant Accounting Policies

The auditor should determine that the audit committee is informed about all significant accounting policies and how they are applied in the organization. To make sure, the audit committee should expect that the auditors will communicate the following:

1. All significant accounting policies, including those that applied for the first time during the year.
    
2. How those accounting policies are applied in the organization.
    
3. Methods the organization used to account for significant unusual transactions.
    
4. The effect of significant accounting policies in controversial or emerging areas for which there is lack of authoritative guidance or consensus (for example, revenue recognition, off-balance-sheet financing).

Management Judgments and Accounting Estimates

Accounting estimates are an integral part of the financial statements prepared by management. These estimates are based on management’s judgments (which are normally based on management’s knowledge and experience about past and current events), and assumptions about future events.

The auditor should address the following issues with the audit committee:

1. The process used by management in formulating particularly sensitive accounting estimates.
    
2. The basis for the auditor’s conclusion about the reasonableness of those estimates.

Audit Adjustments

The auditor should inform the audit committee about all audit adjustments arising from the audit that could, in the auditor's judgment, have a significant effect on the organization's financial reporting process. The audit team will keep track of those proposed adjustments for later discussion with management. Management will evaluate those proposed adjustments and decide whether the adjustment should be booked to the account balances as proposed. The auditor may find it necessary to qualify the audit report if management does not record the adjustments that the auditor deems necessary to record.

As part of its communications, the auditor should:

1. Inform the audit committee about adjustments arising from the audit that could either individually or in the aggregate have a significant effect on the organization’s financial reporting process.
    
2. Address whether the adjustments were recorded.
    
3. Determine whether the adjustments may not have been detected except through the auditing procedures performed (meaning that the organization’s own internal control system did not detect the need for the adjustment).
    
4. Explain about uncorrected misstatements aggregated by the auditor during the current engagement and pertaining to the most recent period presented in the financial statements that were determined by management to be immaterial, both individually and in the aggregate, to the financial statements taken as a whole.

Auditor’s Judgments About the Quality of the Organization’s Accounting Principles
Note: This communication is required for audits of public companies. It is not required for organizations that are not public companies, but could be considered a good practice.

Although objective criteria for evaluating the quality of an organization's accounting practices have not been established, the auditor's judgments about the quality, not just the acceptability of the organization's accounting principles as applied in its financial statements, including disclosures, should be discussed. The discussion should be open and frank, and tailored to the organization's specific circumstances. It should include the following topics:

1. Consistency of the organization’s accounting principles and their application
    
2. Clarity of the financial statements and related disclosures
    
3. Completeness of the financial statements and related disclosures
    
4. Any items that have a significant impact on the representational faithfulness, verifiability, and neutrality of the accounting information included in the financial statements, examples of which follow:
    
   1. Selection of new accounting policies or changes to current ones
       
   2. Estimates, judgments, and uncertainties
       
   3. Unusual transactions
       
   4. Accounting policies relating to significant financial statement items, including the timing of transactions and the period in which they are recorded
   
   
5. A discussion of accounting practices that are not specifically addressed in the accounting literature, for example, those that may be unique to the not-for-profit industry.

Other Information Contained in Audited Financial Statements

Although the notes to the financial statements are an integral part of the financial statements and therefore are included in the scope of the auditing procedures, other information prepared by management that may accompany financial statements is not necessarily included in the scope of the auditing procedures.

The auditor should discuss the responsibility, if any, that he or she has for other information in documents containing audited financial statements, any procedures performed, and the results.

Disagreements With Management

Disagreements may arise between the auditor and management over the application of accounting principles to specific transactions and events, as well as the basis for management's judgments about accounting estimates, or even the scope of the audit or disclosures to be made in the financial statements or footnotes. Differences of opinion based on incomplete facts or preliminary information that are later resolved are not considered disagreements for this purpose.

When meeting with the audit committee, the auditors should discuss any disagreements with management, whether or not resolved, about matters that individually or in the aggregate could be significant to the organization's financial statements or the auditor's report.

Consultation With Other Accountants

Sometimes, management of the organization may consult with other accountants about accounting and auditing matters. If the auditor is aware that such consultation has occurred, the auditor should discuss with the audit committee their views about the significant matters that were the subject of the consultation. The audit committee may wish to ask management whether they have consulted with other accountants about accounting and auditing matters.

Major Issues Discussed With Management Prior to Retention

The auditor should discuss with the audit committee any major issues that were discussed with management in connection with the initial or recurring retention of the auditor. This includes any discussions regarding the application of accounting principles or auditing standards.

Difficulties Encountered in Performing the Audit

The auditor should inform the audit committee about any serious difficulties encountered in working with management during the audit. Examples include, but are not limited to:

1. Unreasonable delays by management in allowing the commencement of the audit
    
2. Unreasonable delays by management in providing needed information to the auditor
    
3. Unreasonable timetable set by management for the conduct of the audit
    
4. Unavailability of client personnel
    
5. Failure of client personnel to complete client-prepared schedules on a timely basis

Illegal Acts

The auditor has the responsibility to assure himself or herself that the audit committee is adequately informed about illegal acts that come to the auditor's attention (this communication need not include matters that are clearly inconsequential). The communication should describe (1) the act, (2) the circumstances of its occurrence, and (3) the effect on the financial statements.

What is an illegal act for purposes of this communication? Statement on Auditing Standards (SAS) No. 54, Illegal Acts by Clients (AICPA, Professional Standards , vol. 1, AU sec. 317), defines it as violations of laws or government regulations attributable to the entity, or acts by management or employees on behalf of the entity. Illegal acts do not include personal misconduct by the entity's personnel unrelated to their business activities.

Internal Control Matters

See also the tool, “Internal Control: A Tool for the Audit Committee,” elsewhere in this toolkit.

SAS No. 60, Communication of Internal Control Related Matters Noted in an Audit (AICPA, Professional Standards , vol. 1, AU sec. 325) as amended, requires the auditor to communicate matters relating to the organization's internal control that are observed by the auditor in the conduct of a financial statement audit. These matters should be discussed with the audit committee because they represent significant deficiencies in the design or operation of the internal control system, which could adversely affect the organization's ability to initiate, record, process, and report financial data consistent with the assertions of management in the financial statements.

Fraud

See also the tool, Fraud and the Responsibilities of the Audit Committee: An Overview, elsewhere in this toolkit.

SAS No. 99, Consideration of Fraud in a Financial Statement Audit (AICPA, Professional Standards , vol. 1, AU sec. 316), requires that the independent auditor bring any evidence of fraud to the attention of the appropriate level of management (generally seen as one level higher than the level at which a suspected fraud may have occurred), even in the case of an inconsequential fraud, such as a minor defalcation by an employee or volunteer. The independent auditor should reach an understanding with the audit committee regarding when an inconsequential fraud (nature and scope) conducted by a low-level employee should be brought to the audit committee's attention.

Fraud involving senior management, and any fraud (whether caused by senior management or other employees) that causes a material misstatement of the financial statements must be reported to the audit committee by the independent auditors.

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