Key Engagement Risks in Audits: Laws, Estimates, Related Parties & Going Concern
Overview: Some areas in every audit engagement pose higher inherent risk and require specific auditor considerations. This guide breaks down key areas — laws and regulations, estimates, related party transactions, litigation, and going concern — with practical audit steps and reporting implications.
✅ Compliance with Laws and Regulations
• Some laws directly affect financial statements (e.g., tax laws), others indirectly (e.g., privacy laws like HIPAA). • Management is responsible for compliance. • The auditor must obtain reasonable assurance financial statements are free of material misstatement due to noncompliance but is not responsible for preventing it.
Procedures: Understand the legal framework; inspect correspondence with regulators; inquire of management and governance. If noncompliance is suspected, consult legal counsel and consider the impact on the report. Severe cases may require withdrawal.
✅ Accounting Estimates (SAS 540)
• Estimates involve uncertainty and possible management bias. • Examples: Allowance for doubtful accounts, warranty obligations, fair value estimates.
Auditor Responsibilities: Understand methods, assumptions, and data used; assess inherent risk and estimation uncertainty; test estimates; consider need for specialists. Bias indicators: changes in methods, assumptions consistently favoring management.
✅ Related Party Transactions
• Related party transactions are rarely at arm’s length and must be disclosed. • Frauds often involve related parties.
Procedures: Understand controls over identification and approval; inquire management and governance; inspect conflict-of-interest statements, contracts, and SEC filings; test balances and transactions; watch for unusual terms. If management’s disclosure is misleading, the auditor may need to modify the opinion.
✅ Litigation, Claims, and Assessments
• Auditors must evaluate whether contingencies are properly accounted for or disclosed. • Evidence sources: management inquiry, attorney letters, minutes, tax reports.
Key Point: If the client refuses to allow attorney inquiry, the auditor may need to disclaim an opinion. Attorneys may limit replies to substantial matters or where confidentiality applies.
✅ Going Concern
• The auditor must assess whether there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period (1 year under FASB).
Indicators (FINE): F - Financial difficulties (loan defaults, denial of credit) I - Internal matters (labor issues, project dependence) N - Negative trends (recurring losses, negative cash flows) E - External matters (lawsuits, loss of key customer)
• Evaluate management’s mitigation plans; if doubt remains, modify the report with emphasis-of-matter (nonissuer) or explanatory paragraph (issuer).
🔗 Helpful References
👉 Know your high-risk areas — respond appropriately, stay skeptical, and issue the right opinion!
