Standard on Auditing (SA) 580 – ‘Written Representations’, why we are not getting it right

Introduction ?

This article is about "Standard on Auditing (SA) 580 - Written Representations" deals with the very important subject of obtaining written representations from the management. This is one of the most important aspects of audit documentation. Per paragraph 5 of the SA the auditor's objective is to obtain representations which the management and the TCWG (Those Charged With Governance) where applicable reinforces the belief that that they have fulfilled their responsibilities for preparation of the financial statements and for the completeness of the information provided to the auditor. This is somewhat analogous to situations where auditors obtain confirmation of balances from banks in addition to the bank passbooks/pass-sheets which show the same balances. The justification for this is of course what is certified consciously by those in charge and responsible after conducting due diligence has greater evidentiary value than something that is produced by a mechanized process in a routine manner.

Even more important is the fundamental belief that the financial statements are prepared in accordance with the applicable financial reporting framework, including where relevant their fair presentation.

How effective is compliance with SA 580?

Of late, there have been some serious questions raised about the ‘excessive’ reliance by auditors on the written representations obtained from the management. In practice, what these representations seek to achieve as an audit process falls short of achieving the objectives of SA 580. Some of the reasons why they have failed to achieve the objective are stated below.

(1) Merely obtaining a standard letter

In most cases, managements routinely issue and the auditors routinely accept a standard format of Written Representations signed off by the client. SA 580 contains as an Appendix an illustrative representation letter. While the letter contains all the requirements that are a must for the effectiveness of a letter of representation letter, it is a general-purpose representation as a best case scenario without any discussion between the auditor and the client. By obtaining a standard letter, the entire exercise is dealt with in routine manner and becomes a ticking-the-box exercise.

(2) Not keeping the independent directors in the loop

As noticed a little later in the ensuing paragraphs of the article, the mandatory requirement of auditors disclosing to TCWG i.e. the independent directors in a set-up where the management and the TCWG are separate bodies is not always followed. There is no communication by auditors with TCWG. Using the time-honoured analogy comparing the corporate governance set up in these situations to a three-legged stool, in which (a) management, (b) TCWG and (c) the auditors are described as the three legs, there is hardly any communication between the auditors and the TCWG of what has been communicated by the management to the auditors through the representations. This is not only desirable but is a mandatory procedure prescribed by "SA 260 (Revised) Communication with Those Charged with Governance" which requires the auditor to communicate with the TCWG the representations which the auditor has requested from management. This is a logical process since the TCWG (in situations where the TCWG and management are different) is hardly aware of the several explanations that the management has offered to the auditors during the process of the audit and in obtaining ‘sufficient appropriate audit evidence’.

Unfortunately, there is also a misapprehension in the minds of some independent directors (a small minority) that lack of knowledge will give them a plausible deniability later on is something goes wrong. This is not correct since corporate governance expects independent directors to be aware of audit procedures and therefore the onus is placed on the independent directors.

The usual practice during the auditor-audit committee meetings when financial statements are discussed is to show on the screen the audit issues raised and how they are resolved. Auditors should adopt the practice of showing the representation letter obtained from the management on the screen and take the audit committee through it point by point. Accepting that across various companies, different practices have evolved, there is a certain minimum amount of discussion on the representation is a must. ?

(3) Specific representations and their impact on audit reports

Issues that manifest themselves during the year, requiring management's confirmation are not usually captured in the standard format of representations and it was never meant to be. The standard format is only template. While the standard Letter of Representations takes care of normal situations, there could be and there usually are situations that require the auditors to engage themselves in inquiries necessary for obtaining a reasonable assurance. For example, imagine a situation in which the client, a manufacturer of components supplying the same to an Original Equipment Manufacturer (OEM) such as an automobile manufacturer or a TV manufacturer. The auditor comes to know that the OEM has recalled several thousand products from the market due to defects in manufacture and is faced with the prospect of the OEM in future making a claim on the client for compensation for supplying defective components. However, the client steadfastly denies any liability on this score to the auditor. Faced with the situation, and in the absence of any evidence to the contrary, the auditor might accept a representation from the management to that effect. Logically, what the process should involve is that the letter of representations should contain a specific reference as to why a provision for claim in the financial statements is considered not necessary with a suitable communication to the TCWG as required by SA 580. Matters such as this are important enough to having to eventually consider in the auditor's report per " SA 701 Communicating Key Audit Matters in the Independent Auditor’s Report, " SA 706 Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor’s Report or "SA 705 Modifications to the Opinion in the Independent Auditor’s Report".

There might be situations when an entity plans to discontinue a line of business and the auditor is not able to obtain sufficient information through other audit procedures to corroborate the plan or intent, the auditor may obtain a written representation to provide evidence of management's intent.

(4) Financial statements approved does not amount to consideration of individual items

There is a wide-spread belief that since the client is approving the financial statements at the meeting of board of directors this would be tantamount to owning up the responsibility for the financial statements by the management. This belief is totally erroneous and would lead both the auditors and the TCWG into grave error of approving the financial statements without adequate knowledge followed by charges of negligence.

(5) Who should sign the Letter of Representation

The signoff is obtained from an inappropriate level of management. As paragraph 8 of SA 580 requires, the auditor shall request Written Representations from management with appropriate responsibilities for the financial statements and knowledge of the matters concerned. This is a logical requirement. There is no point in obtaining from someone no matter how high they are in the hierarchy unless they assume "ownership" for the matter concerned with knowledge of the matter. One finds that auditors routinely obtain Written Representations from the Chief Financial Officer (CFO) since they deal with them on a regular basis.

Having said that, Written Representations are requested from those responsible for the preparation and presentation of the financial statements. Those individuals may vary depending on the governance structure of the entity, and relevant law or regulation. However, management, rather than the TCWG is always the responsible party. Written Representations may therefore be requested from the entity’s chief executive officer and chief financial officer, or other equivalent persons in entities that do not use such titles. In some circumstances, however, other parties, such as TCWG are also responsible for the preparation and presentation of the financial statements. Quiet simply, the CFO’s responsibility is to record transactions and of business dealings conducted by others. One fails to see how a CFO can issue a Letter of Representation.

In specialized fields, the management may decide to make inquiries of others who participate in preparing and presenting the financial statements and assertions therein, including individuals who have specialized knowledge relating to the matters about which Written Representations are requested. Such entities may include:

·??????? An actuary responsible for actuarially determined accounting measurements;

·??????? Degree of percentage of completion in long duration projects;

·??????? Executives who may have responsibility for and specialized knowledge about environmental liability measurements; and

·??????? Internal counsel who may provide information essential to provisions for legal claims.

(6) Written Representations are obtained for everything

Sometimes, one finds that auditors indulge in an 'overkill' in obtaining Written Representations by requesting the clients to confirm even transactions for which there is valid and adequate third party evidence. This practice has a side-effect of trivializing the audit in the eyes of the management.

Conclusion

This is a crucial issue concerning the manner of closing off the exercise of approving the financial statements. Where auditors have not shared the information with the TCWG as required by the SA, the question remains answered as to whether the TCWG could claim deniability when something goes wrong. In the opinion of the author of the Article this would not be the case since the audit committee as a group is expected to be familiar with the audit process and should have inquired of the auditor with regard to the Written Representations. Auditors can claim even less of an excuse for not having initiated the process of communicating with the TCWG as? mandatorily required. The answer probably lies in independent directors being prepared for the technicalities when they agree to serve on boards of directors of companies. An impeccable service record, an untarnished reputation for integrity and good intentions are not the sole criteria for identifying worthy candidates for these offices in the present day climate.

The Institute of Chartered Accountants of India (ICAI) has issued an ‘Implementation Guide to Standard on Auditing (SA) 580, Written Representations’ in 2023 which should be read thoroughly.

Speaking of representations where auditors seek routinely representation for everything, one lingering doubt is, unlike accounting standards which have a statutory recognition under section 133 of the Companies Act, 2013, Standards on Audit have no such recognition except for section 143 which requires the auditors to follow the Standards on Audit in the conduct of an audit. There is no corresponding obligation on companies. While SA 580 requires an auditor to obtain representation with regard to the responsibilities of the management in preparation of financial statements, what would be the consequences of a company refusing to provide with the routine representations. Theoretically speaking, a company takes a stand that all evidence required has been provided to the auditors and it is up to the auditors to come to a conclusion with regard to the appropriateness of the audit evidence, where would the auditors stand? Would the auditors be justified in qualifying their reports? Although there have been no such cases, the requirement for a representation when it is justified and when it isn’t is divided by a thick line. ?Paragraph 6 of SA 580 defines "Written Representations"? as "a written statement by management provided to the auditor to confirm certain matters or to support other audit evidence. Written representations in this context do not include financial statements, the assertions therein, or supporting books and records”.

It is an interesting thought but what is evident is that perhaps we are missing the wood for trees and losing the big picture. Going forward, the entire practice of obtaining representations will attract more attention. There has to be a more effective approach. In any case, the auditing profession has been put on notice.

The views presented are of the author.

#SA580 #writtenrepresentations