7571 Contracts

Jul-2017

OAG Guidance

During the course of an audit we identify various types of contracts or agreements that the entity enters into related to its operations and financial position. For the purposes of this guidance, contracts are defined as any significant or specific contract or agreement impacting the financial statements.

During our planning and risk assessment activities, as part of gaining or updating our understanding of the entity and its environment, through initial meetings with management, reviews of minutes and other risk assessment procedures, we seek to identify the entity’s contracts that will be significant to the financial statements. For this purpose, we use our general business, entity and industry knowledge, including our understanding of the types of significant and specific contracts ordinarily used by the entity. We consider any information which might indicate significant new or changed contracts.

Obtain from management or officers of the entity, for example in-house legal counsel, a listing of all new or changed significant contracts or agreements entered into by the entity. Examine these documents, gain a thorough understanding of their contents if they impact the financial statements, and identify and assess the risks of material misstatement associated with new or changed contracts or agreements for each class of transaction, account balance and disclosure. The risk assessment procedures will include relating the significant clauses of the contracts to the entity’s business processes and FSLIs and discussing the potential impacts with the entity’s personnel who are involved either in their preparation or review, e.g., the company secretary or the internal legal advisor, in order to understand the significance of the contract clauses to the entity’s operations or financial position.

It may be efficient to combine the work of assessing and responding to risk on a recurring engagement where we maintain our knowledge and understanding of the implications of the entity’s contractual arrangements, i.e., in those circumstances we limit our risk assessment procedures because they will ordinarily be the same risks as before and we only need to identify new or changed significant contracts.

If we identify related party relationships and transactions or fraud risk factors when auditing significant contracts (e.g., contracts with impact on management’s bonuses), consider such information when identifying and assessing the risks of material misstatement due to related party transactions and/or fraud (see OAG Audit 5504 and OAG Audit 7532).

OAG Guidance

Depending of the type of the entity and their operations through our understanding and evaluation of the entity’s system of internal control, understand management’s considerations related to contracts impacting the business.

For example:

• What does management need to do well in order that the contract ‘performs’? What will be the financial consequences if it does not?
• What risks are there to the business of entering into the contract? What are the rights and obligations arising out of the contacts (which may affect the related assertion)?
• What is the business purpose (refer to OAG Audit 5500 if fraud risk factors are identified, e.g., no clear business purpose)?
• How does management:
  • Identify all the contracts the entity has entered into (completeness).
  • Determine that all contracts have been properly approved (authorization).
  • Determine that controls, including controls over performance risks are effective and the information reliable.

If we plan to rely on controls related to significant contracts, consider understanding, evaluating and testing how the entity:

• Identifies all new or changed significant contracts and agreements.
• Determines that all new significant contracts have been appropriately authorized, including appropriate review of contract terms, counterparties etc.
• Consults with experts, where necessary.
• Identifies potential contracts with related parties.
• Determines ongoing compliance with terms and conditions of significant contracts.
• Determines and accurately records the accounting implications of significant contracts (e.g., how does management determine that significant long term contracts are correctly accounted for over the life of the contract).

OAG Guidance

For all significant contracts identified, design audit procedures in order to obtain sufficient appropriate audit evidence to enable us to evaluate the implications for the entity’s classes of transaction, account balance and disclosures. These procedures may include the following:

• Obtain an original or certified true copy of the contract, unless it is impracticable, in which case we consider whether it is appropriate to examine a copy.
• Verify that we have the complete document including any attachments, appendices and side agreements and any amendments.
• For significant clauses of a contract that will have an impact on the presentation and disclosure in the financial statements, agree the details to the accounting records and to the disclosures in the financial statements. Consider if the contract constitutes obligations which require disclosure of contingencies or commitments in the financial statements.
• If a contract has a duration of more than one year and its existence has an impact on the presentation/disclosure in the financial statements, consider these presentations/disclosures in subsequent years.

When inspecting significant contracts, consider the following matters:

• Effective date of the contract. Determine that it relates to the audited period and that the disclosure in the financial statements is correct.
• Other key dates (e.g., receipt / payment dates). Determine that these dates agree to the accounting records and that any receipts / payments after the balance sheet date are valid and properly disclosed in the financial statements.
• Names of the parties involved. Determine proper accounting for related party disclosures.
• Rights and obligations. Are the rights and obligations of each party clear? Identify possible contingent liabilities and commitments that require disclosure in the financial statements.
• Default clauses. Determine that we identify any possible defaults, which would be derived from our knowledge of the company, and that these defaults have been properly accounted for (i.e., de-recognizing income/expense or recognizing monetary penalties).
• Duration of the contract and recognition of income / expense. Determine that revenue / expense recognition criteria have been properly identified and included in the accounting records.
• Amendments to the original contracts. Determine proper accounting for the amendments affecting the accounting records and the financial statements.
• Attachments/appendices detailing the items being sold / purchased (e.g., fixed assets, inventory, shares). Determine that the amounts are correctly accounted for in the accounting records and the financial statements.
• Other relevant terms, for example interest rates. Determine that the interest income/expense was calculated using the correct interest rates.

In order to obtain sufficient appropriate audit evidence, consider the need to involve an auditor’s expert (i.e., in the case of a complex contract where the audit team does not have the expertise to review and extract the necessary information) or to evaluate the work of a management’s expert.

If we identify specific issues that require further investigation, design and perform the necessary procedures. This may include more specific inquiries of management and obtaining appropriate audit evidence relevant to management’s responses.

OAG Guidance

Evaluate all audit evidence obtained when drawing conclusions about whether significant contracts have been properly accounted for and significant matters adequately disclosed. Consider recent minutes, the presence of relevant litigation affecting or claims on the entity, and information from the entity’s lawyers. Verify management’s disclosures, including any specific assertions, in the financial statements.

See the guidance in OAG Audit 5500 on how to address possible fraud relating to revenue recognition.

Where applicable, include management’s assertions about the proper accounting for significant contracts in the management representation letter, including confirmation of completeness of contracts (attachments, appendices, side agreements) (see also OAG Audit 9050).

OAG Guidance

Any additional work that may arise as a result of reviewing contracts (e.g., identification of revenue recognition issues) is documented appropriately in our audit file, e.g., see OAG Audit 5510. Significant matters are documented separately along with related conclusions reached (see OAG Audit 1143).