Internal Auditor

The Impact Of The New External Auditing Standards

The Impact Of The New External Auditing Standards

Janet L. Colbert

In the long term, the advent of the AICPA’s SAS 89 and SAS 90 will strengthen audit committee understanding of financial statements. Short term, the knowledge and assistance of internal auditors may be essential in helping the organization respond to the requirements and discern the effects.

Two external auditing standards recently issued by the American Institute of Certified Public Accountants (AICPA) are likely to generate questions from both audit committee members and management in the United States. Although neither of the Statements on Auditing Standards (SAS) is lengthy, their impact is expected to be significant. Internal auditors should be prepared to explain the standards to their constituents and to assist in planning for possible system changes precipitated by the new requirements.


As financial statement audits are performed, the external auditor typically encounters misstatements. Proposed adjusting journal entries are accumulated and presented to management near the end of the engagement. SAS 89, “Audit Adjustments,” addresses these proposed journal entries.

SAS 89 requirements focus on three distinct junctures in the external audit engagement: (1) when the entity and the external auditor reach an understanding regarding the scope and terms of the engagement; (2) when the external auditor asks management to sign the management representation letter; and (3) at the point when the external auditors communicate with the audit committee.

THE ENGAGEMENT LETTER The organization and the external auditor normally document their mutual understanding in an engagement letter. Prior to the adoption of SAS 89, one of the engagement letter requirements was a notice indicating management’s responsibility for the financial statements. SAS 89 expands this requirement by specifying that the engagement letter should declare that management is responsible for correcting material misstatements in the financial statements by making appropriate adjustments. SAS 89 also requires that the engagement letter communicate that, at the conclusion of the engagement, management will be expected to affirm that the effects of any uncorrected misstatements noted by the external auditor and related to the latest period presented in the financial statements are immaterial. As shown on page 49, the AICPA has suggested wording for the engagement letter.

THE MANAGEMENT REPRESENTATION LETTER Near the conclusion of the engagement, management is asked to sign a representation letter. In addition to management’s acknowledgment of its responsibility for the financial statements, other items that must be included in the representation letter relate to the completeness of information; recognition, measurement, and disclosure; issues, significant risks, and uncertainties; and subsequent events. SAS 89 adds another significant item to this list: Adjustments proposed by the external auditor but left uncorrected by management must either be included in or attached to the letter. In the representation letter itself, management must affirm that the uncorrected adjustments are not material. Appropriate wording for the representation letter, as suggested by the AICPA, is shown on page 49.

THE AUDIT COMMITTEE Shortly after the annual financial statement audit has been completed, the external auditor usually communicates with the audit committee, in keeping with the requirements of SAS 61, “Communications With Audit Committees.” SAS 61 notes that significant adjusting journal entries, including those that management has elected to correct as well as those not booked, are among the required items in this communication. SAS 61 also stipulates that the following other matters should be discussed with the audit committee: the auditor’s responsibility under generally accepted auditing standards, significant accounting policies, management’s judgments and estimates, other information in documents containing audited financial statements, disagreements with management, consultation with other accountants, major issues discussed with management before retention, and difficulties encountered during the audit.

SAS 89 extends these communications by requiring the external auditor to inform the audit committee about any uncorrected audit adjustments that management feels are immaterial, either individually or in total, to the financial statements. The addition of adjustments proposed by the external auditor, but viewed by management to be immaterial to the topics covered in the communication with the audit committee, is subtle, but important. It provides the audit committee with additional insights, not only into the financial statements, but also into management’s performance and actions.


Although SAS 89 affects the external auditor’s communications with the audit committee regarding audit adjustments, SAS 90 addresses two other aspects of these communications. One relates to the quality of accounting principles while the other focuses on interim financial information. The requirements of SAS 90 are applicable to external auditors of U.S. Securities and Exchange Commission (SEC) companies.

Prior to the issuance of SAS 90, external auditors were required to communicate with the audit committee regarding the acceptability of the accounting principles chosen by management and the process used by management to arrive at accounting estimates. The new requirements call for the external auditor to communicate regarding the quality, rather than simply the acceptability, of accounting principles and estimates. Management, as the party primarily responsible for the selection of accounting principles and the formulation of estimates, should contribute to the discussion. Examples of potential discussion topics are shown on page 50.

Dialogue between the external auditor and the audit committee is an important part of the annual audit, and SAS 90 seeks to increase the number of these communications. The new standard recommends that the external auditor attempt to discuss the items in SAS 61 with the audit committee before the entity files its Form 10-Q with the SEC. Alternatively, management may choose to be the party that communicates these matters to the audit committee on a quarterly basis. This approach is acceptable if the external auditor is able to ascertain, via discussion with the audit committee, that the items have indeed been communicated. Regardless of whether the external auditor or management initiates the communications, the information made available to the members of the audit committee will increase as a result of SAS 90.


Both SAS 89 and SAS 90 are likely to have significant impact on the work of audit committees. By helping audit committee members understand the effects of the two standards and how to respond to their requirements, internal auditors are also providing value to management and the organization at large.

SAS 89 According to SAS 89, management is required to acknowledge its responsibility to correct material misstatements in both the engagement and representation letters and to communicate with the audit committee regarding misstatements. Taken together, these mandates apply pressure on management to book many, if not all, of the external auditor’s proposed adjusting journal entries. If any uncorrected misstatements remain, they are those that management believes to be immaterial. Thus, the internal auditor should be prepared to explain to the audit committee the difference between booked adjustments and any remaining, uncorrected misstatements. Internal auditors may also want to encourage discussion about the concept of material/immaterial and about possible reasons why management would choose not to correct all misstatements. Such dialogue might help the committee members in its considerations of the uncorrected information, as well as in evaluating management performance.

The effects of SAS 89 may extend beyond the impact of misstatements on the current year’s financial statements and the resulting communications involving management, the audit committee, and internal and external auditors. The internal auditor can be especially helpful to the audit committee and management by pointing out other potential effects, such as the costs of SAS 89 to the entity. In the short run, SAS 89 may result in increased time and expense, because both corrected and uncorrected misstatements will be considered. The entity’s concern with the occurrence of misstatements and the process that produces them may then result in modifications to the system; and, again, costs are increased.

In the long run, however, costs should decrease. If the systems and processes can be amended to yield financial statements containing fewer misstatements, costs of the external auditor’s searches for this type of information in future engagements should decrease. Also, the organization’s costs related to correcting the misstatements and to communications between the external auditor, management, and the audit committee should be reduced.

SAS 90 Internal auditors of SEC companies can aid their audit committees by addressing both of the issues covered in SAS 90: the quality of accounting principles and interim communications with the external auditor.

To aid the audit committee in assessing the quality, and not just the acceptability, of accounting principles that management has selected, internal auditors can educate the audit committee on relevant accounting principles. Depending upon the level of expertise of committee members, internal auditors can explain the accounting principles used by the entity and how they are applied, as well as acceptable alternative methods. A summary of other accounting principles and their applications by other organizations in the same industry might be very useful to audit committee members. In addition, a description of the various estimates incorporated into the financial statements and an explanation of management’s process for deriving the numbers would be beneficial.

The second requirement of SAS 90, which relates to interim reporting, impacts the frequency and timing of the audit committee meetings. The internal auditor should explain to the committee that if the external auditor’s interim reviews disclose items noted in SAS 61, the external auditor must endeavor to communicate these to the audit committee before the organization files its Form 10-Q with the SEC. Thus, if the audit committee is not already meeting quarterly, more sessions should be planned. Also, the timing of the meetings may have to be amended to occur before the Form 10-Q filing.


Both SAS 89 and SAS 90 should be beneficial to audit committees, boards of directors, and ultimately, to the organization. The requirements of the standards should lead the members of the audit committee to a deeper understanding of the financial statements. Committee members should comprehend more fully the various alternatives to specific accounting principles, how management selects from among its options, the methods used to apply the principles, the process of developing accounting estimates, how and why misstatements arise, and the process of filing Form 10-Q. Also, the interim meetings recommended in SAS 90 should underscore to committee members the difference between the audit of the annual financial statement and the reviews of interim information and the corresponding difference in assurances given. Internal auditors can help their audit committees, management, and their organizations through their knowledge of the two standards and by preparing them for the effects.

JANET L. COLBERT, CIA, CPA, PhD, is a James R. Meany professor of accounting at Western Kentucky University in Bowling



“Management is responsible for adjusting the financial statements to correct material misstatements and for affirming to the auditor in the representation letter that the effects of any uncorrected misstatements aggregated by the auditor during the current engagement and pertaining to the latest period presented are immaterial, both individually and in the aggregate, to the financial statements taken as a whole.”


“Management believes that the effects of uncorrected financial statement misstatements summarized in the accompanying schedule are immaterial, both individually and in the aggregate, to the financial statements taken as a whole.” (A summary of such items should be included in or attached to the letter.)

KEY DISCUSSION TOPICS for External Auditors/Audit Committee/Management

* Consistency of accounting principles with prior periods

* Consistency of the application of accounting principles with prior periods

* Clarity of the financial statements and disclosures

* Completeness of the financial statements and disclosures

* Items that have a significant impact on the representational faithfulness and neutrality of the information in the financial statements

COPYRIGHT 2000 Institute of Internal Auditors, Inc.

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