The second section of the management representation letter gets into the heart of how you went about disclosing information to the independent accountant. This section is titled, “Information Provided” and you should be aware of what is actually being stated here.
- You are stating that you have responded fully and truthfully to all inquiries made. Keep in mind one of the bigger concerns is related party transactions – if you know one exists but fail to disclose it, you have technically misrepresented yourself.
- You provided access to all relevant information which deals with the preparation and fair presentation of the financial statements.
- Board minutes (if you had a board and kept minutes
- Schedules requested, like an amortization schedule for interest
- Most importantly, unrestricted access (my emphasis) to persons within the entity that the accountant felt was necessary to interview to feel confident about the evidence.
As a quick aside, this is a potential for a scope limitation which is an engagement killer for both an audit and review. We have had client management tell us we cannot interview certain employees. Sorry, that is a huge red flag issue. We don’t like wasting our time talking with employees or business partners who cannot provide evidence, but if you have a purchasing manager and we question the values of inventory, to say we cannot talk with that person means we cannot issue our independent report. You have been warned.
- You have recorded all transactions in your accounting system and these show up on the financial statements. You are the entities first line of defense. We have been involved with engagements where specific transactions were not recorded, only to find out later that someone (like the owner) knew about it but failed to ensure it was included.
- You are stating you are either have no knowledge of fraud or suspected fraud or have shared with us your suspicions or evidence. Think about this representation. As I have discussed in other posts ,we have discovered odd journal entries which were possibly created to misrepresent the financial condition of the company. We have required management to represent that they had evidence of this misrepresentation and have taken steps to address the action and then state if they know of anything else. The fact that it the transaction was caught by us and not management is the problem since it never should have been entered in the first place.
- You are stating that there are either no instances of noncompliance with laws or have disclosed all such instances to us and have either made allowance for it in the financial statements or are disclosing such. There was one instance where a construction company bid on a job in a new state. They started the work and failed to file as a foreign corporation, failed to register as a contractor and failed to file for payroll taxes and workers compensation coverage. Even though it was eventually corrected, we required an accrual of the expenses and also a note disclosure.
- You state that all possible litigation and potential claims have been identified. If your company is being sued for, say a hostile work environment, you should let the accountant know so that a proper disclosure can be prepared. Your relative guilt or innocence is not the question, the fact that there is a risk is the concern.
- You are stating that you have disclosed all related parties. By the way, you are required to disclose related party matters even when you are not doing business with them.
- The last big one, you state that the entity has complied with all contractual agreements that would have a material effect on the financial statements in the event of noncompliance. Now, before you say it is never a problem, think about a line of credit that is tied to your inventory by way of a borrowing base calculation. It requires that inventory over 120 days be excluded from the calculation. At the end of the year you are on day 119 for 50% of your inventory. You are likely going to be out of compliance and it may have a material impact.
For the most part, management representation letters are simple and straightforward. But they are designed to protect the independent accountant by putting you on notice that you are making, and they are relying upon, certain representations. In the event of a problem their defense is that you represented that you told them one thing and obviously something else happened. So, to protect yourself, don’t be afraid to add specific language which makes the representation letter more effective for you and the accountant.
We hope this journey through the standard management representation letter has been helpful. If you have questions about the representation letter, feel free to ask. And if you would like a proposal on audit or review services, go to our website and learn a little more about us. We have a page where you can request a proposal and we would love the opportunity to be of service to you.