Management representations are a standard component of every audit. Before the audit report is issued, management provides the auditor with a written representation letter confirming, among other things: that the financial statements are complete and accurate, that all transactions have been recorded, that all liabilities have been disclosed, that all related-party transactions have been identified, that there are no subsequent events requiring disclosure, and that management has provided the auditor with all information and access necessary to conduct the audit.
The representation letter is signed by the CEO and the CFO. It is a formal document. It carries legal weight.
It is also, by itself, insufficient evidence for any material balance.
Why representations are necessary but not sufficient
Management representations serve two purposes. First, they formally establish management’s responsibility for the financial statements (the financial statements are management’s product, not the auditor’s). Second, they provide the auditor with management’s explicit confirmation on matters that only management can know (the existence of undisclosed liabilities, the completeness of related-party disclosures, the occurrence of subsequent events).
But a representation is a statement by the party whose financial statements are being audited. The entire purpose of the audit is to independently verify what management says. Accepting management’s representation as sufficient evidence would make the audit circular: management says the numbers are right, the auditor accepts the statement, the auditor certifies the numbers are right. No independent verification has occurred.
SA 580 (Written Representations) is explicit: management representations are not a substitute for audit evidence. They are a complement to audit evidence. The auditor obtains the representation and then performs procedures to corroborate it. If the corroboration supports the representation, the evidence is sufficient. If the corroboration contradicts the representation, the contradiction is a finding.
Where the risk lies
The risk of over-reliance on management representations is greatest in three situations.
Situation 1: Judgmental estimates where management controls the assumptions. The company estimates an asset’s fair value at Rs 25 crore. The auditor asks management for the basis. Management provides a valuation report from a management-appointed valuer using assumptions management provided (growth rates, discount rates, comparable transactions). Management represents that the assumptions are reasonable. The auditor reviews the valuation report and finds it internally consistent.
But the auditor has not independently verified the assumptions. The growth rate may be optimistic. The discount rate may be artificially low (which inflates the value). The comparable transactions may be cherry-picked (selected because they support the desired value, not because they are the most relevant comparisons). The valuation is internally consistent because it was built to be internally consistent. The question is whether the inputs are independently supportable, not whether the arithmetic works.
The auditor’s responsibility: challenge the assumptions against external evidence. Compare the growth rate to the company’s historical growth and to industry benchmarks. Compare the discount rate to independently derived rates for comparable risk profiles. Verify that the comparable transactions are genuinely comparable and that no contradictory transactions were excluded. If the independently derived range is Rs 18 crore to Rs 22 crore and management’s valuation is Rs 25 crore, the difference is a potential misstatement, not a “reasonable judgment.”
Situation 2: Completeness assertions. Management represents that all liabilities have been disclosed. The representation covers: bank borrowings, trade payables, statutory dues, employee obligations, provisions for litigation, contingent liabilities and any other obligation.
The representation is the starting point, not the conclusion. The auditor then tests: are there bank borrowings that the financial statements do not show (tested through bank confirmation letters and credit bureau reports)? Are there supplier balances that the financial statements omit (tested through supplier confirmations and purchase-ledger analysis)? Are there statutory demands that management has not disclosed (tested through review of correspondence with tax and regulatory authorities)? Are there litigation claims that the legal counsel has not reported (tested through independent confirmation from the company’s lawyers)?
A completeness assertion that is corroborated by these tests is reliable evidence. A completeness assertion that is not tested is a management claim with no independent support.
Situation 3: Related-party disclosures. Management represents that all related-party transactions have been identified and disclosed. The representation covers: transactions with entities controlled by directors and KMP, transactions with entities in which directors have a significant interest and transactions with close family members of directors and KMP.
The self-declaration mechanism for related parties relies on directors voluntarily disclosing their interests. The auditor who accepts the self-declaration without independent verification is trusting that the directors disclosed every relevant interest, including interests they may prefer to conceal (a spouse’s business that supplies the company at inflated prices, a family trust that receives “consulting fees” for services never delivered, a personal investment funded by company cash routed through an intermediary entity).
The auditor’s responsibility: perform the independent verification described in Article 1 of this series (the Twelve-Layer Independence Verification). Test every significant counterparty for connections to the company’s directors and management through common directors, addresses, shareholders, employees, phone numbers, bank accounts, GST data and transaction timing patterns. The verification extends beyond the self-declaration to test whether undisclosed connections exist.
What happens when a representation is contradicted
If the auditor obtains evidence that contradicts a management representation, two issues arise simultaneously.
First, the substantive issue: the balance, transaction or disclosure that the representation covered is potentially misstated. The auditor assesses the misstatement’s materiality and determines the impact on the opinion.
Second, the integrity issue: management provided a formal written representation that is contradicted by the evidence. The contradiction may be an honest error (management did not know about the undisclosed liability because the information was not reported internally). Or the contradiction may be deliberate (management knew about the liability and chose not to disclose it).
If the contradiction is deliberate, the auditor faces a fraud consideration under SA 240, a reconsideration of all other management representations (if management misrepresented one matter, can the other representations be trusted?) and a potential fundamental reassessment of the audit’s approach.
SA 580 requires the auditor to disclaim an opinion if management refuses to provide the representation letter (because the auditor cannot complete the audit without management’s confirmation of its responsibilities). The standard also requires the auditor to consider the impact on the opinion if a specific representation is unreliable (because the balance or disclosure it covers cannot be independently verified and the representation is the only evidence available).
What audit committees should require
The audit committee should review: the management representation letter before it is signed (not after), the auditor’s assessment of which representations were corroborated by independent evidence and which were accepted primarily on the strength of the representation, the auditor’s identification of any representations that were contradicted by evidence and the auditor’s evaluation of the implications of any contradictions for the reliability of other representations.
The committee’s role is to satisfy itself that the management representation letter is accurate (the management is representing truthfully) and that the auditor is not over-relying on the letter in lieu of independent evidence (the auditor is auditing, not accepting).
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