Ch 3 Audit Report PDF

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Chapter 3 Audit Reports Standard Unmodified Opinion Audit Report for Non Public Entities Standard uniform wording typically used in audit reports. Unmodified opinion the fact that the opinion about the financial statements contains no material exceptions or qualifications. Parts of Standard Unmodifi...

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Chapter 3 Audit Reports Standard Unmodified Opinion Audit Report for Non Public Entities Standard  uniform wording typically used in audit reports. Unmodified opinion  the fact that the auditor’s opinion about the financial statements contains no material exceptions or qualifications. Parts of Standard Unmodified Opinion Audit Report 1. Report title 2. Audit report address 3. Introductory paragraph 4. Management’s responsibility 5. Auditor’s responsibility 6. Opinion paragraph 7. Signature and address of CPA firm 8. Audit report date

Conditions for Standard Unmodified Opinion Audit Report 1. All statements—Balance sheet, income statement, statement of changes in stockholders’ equity, and statement of cash flows—are included in the financial statements. 2. Sufficient appropriate evidence has been accumulated, and the auditor has conducted the engagment in a manner that enables him or her to conclude that the audit was performed in accordance with auditing standards. 3. The financial statements are presented fairly in all material respects in accordance with U.S GAAP or other appropriate accounting framework. This also means that adequate disclosures have been included in the footnotes and other parts of the financial statements. 4. There are no circumstances requiring the addition of an emphasis-of-matter paragraph or modification of the wording or auditor’s opinion in the report.

Standard Audit Report and Report on Internal Control over Financial Reporting Under PCAOB Auditing Standards  Unmodified opinion  unqualified opinion  Categories of audit reports:

Standard Unmodified Opinion the conditions stated above has been met/ Unmodified Opinion with Emphasis-of-matter complete audit took place with satisfactory results and financial statements Explanatory Paragraph or A are fairly presented, but the auditor believes that it is important or is required Nonstandard Wording to provide additional information

Qualified

the auditor concludes that the ov erall financial statements are fairly presented, but the scope of the audit has been materially restricted or applicable accounting standards were not followed in preparing the financ ial statements.

Adverse the auditor concludes that the financial statements are not fairly presented.

Disclaimer he or she is unable to form an opinion as to whether the financial statements are fairly presented, or he or she is not independent.

Standard Unmodified Opinion Audit Report for Public Companies First Paragraph  an audit was performed and the financial statements that were audited (Management’s responsibility) Second Paragraph  audit is designed to provide reasonable assurance that the financial statements are free from material misstatement (done on the test basis) Opinion Paragraph  auditor’s opinion -

If auditor also issues a separate report on internal control over financial reporting  4th paragraph + reference the audit report on internal control. Reports on Internal Control Over Financial Reporting - Title - Introductory, scope, and opinion paragraphs management’s responsibility - Introductory and opinion paragraphs  framework used - Defining internal control over financial reporting - Inherent limitation paragraph of internal control - Opinion paragraph about the effectiveness of internal control as of the end of the most recent fiscal year - Cross-reference paragraph

Unmodified Opinion Audit Report with Emphasis-of-matter Explanatory Paragraph or Nonstandard Report Wording  Meets the criteria of a complete audit with satisfactory results and financial statements that are fairly presented, but the auditor believes, it is important to draw the reader’s attention to certain matters or the auditor is required to provide additional information. The most important cause are: 

Lack of Consistent Application of GAAP - When a material change occurs, the auditor should add an explanatory paragraph after the opinion paragraph that discusses the nature of the change and points the reader to the footnote that discusses the change. - The materiality of a change is evaluated based on the current year effect of the change. - Required for both voluntary changes and required changes due to a new accounting pronouncement. Consistency vs Comparability  auditor must be able to distinguish. Changes that affect consistency and require an explanatory paragraph

Changes in accounting principle (FIFO to LIFO) Changes in reporting entities (the inclusion of an additional company in combined financial statements) corrections of errors including principles (by changing from accounting principle that is not generally acceptable to one that is generally acceptable, including correction of the resulting error)

Changes that affect comparability but not consistency, no need to be included in the audit report

Changes in an estimate (a decrease in the life of an asset for depreciation) Error corrections not involving principles (previous year's mathemathical error) Valuations in format and presentation of financial information Changes because of substantially different transactions or events (new endeavors in research and development or the sale of a subsidiary)

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Substantial Doubt About Going Concern - Auditor has a responsibility under auditing standards to evaluate whether the company is likely to continue as going concern. - Factors causing uncertainty about the ability of a company to continue as going concern: 1. Significant recurring operating losses or working capital deficiencies.

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2. Inability of the company to pay its obligations as they come due. 3. Loss of major customers, the occurrence of uninsured catastrophes (earthquake, flood, unusual labor difficulties) 4. Legal proceedings, legislation, or similar matter that have occurred that might jeopardize the entity’s ability to operate. When the auditor concludes that there is substantial doubt about the entity’s ability to continue as going concern  an unmodified opinion audit report with an explanatory paragraph is required, regardless of the disclosures in the financial statements

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Auditor Agrees with a Departure from a Promulgated Principle - AICPA : in usual situations, a departure from GAAP may not require a qualified or adverse opinion. - To justify unmodified opinion  auditor must be satisfied and must state and explain, in a separate paragraph or paragraphs in the audit report  adhering to the principlewould produce misleading result in that situation.

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Emphasis of Other Matters  should be included in a separate paragraph Examples of explanatory information the auditor may report as an emphasis of a matter include the following: - The existence of material related party transactions - Important events occurring subsequent to the balance sheet date - The description of accounting matters affecting the comparability of the financial statements with those of the preceding year - Material uncertainties disclosed in the footnotes such as unsually important litigation or regulatory action. - A major catastrophe that has had or continue to have a significant effect on the entity’s financial position.

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Reports Involving Other Auditors - Principal auditor: the primary auditor issuing the opinion on the financial statements  under PCAOB standard. - Group engagement partner: under AICPA standards - Component auditor: the auditor who performs work on financial information of a component  under AICPA standards Three alternatives when CPA relies on different CPA firm: 1. Make No Reference in the Audit Report o Standard unmodified opinion o Followed when the other auditor audited on immaterial portion of the statements, the other auditor is well known or closely supervised by the principal auditor, or the principal auditor has thoroughly reviewed the auditor’s work.

The other auditor  responsible for the report & lawsuit Reference in the Report (Shared Opinion) Shared unmodified opinion  reference to another auditor Appropriate when the portion of the financial statements audited by the other CPA is material in relation to the whole. 3. Qualify the Opinion (or disclaimer) o Depending on materiality  required if the principal auditor is not willing to assume any responsibility for the work of the other auditor.

o 2. Make o o

Modifications to the Opinion in the Audit Reports I.

Conditions Requiring a Modification to the Opinion 1. The Scope of the Audit Has Been Restricted (Scope Limitation) When the auditor has not accumulated sufficient appropriate evidence to conclude whether financial statements are stated in accordance with the appropriate financial reporting framework, a scope restriction exist. Two major causes: o Restriction imposed by client e.g: management’s refusal to permit the auditor to confirm material receivables or to physically examine inventory. o Restriction caused by circumstances beyond either the client’s or auditor control e.g: when the auditor is not appointed after the client’s year end. It may not be possible to physically observe inventories, confirm receivables, etc. 2. The Financial Statements Have Not Been Prepared in Accordance with GAAP Departuree e.g: client insists on valuing inventory at selling price rather than historical cost as required by GAAP - consideration of all informative disclosures is important. 3. The Auditor is not independent When any of three conditions requiring a departure from an unmodified opinion exists and is material, the opinion in the audit report must be modified. o Qualified opinion  Can result from a limitation on the scope of the audit or failure to follow GAAP.  Can be used only when the auditor concludes that the overall financial statements are fairly stated. o

Adverse opinion  Used only when the auditor believes that the overall financial statements are so materially misstated or misleading that

they do not present fairly the financial position or results of operations and cash flows in conformity with GAAP.  Can arise only when the auditor has knowledge, after an adequate investigation, of the absense of conformity o

Disclaimer opinion  Issued when the auditor has been unable to satisfy himself or herself that the overall financial statements are fairly presented.  May arise due to severe limitation on the scope of audit or a nonindependent relationship under AICPA between auditor and client.  Distinguished from adverse  can arise only from a lack of knowledge by the auditor.

Materiality A misstatement in the financial statements can be considered material if knowledge of the misstatement will affect a decision of a reasonable user of the statements. Levels of materiality: 

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Amounts are immaterial When a misstatement in the financial statements exists but is unlikely to affect the decision of a reasonable user, it isconsidered to be immaterial  unmodified opinion. Amounts are material but do not overshadow the financial statements as a whole When misstatement in the financial statements would affect a user’s decision, but the overall statements are still fairly stated and therefore useful  qualified opinion Amounts are so material or so pervasive that overall fairness of the statements is in question (highly material) When users are likely to make incorrecy decisions if they rely on the overall financial statements. Pervasiveness : when determining whether an exception is highly material, the extent to which exception affects different parts of the financial statements must be considered. For example, failure to record material sale  affects A/R, income tax expense, accrued income taxes, RE  affects current assets, total assets, current liabilities, owner’s equity, gross margin, operating income. Thus, the opinion would be adverse or disclaimer opinion. Materiality Decision

Materiality decisions—Non GAAP condition Client has failed to follow GAAP  unmodified, qualified, adverse o Dollar amounts compared with a benchmark Misstatements must be compared with some measurement base before a decision can be made about the materiality of the failure to follow GAAP. (net income, total asset, current asset) o Measurability The dollar amount of some misstatements cannot be accurately measured. o Nature of the item The following may affect a user’s decision and therefore the auditor’s opinion in a different way than most misstatement: 1. Transactions are illegal or fraudulent 2. An item may materially affect some future period, even though it is immaterial when only the current period is considered. 3. An item has a “psychic” effect (for example, the item changes a small loss to a small profit, maintains a trend of increasing earnings, or allows earnings to exceed analysts’ expectations). 4. An item may be important in terms of possible consequences arising from contractual obligations (for example, the effect of failure to comply with a debt restriction may result in a material loan being called). o Materiality Decisions—Scope Limitations Condition When there is a scope limitation in an audit, the audit report will be a standard unmodified report, a report with a qualified scope and opinion, or a disclaimer report depending on the materiality of the scope limitation. o

Discussion of Conditions Requiring a Modification of Opinion 

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Auditor’s scope has been restricted 1. Caused by a client  The possibility that management is trying to prevent discovery of misstated information  Disclaimer opinion 2. Caused by conditions beyond the control of either client or the auditor  A qualification of scope and opinion is more likely  When the auditor is appointed after the client’s balance sheet date. Statements are not in conformity with GAAP - When the auditor knows that the financial statements may be misleading because theywere not prepared in conformity with GAAP, and the client is unable or unwilling to correct the misstatement, he or she must issue a

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qualified or an adverse opinion, depending on the materiality of the item in question. - When the amount is so material  adverse - When the auditor decides that adherence to GAAP would result in misleading statements, there should be a complete explanation in an added paragraph. Auditor is not independent A disclaimer opinion is needed even though all the audit procedures considered necessary in the circumstances performed.

Auditor’s Decision Process for Audit Reports 1. Determine whether any condition exists requiring a departure from a standard unmodified opinion report 2. Decide the materiality for each condition 3. Decide the appropriate type of report for the condition, given the materiality level 4. Write audit report More Than One Condition Requiring a Departure or Modification

 The auditor is not independent and the auditor knows that the company has not followed generally accepted accounting principles.  There is a scope limitation and there is substantial doubt about the company’s ability to continue as a going concern.  There is a substantial doubt about the company’s ability to continue as a going concern and information about the causes of the uncertainties is not adequately disclosed in a footnote.  There is a deviation in the statements’ preparation in accordance with GAAP and another accounting principle was applied on a basis that was not consistent with that of the preceding year....