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Auditors’ Reports Expressing an independent and expert opinion on the airness o financial statements is the most requently perormed attestation service rendered by the public accounting proession. This opinion, which is expressed in the auditors’ report, provides users o financial statements with reasonable assurance that the statements are in conormity with the appropriate financial reporting ramework, most requently generally accepted accounting principles. In Chapter 2 we saw that the auditors’ standard report states that the audit was perormed in conormity with generally accepted auditing standards and expresses an opinion that the client’s financial statements are presented airly in conormity with generally accepted accounting principles. However, auditors cannot issue the standard report i: • There are conditions, although not departures rom GAAP, about which the readers o the financial statements should be inormed (e.g., a lack o consistent application o GAAP). • There are material departures rom GAAP in the client’s financial statements. • The auditors are unable to obtain sufcient appropriate audit evidence (e.g., due to client not retaining certain important records). Instead, they must modiy their report to communicate those matters. In this chapter we describe the dierent types o audit reports that auditors issue in various circumstances. Their goal in reporting is to present clearly the nature o the audit and their opinion on the financial statements.
Financial Statements and Standard Unmodified Audit Reports Because we are discussing audit reports on financial statements, we first briefly provide an overview o financial statements, including disclosures. Next, we discuss in detail the standard unmodified audit reports included in AICPA Auditing Standards Board and Public Company Accounting Oversight Board proessional standards.
Financial Statements
Auditors most requently report upon a complete set o financial statements: that is, the balance sheet, the income statement, the statement o retained earnings, and the statement o cash flows and related notes. 1 In some cases, the statement o retained earnings is either expanded to a statement o stockholders’ equity or combined with the income 1
As is discussed in further detail in Chapter 19, an auditor may report on less than the complete set of financial statements. Thus, for example, an auditor could issue an audit report with an opinion on a balance sheet alone. One issue that complicates matters is a GAAP requirement that when a company presents a balance sheet and an income statement, it must also present a statement of cash flows; if a statement of cash flows is omitted in this situation, a departure from GAAP exists.
17 Learning objectives After studying this chapter, you should be able to: LO1
Describe the standard audit report for nonpublic entity (nonissuer) audits.
LO2
Describe the standard audit report for public entity (issuer) audits.
LO3
Identify the circumstances that result in audit reports with emphasis of matter paragraphs added to reports with unmodified opinions.
LO4
Identify the circumstances that result in modified audit opinions.
LO5
Describe the auditors’ responsibilities for reporting on comparative financial statements.
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statement. Financial statements generally generally are presented in comparative orm or the current year and one or more preceding years. The financial statements or a parent corporation usually are consolidated with those o the subsidiaries. In the United States, these financial statements are most requently prepared ollowing the general-purpose framework reerred to as accounting principles principles generally accepted in the United States o America.2
Financial Statement Disclosures
The purpose o notes to financial statements is to achieve adequate disclosure o inormation required by generally accepted accounting principles (or any other financial reporting ramework ollowed [e.g., International Financial Reporting Standards ]) that cannot be adequately conveyed on the ace o the financial statements. Adequate disclosure in the notes to the financial statements is necessary or the auditors to issue an unmodified opinion on the financial statements. The Financial Accounting Standards Board (FASB), the Government Accounting Standards Board (GASB), the Federal Accounting Standards Advisory Board (FASAB), and the Securities and Exchange Commission (SEC) have issued numerous pronouncements that have added extensive disclosure requirements. Examples o these requirements include the disclosure o significant accounting policies, accounting changes, loss contingencies, and lease and post-retirement benefit inormation. In evaluating financial reporting disclosures, the auditors should keep in mind that disclosures are meant to supplement the inormation on the ace o the financial statements— not correct improper financial statement presentation. Thus, a note or supplementary schedule, no matter how skillully drated, does not compensate or the erroneous presentation o an item in the financial statements.
Comparative Financial Statements
Comparative financial statements are financial statements or one or more prior periods, included or comparison with the financial statements statements o the current period. Com parative financial statements allow users to identiy changes and trends in the financial position and operating results o a company over an extended period, and thus are more useul to investors and creditors than are financial statements or a single period. Publicly owned companies are required to include in their annual reports the balance sheets or each o the last two years and the related statements o income, retained earnings, and cash flows or each o the last three years. The auditors’ report covers all financial statements that are presented. Later in this chapter we will describe in detail the auditors’ reporting responsibilities when management presents comparative financial statements.
The Auditors’ Standard Report— Nonpublic Clients
Chapter 2 includes a standard audit report on the audit o a nonpublic company’s financial statements or two years. The ollowing is a nonpublic company standard unmodified report on financial statements or one year ( AICPA AU 700):
LO1
Independent Auditors’ Report
Describe the standard audit report or nonpublic entity (nonissuer) audits.
To the Board of Directors and Stockholders of ABC Company: We have audited the accompanying consolidated financial statements of ABC Company and its subsidiaries, which comprise the consolidated balance sheet as of December 31, 20X1, and the related consolidated statements of income, changes in stockholders’ equity and cash flows for the year then ended, and the related notes to the financial statements. Management’s Responsibility for the Financial Statement
Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with accounting principles generally accepted in the United
2
While financial statements may be prepared using a number of financial reporting frameworks other than GAAP (e.g., International Financial Reporting Standards, Cash Basis, Tax Basis), throughout this chapter we will ordinarily just refer to GAAP unless a distinction relating to another framework is being made.
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statement. Financial statements generally generally are presented in comparative orm or the current year and one or more preceding years. The financial statements or a parent corporation usually are consolidated with those o the subsidiaries. In the United States, these financial statements are most requently prepared ollowing the general-purpose framework reerred to as accounting principles principles generally accepted in the United States o America.2
Financial Statement Disclosures
The purpose o notes to financial statements is to achieve adequate disclosure o inormation required by generally accepted accounting principles (or any other financial reporting ramework ollowed [e.g., International Financial Reporting Standards ]) that cannot be adequately conveyed on the ace o the financial statements. Adequate disclosure in the notes to the financial statements is necessary or the auditors to issue an unmodified opinion on the financial statements. The Financial Accounting Standards Board (FASB), the Government Accounting Standards Board (GASB), the Federal Accounting Standards Advisory Board (FASAB), and the Securities and Exchange Commission (SEC) have issued numerous pronouncements that have added extensive disclosure requirements. Examples o these requirements include the disclosure o significant accounting policies, accounting changes, loss contingencies, and lease and post-retirement benefit inormation. In evaluating financial reporting disclosures, the auditors should keep in mind that disclosures are meant to supplement the inormation on the ace o the financial statements— not correct improper financial statement presentation. Thus, a note or supplementary schedule, no matter how skillully drated, does not compensate or the erroneous presentation o an item in the financial statements.
Comparative Financial Statements
Comparative financial statements are financial statements or one or more prior periods, included or comparison with the financial statements statements o the current period. Com parative financial statements allow users to identiy changes and trends in the financial position and operating results o a company over an extended period, and thus are more useul to investors and creditors than are financial statements or a single period. Publicly owned companies are required to include in their annual reports the balance sheets or each o the last two years and the related statements o income, retained earnings, and cash flows or each o the last three years. The auditors’ report covers all financial statements that are presented. Later in this chapter we will describe in detail the auditors’ reporting responsibilities when management presents comparative financial statements.
The Auditors’ Standard Report— Nonpublic Clients
Chapter 2 includes a standard audit report on the audit o a nonpublic company’s financial statements or two years. The ollowing is a nonpublic company standard unmodified report on financial statements or one year ( AICPA AU 700):
LO1
Independent Auditors’ Report
Describe the standard audit report or nonpublic entity (nonissuer) audits.
To the Board of Directors and Stockholders of ABC Company: We have audited the accompanying consolidated financial statements of ABC Company and its subsidiaries, which comprise the consolidated balance sheet as of December 31, 20X1, and the related consolidated statements of income, changes in stockholders’ equity and cash flows for the year then ended, and the related notes to the financial statements. Management’s Responsibility for the Financial Statement
Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with accounting principles generally accepted in the United
2
While financial statements may be prepared using a number of financial reporting frameworks other than GAAP (e.g., International Financial Reporting Standards, Cash Basis, Tax Basis), throughout this chapter we will ordinarily just refer to GAAP unless a distinction relating to another framework is being made.
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States of America; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of consolidated financial statements that are free from material misstatement, whether due to fraud or error. Auditors’ Responsibility
Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statement. The procedures selected depend on the auditors’ judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity’s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. Opinion
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of ABC Company and its subsidiaries as of December 31, 20X1, and the results of their operations and their cash flows for the year then ended in accordance with accounting principles generally accepted in the United States of America. February 5, 20X2 Williams & Co., LLP
Phoenix Arizona
Beore continuing, notice several details about this report. It has a title that includes the word independent. It is addressed to those or whom it is prepared, generally the audited company itsel or to those charged with governance. Ater the introductory paragraph, the report is divided into sections with headings. The introductory paragraph o the auditors’ report indicates that the financial statements have been audited. The section heading o Management’s Responsibility or the Financial Statement indicates that management is responsible or the preparation and air presentation o the financial statements, in accordance with generally accepted accounting principles (or another financial reporting framework such as cash basis, i appropriate) and its responsibility or internal control. The Auditors’ Responsibility section includes three paragraphs that indicate that it is the auditors’ responsibility to express an opinion on the financial statements based on audits conducted in accordance with generally accepted auditing standards, outline the nature o an audit, and conclude that the auditors believe that sufcient appropriate audit evidence has been obtained to provide a basis or the audit opinion. Finally, the Opinion Section presents the auditors’ opinion on whether the financial statements are in conormity with accounting principles generally accepted in the United States.3 3
Auditors sometimes have reporting responsibilities related to other legal and regulatory requirements. For example, for audits performed under Government Auditing Standards the auditor may be required to report on internal control over financial reporting and on compliance with laws, regulations, and other matters. It is when the relevant law or regulation requires or permits the auditors to report within the auditors’ report on the financial statements that this becomes relevant. In such a situation the overall report is divided by: • Report on Financial Statements. This heading is added following the opinion paragraph. • Report on Other Legal and Regulatory Requirements. This heading and the related report follow the opinion paragraph on the financial statements. Note that this treatment is not applicable for emphasis of matter or other matter paragraphs added to an audit report and is not required by the PCAOB.
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Historically, audit reports reerred simply to generally accepted auditing standards and generally accepted accounting principles. Today, however, a number o nations have their own generally accepted standards (principles), and those standards usually dier rom one another. To reduce conusion, audit reports issued in the United States now use terms such as “generally accepted auditing standards (United States o America)” or “auditing standards generally accepted in the United States o America.” A similar modification is made relating to generally accepted accounting principles. For simplicity’s sake, in our text discussion we will use the simpler historical terms or their abbreviations “GAAP” and “GAAS.” Notice that the audit report is signed with the name o the CPA firm, not the name o an individual partner in the firm. This signature stresses that it is the firm, not the individual, that takes responsibility or the audit report. I the CPA is practicing under his or her own name as a sole practitioner, the report is signed with the CPA’s personal signature. In addition, a sole practitioner should use I instead o we in the audit report.4 Also notice the date under the signature. The auditors’ report should not be dated earlier than the date on which the auditors have obtained sufcient appropriate audit evidence to support their opinion on the financial statements. Suf cient appropriate audit evidence has been obtained when all audit documentation has been reviewed, the financial statements (including notes) are prepared, and management has asserted that they have taken responsibility or these financial statements (ordinarily through a representation letter). The date o the audit report is quite significant because the auditors have a responsibility to perorm procedures through that date to search or any subsequent events that may aect the airness o the client’s financial statements (see Chapter 16), and due to requirements relating to changes in documentation that arise ater that date (see Chapter 5). It is important to note that under PCAOB standards, the report is dated as o the last day o field work, which is the day in which the auditors conclude their investigative procedures at the client’s ofces. An auditors’ report with an unmodified opinion may be issued only when the auditors have obtained suf cient appropriate audit evidence to conclude that the financial statements, as a whole, are not materially misstated.
The Auditors’ Standard Report— Public Clients
Standard Nos. 1 and 5 o the Public Company Accounting Oversight Board 5 modiy the wording o the standard audit report or audits o public companies. The resulting report is ollows.
LO2
Report of Independent Registered Public Accounting Firm
Describe the standard audit report or public entity (issuer) audits.
To the Board of Directors and Stockholders of Southwest Airlines Co.: We have audited the accompanying consolidated balance sheets of Southwest Airlines Co. as of December 31, 2009 and 2008, and the related consolidated statement of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2009. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
We made this line roman for consistency
4
Section ISA 700 of the International Standards on Auditing allows the signature to be that of the audit firm, the personal name of the auditor who directed the audit, or both, as appropriate for the particular jurisdiction. 5 The titles of Nos. 1 and 5 are References in Auditors’ Reports to the Standards of the Public Com pany Accounting Oversight Board and An Audit of Internal Control over Financial Reporting Performed in Conjunction with an Audit of Financial Statements, respectively.
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In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Southwest Airlines Co. at December 31, 2009 and 2008, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Southwest Airlines Co.’s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated January 29, 2010, expressed an unmodified opinion thereon. Dallas, Texas January 29, 2010
Ernst & Young LLP
There are a number o dierences between this PCAOB audit report and the report used or audits o nonpublic companies. The primary dierences are that the PCAOB report: • • • •
Includes the words “Registered” in the title. Reerences standards o the PCAOB rather than generally accepted auditing standards. Includes less detailed discussions o management and auditor responsibilities. Includes an additional paragraph indicating that the auditors have also issued a report on the client’s internal control over financial reporting. (For a description o audits o internal control over reporting, see Chapters 7 and 18.) • Does not include section headings. We will now turn our attention to modifications o auditors’ standard reports. Although our illustrations using audit reports are or nonpublic companies, they require ew or no changes to be used with the PCAOB audit report.
Expression of an Opinion The options when expressing an opinion on financial statements may be summarized as being either unmodified or modified as ollows: Unmodified Opinions
• Unmodified opinion—standard report. This report expresses a “clean opinion” and may be issued only when the auditors have obtained suf cient appropriate audit evidence to conclude that the financial statements, taken as a whole, are not materially misstated and there is no need to modiy the report or an emphasis of matter paragraph, an other matter paragraph or to indicate a group audit situation.6 • Unmodified opinion with an emphasis o matter paragraph. An emphasis o matter paragraph in an audit report ollows the opinion paragraph and is included to reer to a matter that is appropriately presented or disclosed in the financial statements but is being emphasized through the audit report. In certain circumstances an emphasis o matter paragraph is required (e.g., when there is substantial doubt about a company’s ability to continue as a going concern and when the company changes accounting principles). In others it is included at the auditors’ discretion (e.g., an uncertainty relating to uture exceptional litigation, significant transactions with related parties, and unusually important subsequent events). 6
PCAOB standards use the term “unqualified” rather than “unmodified.” In 2010, the AICPA Auditing Standards Board switched from using “unqualified” to align its terminology with International Standards on Auditing.
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• Unmodified opinion with an other matter paragraph. An other matter paragraph in an audit report ollows the opinion paragraph (and any emphasis o matter paragraph) and reers to a matter other than those presented or disclosed in the audited financial statements. The matter is, in the auditors’ judgment, relevant to users’ understanding o the audit, the auditors’ responsibilities, or the auditors’ report. These may arise in a variety o circumstances, including those presented in Chapter 16, relating to other inormation in documents containing audited financial statements and required supplementary inormation. Also, as discussed in Chapter 19, an other matter paragraph is added when auditing financial statements prepared in accordance with special-purpose rameworks. In this chapter we discuss other matter paragraphs relating to reporting on comparative statements when there are predecessor auditors and to alert readers about the intended use o an audit report when it is not or general use. • Unmodified opinion on group financial statements. This circumstance involves a situation in which two or more CPA firms are involved in the audit o components o group financial statements (e.g., the component auditors may audit one subsidiary o an organization structured as a parent company with five subsidiaries). When the audit firm that does the remainder o the audit does not wish to take responsibility or the work o the component auditors, the audit report is modified throughout to divide responsibility between the CPA firms. This situation is unique in that the report modifications do not involve inclusion o an emphasis o matter or an other matter paragraph. Modified Opinions
• Qualified opinion. A qualified opinion states that the financial statements are presented airly in conormity with generally accepted accounting principles “except or” the eects o some matter. Qualified opinions are issued when the financial statements are materially misstated (“a departure rom GAAP”) or when the auditors are unable to obtain suf cient appropriate audit evidence on which to base the opinion (“a scope limitation”). In both cases, the likely eects, while material, are not considered pervasive. All significant reasons or the issuance o a qualified opinion should be set orth in a basis for modification paragraph (expanatory paragraph under PCAOB standards) that precedes the opinion paragraph. • Adverse opinion. An adverse opinion states that the financial statements are not presented airly in conormity with generally accepted accounting principles. Auditors issue an adverse opinion when the deficiencies in the financial statements are both material and pervasive. All significant reasons or the issuance o an adverse opinion should be set orth in a basis or modification paragraph that precedes the opinion paragraph. • Disclaimer o opinion. A disclaimer o opinion most requently is the result o a scope limitation that creates a situation in which the auditors are unable to obtain sufcient appropriat e audit evidence on which to base the opinion, and they conclude that the possible eects on the financial statements o undetected misstatements, i any, could be both material and pervasive. A disclaimer is not an opinion; it simply states that the auditors do not express an opinion on the financial statements. All significant reasons or the issuance o a the disclaimer o opinion should be set orth in a basis or modification paragraph that precedes the opinion paragraph. As we discuss later in this chapter, disclaimers may also result rom substantial doubt about a client’s ability to continue as a going concern and multiple uncertainties relating to the financial statements. We structure our discussion o audit reports around the above two basic types o opinions— unmodified and modified opinions. Since several circumstances may result in either an unmodified or a modified opinion (e.g., substantial doubt about going-concern status and uncertainties), we emphasize that circumstance in the category in which the report is most requently issued.
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Reports with an Unmodified Opinion and an Emphasis of Matter Paragraph LO3 Identiy the circumstances that result in audit reports with emphasis o matter paragraphs added to reports with unmodified opinions.
Substantial Doubt about a Company’s GoingConcern Status
Auditors express an unmodified opinion when they are able to obtain sufcient appropriate audit evidence to conclude that the financial statements as a whole are ree rom material misstatement. As indicated in the preceding section, under certain circumstances auditors add an additional paragraph, reerred to as an emphasis o matter paragraph, to the report, emphasizing a matter relating to the financial statements or the audit ( AICPA AU 706). This paragraph always ollows the opinion paragraph and states that the auditors’ opinion is not modified with respect to t his matter.7 The proessional standards require that auditors evaluate whether there is substantial doubt about the client’s ability to continue as a going concern or a reasonable period o time, which is defined as not to exceed one year beyond the date o the financial statements being audited. Going-concern status is a significant issue or users o financial statements, because assets and liabilities are normally recorded and classified on the assumption that the company will continue to operate. Assets, or example, may be presented at amounts that are significantly greater than their liquidation values. The proessional standards state that although the auditors are not required to per orm procedures specifically designed to test the going-concern assumption, they must evaluate the assumption in relation to the results o the normal audit procedures. When perorming risk assessment procedures, the auditors should consider whether there are events or conditions that indicate that there could be substantial doubt about the entity’s ability to continue as a going concern. Also, throughout the audit the auditors should remain alert or audit evidence indicating such substantial doubt. Conditions that may cause the auditors to question the going-concern assumption include negative cash flows rom operations, deaults on loan agreements, adverse financial ratios, work stoppages, and legal proceedings. When such conditions or events are identified, the auditors should gather additional inormation and consider whether management’s plans or dealing with the conditions are likely to mitigate the problem. I, ater evaluating the inormation and management’s plans, the auditors conclude that the substantial doubt is resolved, they may issue a standard unmodified report. I, on the other hand, substantial doubt still exists about the company’s ability to continue as a going concern or a period o one year rom the balance sheet date, the auditors should add an emphasis o matter paragraph to their unmodified opinion or issue a disclaimer o opinion.8 Including an emphasis o matter paragraph with an unmodified opinion is the most requent resolution. The ollowing is an example o an emphasis o matter paragraph relating to substantial doubt about a company’s ability to continue as a going concern (emphasis added): Emphasis of Matter
The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company has suffered negative cash flows from operations and has an accumulated deficit, [conditions] that raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. Our opinion is not modified with respect to this matter.
7
PCAOB standards require that consistency and going-concern emphasis of matter paragraphs follow the opinion paragraph of the audit report; other emphasis of matter paragraphs may either precede or follow the opinion paragraph. PCAOB standards also do not require a statement concerning the opinion not being modified. ( International Standards of Auditing (ISA) are consistent with GAAS in this area.) 8 The International Standards on Auditing (ISA 570) state that in rare cases involving multiple material uncertainties that are significant to the financial statements the auditor may consider it appropriate to issue a disclaimer of opinion. This is consistent with GAAS and PCAOB standards.
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Regardless o whether the auditors decide to add an emphasis o matter paragraph to a report with an unmodified opinion or to issue a disclaimer o opinion, the auditors should consider the adequacy o financial statement disclosures that relate to the firm’s goingconcern status. Financial statement disclosures include: • Pertinent conditions and events giving rise to the substantial doubt and their possible eects. • Management’s evaluation o the significance o the conditions and eect and management’s plans or dealing with them. • Possible discontinuance o operations. • Inormation about the recoverability or classification o recorded asset amounts and the amounts and classification o liabilities. When conditions and events indicate that there could be substantial doubt about the entity’s ability to continue as a going concern, the auditors should document in the working papers the conditions and events and significant management plans. In addition, they should document the auditing procedures perormed to evaluate management’s plans, the conclusion about whether substantial doubt exists, and their consideration o the adequacy o financial statement disclosures. I those financial statement disclosures are inadequate, a qualified or adverse opinion is appropriate due to the departure rom generally accepted accounting principles. Recall that this section is entirely based on the client’s “substantial doubt” about the client’s ability to continue as a going concern. What about the situation in which liquidation o the company is imminent (that is, the company definitely is not a going concern)? In such a case, using the liquidation basis o accounting is considered ollowing generally accepted accounting principles. The auditors’ report ordinarily should use an emphasis o matter paragraph that states that the company has changed the basis o accounting rom the going-concern basis to a liquidation basis. Consequentially, to ollow a goingconcern basis o accounting when liquidation is imminent is a departure rom GAAP, which results in an adverse opinion due to its materiality and pervasiveness.
Generally Accepted Accounting Principles Not Consistently Applied
United States auditing standards or both public (PCAOB AS 1) and nonpublic companies (ASB AU 708) require that auditors evaluate the client’s current period financial statements or consistency o application o accounting principles with the past.9 Which periods should be considered in this evaluation? Both Auditing Standards Board and PCAOB standards base that decision on the periods covered by the auditors’ report on the financial statements. • When the auditors are reporting only on the current period, they should evaluate whether the current-period financial statements are consistent with those o the preceding period, regardless o whether the preceding period is presented. • When the auditors are reporting on two or more periods, they should evaluate consistency between such periods and the consistency o such periods with the period prior thereto i that prior period is presented with the financial statements being reported upon. When the client makes a change in accounting principles, the nature o, justification or, and eect o the change are reported in a note to the financial statements or the period in which the change is made. The auditors should evaluate the change by determining whether it meets the ollowing our requirements: 1. 2. 3. 4. 9
The newly adopted principle is generally accepted. The method o accounting or the eect o the change is in conormity with GAAP. The disclosures related to the change are adequate. Management has justified that the new accounting principle is preerable.
International Standards on Auditing (ISA 706) allow, but do not require, an emphasis of matter situation relating to a properly accounted for change in accounting principles.
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When the auditors believe that the new principle meets the above requirements, an emphasis o matter paragraph is added to the audit report to highlight the lack o consistent application o acceptable accounting principles; but the opinion remains unmodified. Following is an example o an emphasis o matter paragraph that would ollow the opinion paragraph: Emphasis of Matter
As discussed in Note 5 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards Update No. XXX, Provide Title, as of December 31, 20X8. Our opinion is not modified with respect to this matter.
When the auditors believe that the new principle does not meet one or more o the above requirements, a departure rom generally accepted accounting principles exists. In such a circumstance, the auditors should issue either a qualified or an adverse opinion. A client’s correction o a material misstatement in previously issued financial statements also results in addition o an emphasis o matter paragraph to the audit report. The paragraph is only included in the year o correction and includes a statement that the previously issued financial statements have been restated or correction o a material misstatement and a reerence to the entity’s disclosure o the correction in the financial statements. Among situations that ordinarily do not result in an emphasis o matter paragraph on consistency are changes in accounting estimates (e.g., changing the lie o a fixed asset) and changes in principles with an immaterial eect (even i the eects are expected to be material in the uture); absent other circumstances, a standard unmodified opinion may be issued in the year o the change. Finally, because consistency is a between-periods concept, a consistency modification is not appropriate or a company in the first year o its existence.
Auditor Discretionary Circumstances That Result in an Emphasis of Matter Paragraph
While the proessional standards require auditors to include an emphasis o matter paragraph in the circumstances presented previously, in t he ollowing circumstances the auditors may elect to include an emphasis o matter paragraph. Uncertainties Uncertainties are situations in which conclusive audit evidence concerning the ultimate outcome cannot be expected to exist at the t ime o the audit, since that outcome will occur in the uture. While all financial statements are aected to some extent by uncertainties, it is only or an uncertainty whose outcome is unusually important that auditors consider adding an emphasis o matter paragraph: or example, unusually important ongoing litigation or regulatory action in process against the client. The ollowing shows the nature o an emphasis o matter paragraph describing an uncertainty: Emphasis of Matter
As discussed in Note X to the financial statements, the company is a defendant in a lawsuit [briefly describe the nature of the litigation consistently with the Company’s description in the note to the financial statements]. Our opinion is not modified with respect to this matter.
Adding an emphasis o matter paragraph or matters such as the above is at the discretion o the auditors. The major assumption underlying the inclusion o an emphasis o matter paragraph is that the matter is adequately disclosed in the notes to the financial statements. The auditors simply choose to emphasize it. As is the case with other emphasis o matter paragraphs, a discretionary emphasis paragraph ollows the opinion paragraph. While an unmodified opinion with an emphasis o matter paragraph is the most requent resolution regarding a particularly important uncertainty, there are situations in
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which a disclaimer may be issued. When multiple uncertainties cause the auditors to conclude that it is not possible to orm an opinion on the financial statements as a whole due to the interaction and cumulative possible eects o the uncertainties, a disclaimer may be appropriate. I a matter such as described above is not adequately disclosed in the financial statements, a departure rom GAAP exists; as described later in the chapter, either a qualified or an adverse opinion is then appropriate. Additional Circumstances That May Result in an Emphasis o Matter Paragraph. Auditors also may at their own discretion choose to add an emphasis o matter paragraph to a report with an unmodified opinion or other circumstances relating to the financial statements. Examples o such matters include:
• Significant related party transactions described in a note to the financial statements. • The company is a component o a larger business enterprise. • Unusually important significant events. Note that the matter should relate to the financial statements, not to the audit itsel (e.g., adding an emphasis o matter paragraph relating to an audit procedure perormed would not be appropriate).
Group Financial Statements
Group financial statements include financial inormation o a company that is composed o more than one component. For example, group financial statements may include financial inormation o a parent and one or more subsidiaries, or joint ventures. When one CPA firm audits the entire group, no particular audit reporting complications arise. It is when one or more components are audited by component auditors other than the group auditors 10 that issues arise about the component auditors’ and group auditors’ responsibility or planning and perorming the audit and reporting. Note that this situation involves two or more CPA firms auditing one year— not dierent CPA firms auditing each year o comparative financial statements. The most common group audit is one in which auditors o one firm rely upon the work o auditors who audited a component o a consolidated entity; or example, the component auditors may have audited one o the company’s five subsidiaries while the group auditors audited the other our as well as the consolidation o the client’s financial statements. The issue here is auditor responsibility relating to the overall consolidated entity—the group financial statements. When the component auditors are involved in an audit, the group auditors should determine whether suf cient appropriate audit evidence can reasonably be expected to be obtained regarding the overall group controls, the consolidation process, and the financial inormation o the components. In addition, the group engagement team should obtain an understanding o: • Whether the component auditors are competent and understand and will comply with all ethical requirements, particularly independence. • The extent to which the group engagement team will be involved with the component auditors. • Whether the group engagement team will be able to obtain necessary inormation on the consolidation process rom the component auditors. • Whether the component auditors operate in a regulatory environment that actively oversees auditors. 10
GAAS (ASB AU 600) and International Standards of Auditing (ISA 600) use the terms “group engagement partner” and “group engagement team”—for simplicity sake, in parts of the discussion, we will also use the term “group auditors.” Also, previously, the group auditors were referred to as the “principal auditors ” and the component auditors as the “other auditors.” The terms “principal auditors” and “other auditors” are still used in PCAOB auditing standards (PCAOB AU 543).
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The group auditors should communicate with the component auditors. Specifically, the group auditors should (1) inorm the component auditors o how their work will be used, (2) communicate ethical requirements, (3) provide a list o related parties, and (4) identiy significant risk o misstatements o the group financial statements. Subsequently, the component auditors should communicate matters relevant to the group auditors’ conclusions on the group audit. I the group auditors encounter problems in perorming the above procedures, they should obtain suf cient appropriate audit evidence without using the work o the component auditors. In addition, the group auditors will not use work o the component auditors when the component auditors’ work is unlikely to be completed in time to meet group auditors’ requirements, or when dierences exist in auditing standards applied by the component auditors. The group auditors should establish an overall group audit strategy and develop a group audit plan. In developing the group audit plan, the group auditors should determine whether the work o the component auditors will be reerred to in the group audit report. Under GAAS and PCAOB standards, the group auditors have two basic reporting alternatives: 11 1. Make reerence to the component auditors. When the group auditors make reerence to the work perormed by the component auditors, they communicate that the source o the group auditors’ audit evidence on the component is obtained through the com ponent auditors. In essence it divides the responsibility or the engagement among the participating CPA firms. Historically, this type o report has oten been called a shared responsibility opinion, even though it is signed only by the group auditors. When the group auditors decide to make reerence to the component auditors, they should perorm the procedures described previously relating to the availability o suf cient appropriate audit evidence and characteristics o the component auditors. In addition, the group auditors should read the component’s financial statements and the component auditors’ report on those statements to identiy significant findings and issues. I considered necessary, the group auditors should communicate with the com ponent auditors. Also, the group auditors may only make reerence to the component auditors (a) when the component’s financial statements are prepared using the same financial reporting ramework (e.g., GAAP) as the group, and (b) the component auditors have perormed an audit and issued an audit report that is not restricted as to use. A shared responsibility opinion indicates the portion o the engagement perormed by the component auditors in terms o dollars or percentages in the Auditors’ Respon sibility section and reers to the component auditors in the Opinion section. The actual report modifications are as presented below. Auditors’ Responsibility
Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We did not audit the financial statements of B Company, a wholly owned subsidiary, which statements reflect total assets and revenues constituting 20 percent and 22 percent, respectively, of the related consolidated totals. Those statements were au dited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for B Company, is based solely on the report of the other auditors. We conducted our
audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditors’ judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditors consider internal control relevant to the entity’s preparation and fair presentation
11
International Standards on Auditing (ISA 600) do not permit the audit report to make reference to a component auditors unless required by law or regulation.
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of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. Opinion
In our opinion , based on our audit and the report of the other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of ABC Company and its subsidiaries as of December 31, 20X1 and 20X0, and the results of their operations and their cash flows for the years then ended in accordance with accounting principles generally accepted in the United States of America.
The additional wording in the illustration is not a qualification, but rather an indication o the divided responsibility between the auditors who conducted the audits o the various portions o the overall financial statements.12 What i the component auditors modiy the opinion o their report on the component? Are the group auditors required to qualiy the report on the consolidated financial statements? The answer to this question depends on the materiality o the matter. The consolidated financial statements ordinarily will have much larger amounts and totals than those o the component. Matters that were material to the component’s financial statements may be quite insignificant to the consolidated entity. To determine whether a qualification is in order, the group auditors must evaluate the materiality o the matter in relation to the consolidated financial statements. 2. Make no reerence to the component auditors. I the group auditors make no reerence in their report to the portions o the engagement perormed by the component auditors, they assume responsibility or the entire audit. This approach is usually ollowed when the component auditors are well known or when the group auditors are responsible or hiring the component auditors. Also, when difculties arise relating to the component auditors’ competence or work, the group auditors may decide to audit the component and not reer to the component auditors. I the group auditors elect to make no reerence, they will issue the standard auditors’ report with no additional wording. When the group auditors decide not to make reerence to the work o the component auditors, they must perorm certain additional audit procedures. First, the group auditors should evaluate the appropriateness o perormance materiality at the component level. The additional required procedures relating to the component depend upon whether that component is considered to be a significant component; a significant component is one identified by the group engagement team as having financial significance to the group or, due to its nature, is likely to include significant risks o material misstatement o the group financial statements. Figure 17.1 summarizes the audit work that ordinarily must be perormed or components. Group auditors are never orced to rely on the work o other auditors. Instead, they may insist upon personally auditing any aspect o the client’s operations. I the client reuses to permit them to do so, the auditors may regard this as a scope limitation and, depending upon materiality, issue a qualified report or a disclaimer o opinion. As a practical matter, opinions are seldom modified or this reason. Satisactory arrangements about who will audit the various aspects o a client’s business normally will be worked out beore the audit begins. 12
Another acceptable, although less frequently used, option allows the group auditor to obtain the permission of the component auditors to explicitly use that auditors’ name in the audit report. In such circumstances the component auditors’ report must also be presented with the report of the group auditors.
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FIGURE 17.1 Additional Procedures When Not Making Reference to the Component Auditors
Component Nature
673
Audit Procedures
Not significant
The group engagement team should perform analytical procedures at the group level. Audit additional components if sufficient appropriate audit evidence has not been obtained.
Significant due to its individual financial significance to the group
1. The group auditors or component auditors should perform an audit of the component, adapted as necessary to the needs of the group engagement team, using the materiality of the component. 2. The group engagement team should be involved in the risk assessment and should: • Discuss with the component auditors or component management the component’s business activities of significance to the group. • Discuss with the component auditors the susceptibility of the component to material misstatement. • Review the component auditors’ documentation of identified significant risks of material misstatement of the group financial statements.
Significant because it is likely to include significant risks of material misstatement of the group financial statements
1. The group auditors or the component auditors: • Should perform an audit of the component, adapted as necessary to the needs of the group engagement team, using the materiality of the component. • Should audit one or more component account balances, classes of transactions, or disclosures that relate to the significant risks. • Should perform specified audit procedures relating to the likely significant risks of material misstatement of the group financial statements. 2. Requirement 2 above.
Figure 17.2 summarizes important points related to emphasis o matter paragraphs and group audits.
FIGURE 17.2
Summary of Emphasis of Matter Paragraphs and Group Audits
Matter Giving Risk to Emphasis of Matter Paragraph Going Concern —Substantial doubt about ability to remain a going concern Consistency —GAAP not consistently applied A uditor Discretionary—Circumstances in which the auditors may add an emphasis of matter paragraph (e.g., significant related party transactions, significant events, or uncertainty) Group Audits
Effect on Audit Report If Matter Is Properly Presented
Effect on Audit Report If the Matter Is Improperly Presented in Financial Statements
Emphasis of matter paragraph added after the opinion paragraph. (Going concern and uncertainties may also lead to disclaimers of opinion.)
A departure from GAAP is involved and the auditors modify the opinion paragraph to either a qualified or adverse opinion and add a basis for modification paragraph preceding the opinion paragraph.
The component auditors are referred to when the group auditors do not take responsibility for the component auditors’ work. If the group auditors take responsibility, no modification of the audit report is necessary.
Not applicable because it is an auditor reporting concern.
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Modified Opinions LO4 Identiy the circumstances that result in modified audit report opinions.
Modified opinions are required in two circumstances: • Materially misstated financial statements (i.e., a “departure rom GAAP”) —The auditors conclude that the financial statements as a whole are materially misstated. • Inability to obtain sufcient appropriate audit evidence (i.e., a “scope limitation”) — The auditors are unable t o obtain suf cient appropriate audit evidence to conclude that the financial statements as a whole are ree rom material misstatements (ASB AU 705; PCAOB AU 508). Recall rom earlier in the chapter that there are three types o modified opinions: qualified opinions, adverse opinions, and disclaimers o opinion. Figure 17.3 describes the situations in which each type o modified opinion is issued. As indicated in Figure 17.3, materially misstated financial statements result in either a qualified opinion or an adverse opinion. Similarly, an inability to obtain sufcient appro priate audit evidence leads to either a qualified opinion or a disclaimer opinion based on the possible eects on the financial statements o undetected misstatements. In both situations the decision is based on whether misstatements are both material and pervasive. In the context o misstatements, pervasive is the term used to describe the eects on the financial statements o misstatements (departures rom GAAP) or the possible eects on the financial statements o misstatements (scope limitations). Eects o misstatements become pervasive when, in the auditors’ judgment, they meet one or more o the ollowing three criteria: • They are not confined to specific elements, accounts, or items o the financial statements. • I confined, they represent or could represent a substantial proportion o the financial statements. • In relation to disclosures, they are undamental to users’ understanding o the financial statements. When a modified opinion is issued, the report includes a basis or modification paragraph prior to the opinion paragraph. The ollowing sections discuss modified opinions (1) or misstated financial statements and (2) or the inability to obtain sufcient appro priate audit evidence.
Materially Misstated Financial Statements (“Departures from GAAP”)
The auditors sometimes do not agree with the accounting principles used in preparing the financial statements—that is, they believe that the financial statements depart rom GAAP. As indicated in Figure 17.3, they must consider the materiality o the eects o any departure rom GAAP to determine the appropriate type o audit report to issue. When the eects o the departures are immaterial, an unmodified opinion may be issued: when the eects are material, the auditors must issue either a qualified opinion or an adverse opinion based on the pervasiveness o the misstatement.
FIGURE 17.3
Auditors’ Judgment about the Pervasiveness of the Effects or Possible Effects on the Financial Statements
Modified Audit Opinions
Nature of Matter Giving Rise to the Modification
Not Material (accordingly, also not pervasive)
Material but not Pervasive
Material and Pervasive
Materially Misstated Financial Statements (Departure from GAAP)
Unmodified
Qualified
Adverse
Inability to Obtain Sufficient Appropriate Audit Evidence (Scope Limitation)
Unmodified
Qualified
Disclaimer
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The distinction between the eects o departures rom generally accepted accounting principles that are material but not pervasive and those that are material and pervasive is a matter o proessional judgment. In the discussions that ollow, it will not be practical to pres ent suf cient detail or readers to make these judgme nts. Thereore, we will either (1) use the terms material, but not pervasive and material and pervasive, or (2) use terms rom the criteria or when a misstatement is pervasive, such as “a substantial proportion o the financial statements” or “undamental to users’ understanding.” When the report is qualified or a departure rom GAAP, the modification involves adding a basis or modification paragraph immediately above the opinion paragraph and qualiying the opinion paragraph. The opinion section should have a heading indicating the nature o the opinion and including the phrase except or the eects o the matter(s) described in the Basis or Qualified Opinion paragraph.13 The ollowing is an example o basis or modification and opinion paragraphs o an audit report qualified or a departure rom generally accepted accounting principles. The report’s other paragraphs would contain standard wording.
Basis for Qualified Opinion
The company has excluded from property and debt in the accompanying balance sheets certain lease obligations that, in our opinion, should be capitalized in order to conform with accounting principles generally accepted in the United States of America. If these lease obligations were capitalized, property would be increased by $15,000,000, long-term debt by $14,500,000, and retained earnings by $500,000 as of December 31, 20X8. Additionally, net income would be increased by $500,000 and earnings per share would be increased by $1.22 for the year then ended. Qualified Opinion
In our opinion, except for the effects of not capitalizing certain lease obligations as discussed in the Basis for Qualified Opinion paragraph, the financial statements referred to above present fairly, in all material respects, the financial position of Wend Company as of December 31,20X8, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.
I the material misstatement is considered pervasive, an adverse opinion is appro priate. An adverse opinion is the opposite o an unmodified opinion; it states that the financial statements do not present airly the financial position, results o operations, and cash flows. When the auditors express an adverse opinion, they should disclose in a separate basis or modification paragraph similar to that o a report with a qualified opinion as illustrated above (although a pervasiveness o misstatement may require a longer paragraph). An illustration o an adverse opinion paragraph ollows:
Adverse Opinion In our opinion , because of the significance of the matter discussed in the Basis for Adverse Opinion paragraph, the consolidated financial statements referred to above do not express fairly the
financial position of Wend Company as of December 31, 20X8, and the results of its operations and its cash flows for the year then ended.
A material misstatement may exist due to the omission o inormation; that is, disclosures required by GAAP or a air presentation may have been omitted. In such a circumstance, i, ater communicating with those charged with governance, the 13
International Standards on Auditing (ISA 705) follow the same approach. PCAOB standards are similar, but rather than “Basis for Modification Opinion paragraph” the phrase used is “preceding paragraph.” The PCAOB also follows this approach for adverse opinions and disclaimers of opinion.
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inormation is still considered necessary and omitted, the auditors will issue a qualified or adverse opinion based upon the pervasiveness o the resulting misstatement.14 The proessional standards require the auditors to describe in the basis or modification paragraph the nature o the omitted inormation and include the omitted inormation i it is practicable to do so. Practicable, as used here, means that the inormation is reasonably obtainable rom the accounts and records and that in providing the inormation in the report the auditors do not assume the position o a preparer o the financial statements. For example, the auditors would not be expected to prepare a basic financial statement or segment inormation and include it in the auditors’ report when management omits such inormation. Also, disclosing the inormation in the basis o modification paragraph would not be practicable i the inormation: • Has not been prepared by management. • Is otherwise not readily available. • In the auditors’ judgment would be unduly voluminous in relation to the auditors’ report. Ordinarily, a client that is reluctant to make a particular disclosure would rather disclose the inormation in a note than have it highlighted in the auditors’ report. Thereore, very ew auditors’ reports actually are qualified because o inadequate disclosure. Instead, the requirements o the proessional standards usually convince the client to include the necessary disclosure among the notes to the financial statements.15
Inability to Obtain Sufficient Appropriate Audit Evidence (Scope Limitation)
Limitations on the scope o an audit may create a situation in which the auditors are unable to obtain suf cient appropriate audit evidence. Such limitations may occur due to: • Circumstances beyond the control o the client (e.g., important accounting records were destroyed), • Circumstances relating to the nature and timing o the auditors’ work (e.g., the auditors are hired too late to observe the client’s beginning inventory16). • The client (e.g., the client’s reusal to allow the auditors to send confirmations to customers). Client-imposed limitations are very significant since they may have other implications or the audit, such as or the auditors’ assessment o raud risks and consideration o whether to continue the engagement or to withdraw. I a management imposes a imitation, the auditors should communicate the limitation to those charged with governance. When a scope limitation is encountered, the auditors attempt to obtain sufcient appro priate audit evidence by perorming alternative procedures. I those procedures provide 14
As indicated in footnote 1, GAAP require that when a balance sheet and an income statement are presented, a statement of cash flows should also be presented and its omission is a departure from GAAP. Historically this has led to a qualified opinion, although the current GAAS standards are silent on whether a qualified opinion or an adverse opinion standard should be issued. PCAOB standards, in this case the superseded GAAS standards that were adopted by the PCAOB as interim standards, still recommend a qualified opinion. International Auditing Standards do not explicitly address omission of the statement of cash flows. 15 Rule 203 of the AICPA Code of Professional Conduct recognizes that in unusual circumstances a departure from accounting principles may be justified. However, the FASB does not allow such a departure from authoritative body pronouncements and this type of report is not generally issued. Under a financial reporting framework that allows such a departure, when the auditors agree with such departure, the auditors may issue a report with an unmodified opinion, but must disclose the departure in an emphasis of matter paragraph after the opinion paragraph. When the auditors do not agree that the departure is justified, a qualified or an adverse opinion is appropriate. Note that it is very seldom that the auditors would consider such a departure as justified under any financial reporting framework. 16 Note that, even though this may be the “fault” of the client, it is not considered a limitation imposed by management because the client is not refusing to allow the auditors to perform a procedure that is possible to perform.
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the required evidence, no report modification is necessary. I they do not, a decision needs to be made about whether a qualified opinion is necessary or whether the possible eects on the financial statements are so pervasive as to require a disclaimer o opinion. I the auditors decide that the possible eects on the financial statements o undetected misstatements, i any, could be material but not pervasive, a qualified opinion is appro priate. The report will include a Basis or Modification Paragraph and a modification o the opinion paragraph as ollows (the remainder o the report uses the standard wording):
Basis for Qualified Opinion
We were unable to obtain audited financial statements supporting the Company’s investment in a foreign affiliate stated at $20,500,000, or its equity in earnings of that affiliate of $6,250,450, which is included in net income, as described in Note 8 to the financial statements; nor were we able to satisfy ourselves as to the carrying value of the investment in the foreign affiliate or the equity in earnings by other auditing procedures. Qualified Opinion
In our opinion, except for the effects of such adjustments, if any, as might have been determined to be necessary had we bee n able to examine evidence regarding the foreign affiliate investment and earnings, the financial statements referred to above present fairly, in all material respects,
the financial position of XYZ Company as of December 31, 20XX, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.
Notice in the opinion paragraph that the qualification is worded as being due to the possi ble eects o the matter(s) on the financial statements, and not to the scope limitation itsel. When the auditors conclude that the possible eects on the financial statements could be both material and pervasive, a disclaimer o opinion is appropriate. A disclaimer of opinion is no opinion. Auditors issue a disclaimer whenever they are unable to orm an opinion or have not ormed an opinion about the airness o presentation o the financial statements. The ollowing is an example o the opinion paragraph when a disclaimer o opinion is issued (the basis or modification paragraph is similar to that presented or a qualified opinion):
Disclaimer of Opinion Because of the significance of the matter described in the Basis for Disclaimer of Opinion paragraph, we have not been able to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion. Accordingly, we do not express an opinion on these financial statements.
Scope Limitations versus Uncertainties It is important to be able to distinguish between inability to obtain sufcient appropriate audit evidence (a scope limitation) and an uncertainty. This is because a scope li mitation results in either a qualified opinion or disclaimer o opinion, while an uncertainty ordinarily results in a report with an unmodified opinion and an emphasis o matter paragraph (or, less requently, a disclaimer o opinion). An inability to obtain sufcient appropriate audit evidence (a scope limitation) occurs in situations in which audit evidence should be available and is not—due to circumstances beyond the control o the organization, circumstances dealing with the timing o the auditors’ work, or limitations imposed by management. Alternatively, an uncertainty involves a situation that is expected to be resolved at a uture date, at which time conclusive audit evidence concerning its outcome would be expected to become available. Complicating the matter is the act that a situation involving an uncertainty may also involve a scope limitation. As an example, assume that an uncertainty exists relating to the uture outcome o a lawsuit against the company. Also assume that the lawyer engaged by the client who has devoted substantive attention to the matter reuses to
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provide appropriate inormation on the uncertainty. Here the lawyer’s reusal to reply may result in a lack o sufcient appropriate audit evidence (a scope limitation) relating to the litigation (an uncertainty). The appropriate audit opinion would be either qualified or a disclaimer o opinion. A Disclaimers Is Not an Alternative to an Adverse Opinion A disclaimer cannot be issued when the auditors have ormed an opinion on the financial statements. For example, i the auditors have already ormed an opinion that the financial statements are materially and pervasively misstated, an adverse opinion is appropriate. A disclaimer o opinion cannot be used as a way to avoid expressing an adverse opinion. In act, even when auditors issue a disclaimer o opinion, they should express in the basis or modification paragraphs o their report any and all material reservations they have concerning the financial statements. These reservations would include any material departures rom generally accepted accounting principles, including inadequate disclosure. In short, the issuance o a disclaimer can never be used to avoid warning financial statement users about problems that the auditors know to exist in t he financial statements.
Summary of Auditors’ Reports
Figure 17.4 summarizes the types o auditors’ reports that should be issued under dierent conditions.
Additional Reporting Issues Two or More Report Modifications
FIGURE 17.4
An audit report may be qualified or two or more matters. For example, an audit report may include a modification or a scope limitation and or a departure rom generally accepted accounting principles. The wording o such a report would include the appropriate qualiying language and basis or modification or both types o qualifications. When there are several matters requiring the qualification o an opinion, the auditors should consider the cumulative eects o those matters. I the eect involves material
Summary of Auditors’ Reports
Unmodified or Modified Opinion?
Unmodified Opinion
Going Concern*
GAAP not Consistent
Auditor Discretionary Circumstances**
Material
Material and Pervasive *
Modified Opinion
Group Audit
GAAP Departure
Qualified “Except for”
Qualified “Except for”
Unmodified with Emphasis of Matter Paragraph Adverse
The auditors may decide to issue a disclaimer in this situation. Examples include an uncertainty relating to the outcome o an unusually important event, a major catastrophe, related party transactions, unusually important subsequent events. Also, note that in circumstances involving multiple uncertainties the auditors may issue a disclaimer o opinion. **
Scope Limitation
Disclaimer
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and pervasive known misstatements, an adverse opinion would be appropriate, not a qualified opinion. When several matters requiring modification o the audit report exist, a separate emphasis o matter and basis or modification paragraphs will ordinarily reer to each matter. As an example, consider the audit report or a company in extremely weak financial condition and with financial statements that include a material departure rom generally accepted accounting principles. The audit report would likely include a emphasis o matter paragraph describing substantial doubt about the ability o the company to continue as a going concern, and a basis or modification paragraph and opinion modification relating to the departure rom generally accepted accounting principles.
Reporting on Comparative Financial Statements LO5 Describe the auditors’ responsibilities or reporting on comparative financial statements.
As indicated previously, many companies present with the current year’s financial statements’ comparative financial statements or one or more prior years. When comparative financial statements are presented by the client company, the auditors’ report should cover the current year’s financial statements as well as those or prior periods that were audited by their firm. The auditors may express dierent opinions on the financial statements o dierent years. In addition, auditors should update their reports or all prior periods presented or comparative purposes. Updating the report means either reexpressing the opinion originally issued or, depending upon the circumstances, revising the opinion rom that originally issued. A dierent opinion on the prior-period financial statements may be warranted because new inormation may have come to light that causes the auditors to alter their original opinion. For example, the client may revise previously issued financial statements to correct a departure rom GAAP, resulting in a situation in which a qualified opinion is no longer warranted. In some situations, the current auditors have not audited the prior period financial statements, because those financial statements are either unaudited or audited by predecessor auditors. I the financial statements o prior comparative periods are unaudited, this act should be indicated on the applicable financial statements and the auditors’ report should include a disclaimer o opinion on those statements. I the prior-period financial statements were audited by predecessor auditors, the current (successor) auditors’ opinion will cover only the period or periods that they have audited. For the financial statements audited by the predecessor auditors, there are two reporting options. First, the report o the predecessor auditors may be reissued by them bearing its original date. Beore reissuing the report, the predecessor auditors should read the subsequent period financial statements, compare them with the prior-period financial statements, and obtain representation letters rom both management and the successor auditors in essence indicating that they are not aware o inormation that would indicate that the financial statements are incorrect or improper. The second reporting option is to have the successor auditors reer to the report o the other auditors by indicating in an other matter section o the current auditors’ report: (1) that the prior-period statements were audited by predecessor auditors, (2) the type o opinion expressed by the predecessor and, i the opinion was modified, the reasons thereore, (3) the nature o any emphasis o matter paragraph or other matter paragraph included in the predecessor auditors’ report and (4) the date o the predecessor auditors’ report. An example o an other matter paragraph o a report in which the predecessor auditors’ report on the prior year was qualified but not presented in the current year is illustrated below, with the explanatory language emphasized. Other Matter The financial statements of XYZ Company for the year ended December 31, 20X7, were audited by a predecessor auditing firm whose opinion, dated March 1, 20X8, on those statements was qualified as being presented fairly except for the effects on the 20X7 statements of the adjustments pertaining to the valuation of inventory, as discussed in Note X to the financial statements.
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Different Opinions The proessional standards provide an illustration o a situation in which auditors may provide diering opinions on the respective financial statements. The situation involves on Different auditors being retained ater the client has taken its beginning inventory count and the Statements
auditors being unable to obtain sufcient appropriate audit evidence relating to that beginning inventory. Here the auditors satisy themselves as to the amounts in the year-end balance sheet, but they are unable to satisy themselves as to the statements o income, retained earnings, and cash flows due to the eects on these statements o the beginning inventory. Thus, the auditors may issue an unmodified opinion on the balance sheet and a disclaimer o opinion on the other financial statements.
Alerting Readers about the Intended Use of the Auditors’ Report
Audit reports on a complete set o general-purpose financial statements (e.g., those pre pared ollowing GAAP) ordinarily are not restricted as to use or users. Indeed, or public companies the SEC requires this to be the case. However, nothing in GAAS precludes an auditor rom “restricting use,” that is indicating that the report is only or use by specified users. As an example, the auditors might indicate that an audit report o a nonpublic company is restricted to use by management, the board o directors, and shareholders. This, however, is seldom done and must be a part o the understanding with the client. When a restriction on use is included in an audit report, it is included in an other matter paragraph that: • Indicates that the report is intended solely or the inormation and use o the specified parties indicated in the audit report. • Identifies the specified parties. • Indicates that the report is not intended to be used by anyone other than the specified parties.17
Reports to the SEC
Most publicly owned corporations are subject to the financial reporting requirements o the ederal securities laws, administered by the Securities and Exchange Commission (SEC). Many o the reports, or orms, filed with the SEC include audited financial statements or one or more years. Among the most important o these orms are the ollowing: • Forms S-l through S-11. These are the “registration statements” or companies planning to issue securities to the public. • Forms SB-1 and SB-2. These are more simplified registration orms or small businesses. • Form 8-K. This is a “current report” filed or any time in which significant events occur or a company subject to the Securities Exchange Act o 1934. I the significant event is a business combination, audited financial statements o the acquired company oten are required in the current report. An 8-K report is also used to notiy the SEC o a change in auditors. • Form 10-Q. This orm is filed quarterly with the SEC by publicly owned companies. It contains unaudited financial inormation. The company’s auditors perorm reviews o this inormation, but their work is substantially less in scope than an audit. • Form I0-K. This report is filed annually with the SEC by publicly owned companies. The report includes audited financial statements and other detailed financial inormation. It also includes management and the auditors’ reports on internal controls over financial reporting. 17
In some circumstances restriction of particular auditor reports is required. As we discussed in Chapter 7, two reports arising from an audit, communicating internal control related matters and the auditor’s communication with those charged with governance, result in reports alerting readers as to intended use. Also, as discussed in Chapter 19, special purpose financial statements prepared in accordance with a contractual or regulatory basis of accounting must be restricted.
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Auditors dealing with these reports should be well versed on the requirements o each orm, as well as in the provisions o the SEC’s Regulation S-X, which governs the orm and content o financial statements filed with the various orms. The SEC, in conjunction with the Public Company Accounting Oversight Board (PCAOB), has the power to enorce a high quality o audit work on financial statements o public companies. The ederal securities laws provide both civil and criminal penalties or any person, including auditors, responsible or misrepresentations o act in audited statements filed with the SEC. The auditors’ legal liability under the ederal securities acts is discussed in Chapter 4.
Chapter Summary
This chapter explained the dierent types o reports that auditors issue to indicate the character o their audit and the degree o responsibility they are taking. To summarize: 1. Audit reports included in this chapter include those with unmodified opinions and those with modified opinions. A report with an unmodified opinion may be “standard in orm,” or include emphasis o matter or other matter paragraph. The three types o modified opinions are qualified, adverse, and disclaimer o opinion. 2. A report with an unmodified opinion and standard in orm includes an introductory paragraph, sections describing management and auditor responsibilities, and an opinion section. The report has a title that includes the word independent, is addressed to the company whose financial statements are being audited or to its board o directors or stockholders, and is signed with the name o the CPA firm. The public company audit report includes similar but less detailed inormation on management and auditor responsibilities. 3. An emphasis o matter paragraph is included ollowing an unmodified opinion paragraph to emphasize matters described in the audited financial statements. Circumstances in which emphasis o matter paragraphs are required include substantial doubt about a client’s ability to remain a going concern and inconsistency in the application o GAAP. Auditors may choose to add an emphasis o matter paragraph in a variety o circumstances involving matters properly described in the financial statements that they believe merit emphasis (e.g., related party transactions, unusually important significant events, and uncertainties). 4. An other matter paragraph is included ollowing an unmodified opinion paragraph to emphasize something other than inormation described in the audited financial statements. Other matter paragraphs are included when required supplementary inormation is present and sometimes regarding inormation included in a document with audited financial statements; other matter paragraphs are also used when an audit report’s use is to be restricted to certain parties. Group financial statements describe the situation when multiple audit firms are involved in an audit and the group auditors do not wish to take responsibility or a component auditors’ work. 5. Modified opinions are issued when material departures rom GAAP exist and when a scope limitation is involved. Figure 17.2 provides details on the appropriate modifications required or each o these types o reports. 6. When a client presents comparative financial statements or one or more prior periods with the current-period financial statements, the auditors should make certain that all periods are covered by an audit report. Audit reports on prior periods should be updated based on any new inormation that might aect the auditors’ opinion. When predecessor auditors have audited the prior-period financial statements, the current (successor) auditors may summarize the predecessor auditors’ opinion in the current-year audit report, or the client may arrange to have the predecessor auditors reissue their audit report. 7. Auditors o publicly held corporations must understand the various reporting requirements o the SEC. The reports filed with the SEC must be in accordance with Regulation S-X, which governs the orm and content o the corporation’s financial statements.
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Key Terms Introduced or Emphasized in Chapter 17
Adverse opinion (xxx) An opinion that the financial statements do not airly present financial position, results o operations, and cash flows in conormity with generally accepted accounting principles. This situation occurs when the auditors believe that departures rom GAAP are both material and pervasive. Auditors’ Responsibility section (xxx) The section o the audit report that sets orth the auditors’ responsibilities and the scope o the audit. Basis for modification paragraph (XXX) A paragraph added to a report with a modified opinion (qualified, adverse, or disclaimer) that provides a description o the matter giving rise to the modification. The paragraph should be placed immediately beore the opinion paragraph in the auditors’ report and use the heading “Basis or Qualified Opinion,” “Basis or Averse Opinion,” or “Basis or Disclaimer o Opinion,” as appropriate. Change in accounting principle (xxx) Changes in accounting principles and reporting entities result in an emphasis o matter paragraph being added to the auditors’ report. Comparative financial statements (xxx) A complete set o financial statements or one or more prior periods included or comparison with the financial statements o the current period. Component auditors (xxx) Auditors that audit one or more components o a group o entities that provide consolidated financial statements. Disclaimer of opinion (xxx) A orm o report in which the auditors state that they do not express an opinion on the financial statements. Emphasis of matter paragraph (xxx) A paragraph included in the auditors’ report that is required by GAAS or is included at the auditors’ discretion, and that reers to a matter appropriately presented or disclosed in the financial statements that, in the auditors’ judgment, is o such importance that it is undamental to users’ understanding o the financial statements (e.g., a lack o consistent application o GAAP, substantial doubt about an entity’s ability to continue as a going concern). Explanatory language (xxx) A paragraph inserted in an auditors’ report to explain a matter or to describe the reasons or giving an opinion that is other than unmodified. This term is still used in PCAOB standards, but has been replaced in AICPA standards by emphasis o matter paragraph and other matter paragraph. Financial reporting framework (xxx) A set o criteria used to determine measurement, recognition, presentation, and disclosure o all material items appearing in the financial statements: or example, accounting principles generally accepted in the United States o America, International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB), or a special purpose ramework (discussed in Chapter 19). An “applicable financial reporting ramework” is the ramework adopted by management o the company being audited in a particular situation. General-purpose framework (xxx) A financial reporting ramework designed to meet the common financial inormation needs o a wide range o users (e.g., GAAP, International Financial Reporting Standards). Group auditors (xxx) Auditors that are responsible or issuing the audit report on the audit o a group o components (subsidiaries). date as equivalent to that used or audits o nonpublic companies (the date on which suf cient appropriate audit evidence has been gathered and evaluated). Material (xxx) Being o substantial importance. Significant enough to aect evaluations or decisions by users o financial statements. Inormation that should be disclosed in order or the financial statements to constitute a air presentation. Determining what is material involves both quantitative and qualitative criteria. Opinion Section (xxx) The paragraph o an auditors’ report that communicates the degree o responsibility that the auditors are taking or the financial statements. Other matter paragraph (XXX) A paragraph included in the auditors’ report that is required by GAAS or is included at the auditors’ discretion, and that reers to a matter other than those presented or disclosed in the financial statements that, in the auditors’ judgment, is relevant to users’ understanding o the audit, the auditors’ responsibilities, or the auditors’ report. Pervasive (xxx) A term used, in the context o misstatements, to describe the eects on the financial statements o misstatements or the possible eects on the financial statements o misstatements, i any, that are undetected due to an inabilit y to obtain sufcient appropriate audit evidence. Pervasive eects on the financial statements are those that, in the auditors’ judgment: •
Are not confined to specific elements, accounts, or items o the financial statements.
•
I confined, represent or could represent a substantial proportion o the financial statements.
•
In relation to disclosures, are undamental to users’ understanding o the financial statements.
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Principal auditors (xxx) The term previously used by the AICPA to describe the group auditors. This term is still used in PCAOB standards. Qualified opinion (xxx) A modification o the auditors’ standard report, employing a clause s uch as except or to limit the auditors’ opinion on the financial statements. A qualified opinion indicates that, except or the eects o some limitation on the scope o the audit or some departure rom generally accepted accounting principles, the financial statements are airly presented. Scope limitation (xxx) A restriction that prevents the auditors rom being able to apply all o the audit procedures that they consider necessary in the circumstances. Scope limitations may be client imposed or may be imposed by other circumstances. Shared responsibility opinion (xxx) An auditors’ report in which the principal auditors decide to share responsibility with other auditors who have audited some segment o the client’s business. The sharing o responsibility is done by making reerence to the other auditors. Making reerence is not, in itsel, a qualification o the auditors’ report. Standard report (xxx) The “standard wording” o an unmodified auditors’ report, not including such modifications as emphasis o matter, substantial doubt about going-concern status, a change in accounting principle, departures rom ofcial GAAP, or a group audit (shared res ponsibility opinion). Unmodified opinion (xxx) The opinion expressed by the auditors when they conclude that the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting ramework (e.g., GAAP).
Review Questions
17–1.
Identiy the sections o the standard audit report or a nonpublic company.
17–2.
What is the unction o notes to financial statements?
17–3.
List three primary dierences between the audit report or nonpublic entities and the one or public entities.
17–4.
Comment on whether you agree with the ollowing and why: GAAP and GAAS represent two requently used financial reporting rameworks.
17–5.
Provide a list o the types o unmodified and modified audit opinions.
17–6.
Howard Green, a partner with Cary, Loeb, & Co., and his audit team have completed the audit o Baker Manuacturing. Determine the proper date o the audit report. •
December 31, 20X0: Baker’s year-end.
•
February 15, 20X1: Green completed audit procedures perormed at Baker’s location.
•
February 19, 20X1: The financial statements were completed.
•
February 20, 20X1: All audit procedures were completed, including the review o all audit documentation.
•
February 25, 20X1: Green signed the audit report.
•
February 26, 20X1: Green delivered the audit report to Baker.
17–7.
When the current auditors make reerence to the work o the component auditors, does this result in expression o a qualified opinion? Explain.
17–8.
Explain three situations in which the wording o a report with an unmodified opinion might depart rom the auditors’ standard report.
17–9.
Wade Corporation has been your audit client or several years. At the beginning o the current year, the company changed its method o inventory valuation rom average cost to last in, first out (LIFO). The change, which had been under consideration or some time, was in your opinion a logical and proper step or the company to take. What eect, i any, will this situation have on your audit report or the current year?
17–10.
What are the two circumstances that result in modified opinions?
17–11.
Comment on the ollowing: “I the financial statements contain an immaterial departure rom generally accepted accounting principles, the auditors issue a qualified opinion; i the financial statements contain a material departure rom GAAP, the auditors issue an adverse opinion.”
17–12.
What actors determine whether a misstatement is considered pervasive?
17–13.
Can the client change a set o financial statements to receive an unmodified opinion instead o an opinion qualified as to the adequacy o disclosure? Explain.
17–14.
Describe the alterations rom the standard orm audit report when a scope limitation has occurred and the auditors have issued a qualified opinion.
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Questions Requiring Analysis
LO 1, 2
17–15.
The auditors know that the client’s accounting or deerred income taxes is not in accordance with generally accepted accounting principles, but because o a very significant scope limitation they have not been able to determine the amount o the misstatement involved and have not been able to orm an opinion on the financial statements taken as a whole. What type o report should they issue?
17–16.
Why are adverse opinions rare?
17–17.
Comment on whether you agree with the ollowing: A basis or modified opinion paragraph is the same as a basis or qualified opinion paragraph.
17–18.
Assume that CPAs are attesting to comparative financial statements. Can the CPAs express diering opinions on the sets o financial statements o two successive years?
17–19.
Assume that CPAs are attesting to comparative financial statements. Can the CPAs change their report on the prior year’s statements?
17–20.
Describe the reports containing audited financial statements that are customarily filed by a company subject to the reporting requirements o the SEC.
17–21.
An accountant o an audit client made the ollowing statement: It is important to read the notes to financial statements, even though they are presented in technical language and are incomprehensible. Auditors may reduce their exposure to third-party liability by stating something in the notes that contradicts completely what the client has presented in the balance sheet or income statement. Evaluate the above statement and indicate: a. Areas o agreement, i any. b. Areas o misconception, incompleteness, or allacious reasoning included in the statement.
LO 3
17–22.
Rowe & Myers audits the financial statements o Dunbar Electronics. During the audit, Ross & Myers engaged Jones & Abbot, a Canadian public accounting firm, as a component auditor to audit Dunbar’s wholly owned Canadian subsidiary. a. Must Rowe & Myers make reerence to the component auditor in its audit report? Explain.
Required
b. Assume that Jones & Abbott issued a qualified report on the Canadian subsidiary. Must Rowe & Myers include the same qualification in its report on Dunbar Electronics?
LO 3
17–23.
Lando Corporation is a domestic company with two wholly owned domestic subsidiaries. Michaels, CPA, has been engaged to audit the financial statements o the parent company and one o the subsidiaries and to act as the group auditors. Thomas, CPA, has audited financial statements o the other subsidiary. Michaels has not yet decided whether to make reerence to the audit o Thomas. a. What audit procedures should Michaels perorm with respect to the component auditor, regardless o whether Michaels decides to make reerence to Thomas in the report?
Required
b. What modifications are made to the audit report i Michaels decides to make reerence to the audit o Thomas?
LO 3
17–24.
While perorming your audit o Williams Paper Company, you discover evidence that indicates that Williams may not have the ability to continue as a going concern. a. Discuss types o inormation that may indicate substantial doubt about a client’s ability to remain a going concern. b. Explain the auditors’ obligation in such situations.
All applicable questions are available with McGraw-Hill’s Connect TM Accounting .
Objective Questions
17–25.
LO 4
Multiple Choice Questions
a. A material departure rom generally accepted accounting principles will result in auditor consideration o:
(1) Whether to issue an adverse opinion rather than a disclaimer o opinion. (2) Whether to issue a disclaimer o opinion rather than a qualified opinion. (3) Whether to issue an adverse opinion rather than a qualified opinion. (4) Nothing, because none o these opinions is applicable to this type o exception.
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685
b. The auditors’ report should be dated as o the date the:
(1) Report is delivered to the client. (2) Auditors have accumulated suf cient evidence. (3) Fiscal period under audit ends. (4) Peer review o the working papers is completed.
LO 3
c. In an audit report on combined financial statements, reerence to the act that a portion o the audit was perormed by a component auditor is:
(1) Not to be construed as a qualification, but rather as a division o responsibility between the two CPA firms. (2) Not in accordance with generally accepted auditing standards. (3) A qualification that lessens the collective responsibility o both CPA firms. (4) An example o a dual opinion requiring the signatures o both auditors.
LO 1, 2
d. Assume that the opinion paragraph o an auditors’ report begins as ollows: “With the explanation given in Note 6., . . .” the financial statements reerred to above present airly. . . .)” This is:
Text unclear, Please check and confirm.
(1) An unmodified opinion. (2) A disclaimer o opinion. (3) An “except or” opinion. (4) An improper type o reporting.
LO 3
e. The auditors who wish to draw reader attention to a financial statement note disclosure on significant transactions with related parties should disclose this act in:
(1) An emphasis o matter paragraph to the auditors’ report. (2) A ootnote to the financial statements. (3) The body o the financial statements. (4) The “summary o significant accounting policies” section o the financial statements.
LO 4
. What type or types o audit opinion are appropriate when financial statements are materially and pervasively misstated?
(1) (2) (3) (4)
LO 3
Qualified
Adverse
Yes Yes No No
Yes No Yes No
g. Which o the ollowing ordinarily involves the addition o an emphasis o matter paragraph to an audit report?
(1) A consistency modification. (2) An adverse opinion. (3) A qualified opinion. (4) Part o the audit has been perormed by component auditors.
LO 2
h. An audit report or a public client indicates that the audit was perormed in accordance with:
(1) Generally accepted auditing standards (United States). (2) Standards o the Public Company Accounting Oversight Board (United States). (3) Generally accepted accounting principles (United States). (4) Generally accepted accounting principles (Public Company Accounting Oversight Board).
LO 2
i. An audit report or a public client indicates that the financial statements were prepared in conormity with:
(1) Generally accepted auditing standards (United States). (2) Standards o the Public Company Accounting Oversight Board (United States) (3) Generally accepted accounting principles (United States) (4) Generally accepted accounting principles (Public Company Accounting Oversight Board).
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j. When the matter is properly disclosed in the financial statements, the likely result o substantial doubt about the ability o the client to continue as a going concern is the issuance o which o the ollowing audit opinions?
LO 3
Qualified
Unmodified with Emphasis of Matter
Yes Yes No No
Yes No Yes No
(1) (2) (3) (4)
k. A change in accounting principles that the auditors believe is not justified is likely to result in which o the ollowing types o audit opinions?
LO 4
Qualified
Unmodified with Emphasis of Matter
Yes Yes No No
Yes No Yes No
(1) (2) (3) (4)
l. Which o the ollowing is least likely to result in inclusion o an emphasis o matter paragraph in an audit report?
LO 3
(1) The company is a component o a larger business enterprise. (2) An unusually important significant event. (3) A decision not to confirm accounts receivable. (4) A risk or uncertainty.
LO 3, 4
17–26.
For each o the ollowing brie scenarios, assume that you are reporting on a client’s financial statements. Reply as to the type(s) o opinion possible or the scenario. In addition: •
Unless stated otherwise, assume the matter involved is material.
•
I the problem does not state that a misstatement (or possible misstatement) is pervasive, assume that it may or may not be pervasive (thus, the appropriate reply may include two possible reports).
•
Do not read more into the circumstance than what is presented.
Do not consider an auditor discretionary circumstance or modification o the audit report unless the situation explicitly suggests that the auditors wish to emphasize a particular matter. Report Types may be used once, more than once, or not at all. Situation
Report Types
a. Bowles Company is engaged in a hazardous trade and has obtained insurance coverage related to the hazard. Although the likelihood is remote, a material portion of the company’s assets could be destroyed by a serious accident. b. Draves Company owns substantial properties that have appreciated significantly in value since the date of purchase. The properties were appraised and are reported in the balance sheet at the appraised values (which materially exceed costs) with related disclosures. The CPAs believe that the appraised values reported in the balance sheet reasonably estimate the assets’ current values. c. During the audit of Eagle Company, the CPA firm has encountered a significant scope limitation relating to inventory record availability and is unable to obtain sufficient appropriate audit evidence in that area. d. London Company has material investments in stocks of subsidiary companies. Stocks of the subsidiary companies are not actively traded in the market, and the CPA firm’s engagement does not extend to any subsidiary company. The CPA firm is able to determine that all investments are carried at original cost, but has no real idea of market value. Although the difference between cost and market could be material, it could not have a pervasive effect on the overall financial statements. e. Slade Company has material investments in stocks of subsidiary companies. Stocks of the subsidiary companies are actively traded in the market. Management insists that all investments be carried at original costs, and the CPA firm is satisfied that the original costs are accurate. The CPA firm believes that the client will never ultimately realize a substantial portion of the investments because the market value is much lower than the cost; the client has fully disclosed the facts in notes to the financial statements.
1. Standard unmodified 2. Unmodified with an emphasis of matter paragraph 3. Qualified 4. Adverse 5. Disclaimer 6. Either qualified or adverse 7. Either qualified or disclaimer 8. Either adverse or disclaimer
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17–27.
687
Use the ollowing to provide the type o audit report the auditors generally should issue in the situations presented below: 1. Unmodified—standard. 2. Unmodified—with an emphasis o matter paragraph. 3. Qualified. 4. Adverse. 5. Disclaimer a. Client-imposed restrictions significantly limit the scope o the auditors’ procedures, and they are unable to obtain sufcient appropriate audit evidence. The possible eects on the financial statements o undetected misstatements, i any, could be both material and pervasive.
Situation:
b. The auditors decide not to make reerence to the report o a component auditor that audited a portion o group financial statements. c. The auditors believe that the financial statements have been presented in conormity with generally accepted accounting principles in all respects, except that a loss contingency that should be disclosed through a note to the fi nancial statements is not included. While they consider this a material omission, they do not believe that it pervasively aects the financial statements. d. The client has changed rom LIFO to FIFO or inventory valuation purposes; the auditors concur with this change. The eect is considered material to the financial statements, although inventory is not a large part o total assets. e. The client has changed rom LIFO to FIFO or inventory valuation purposes; the auditors do not concur with this change. The eect is considered material and pervasive.
LO 3
17–28.
Auditors report on the consistency o application o accounting principles. Assume that the ollowing list describes changes that have a material eect on a client’s financial statements or the current year. (1) A change rom the completed-contract method to the percentage-o-completion method o accounting or long-term construction contracts. (2) A change in the estimated service lives o previously recorded plant assets based on newly acquired inormation. (3) Correction o a mathematical error in inventory pricing made in a prior period. (4) A change rom direct costing to ull absorption costing or inventory valuation. (5) A change rom deerring and amortizing preproduction costs to recording such costs as an expense when incurred because uture benefits o the costs have become doubtul. The new accounting method was adopted in recognition o the change in estimated uture benefits. (6) A change to including the employer’s share o FICA taxes as “Retirement benefits” on the income statement. This inormation was previously included with “Other taxes.” (7) A change rom the FIFO method o inventory pricing to the LIFO method o inventory pricing. For each o the above situations, state whether the audit report should include an emphasis o matter paragraph on consistency.
Required
LO 3, 4
17–29.
Simulation
Items 1 through 5 present various independent actual situations an auditor might encounter in conducting an audit. For each situation assume: •
The auditor is independent.
•
The auditor previously expressed an unmodifi ed opinion on the prior year’s financial statements.
•
Only single-year (not comparative) statements are presented or the current year.
•
The conditions or an unmodified opinion exist unless contradicted in the actual situations.
•
The conditions stated in the actual situations are material.
• No report modifications are to be made except in response to the actual situation.
1. In auditing the long-term investments account, an auditor is unable to obtain audited financial statements or an investee located in a oreign country. The auditor concludes that sufcient appropriate audit evidence regarding this in vestment cannot be obtained.
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2. Due to recurring operating losses and working capital deficiencies, an auditor has substantial doubt about an entity’s ability to continue as a going concern or a reasonable period o time. However, the financial statement disclosures concerning these matters are adequate. The auditor has decided not to issue a disclaimer o opinion. 3. A group auditor decides to take responsibility or the work o a component CPA who audited a wholly owned subsidiary o the entity and issued an unmodified opinion. The total assets and revenues o the subsidiary represent 17 percent and 18 percent, respectively, o the total assets and revenues o the entity being audited. 4. An entity changes its depreciation method or production equipment rom straight-line to a units-o-production method based on hours o utilization. The auditor concurs with the change, although it has a material eect on the comparability o the entity’s financial statements. 5. An entity discloses certain lease obligations in the notes to the financial statements. The auditor believes that the ailure to capitalize these leases is a departure rom generally accepted accounting principles and, although the possible eects on the financial statements o the misstatements is material, they could not be pervasive. List A represents the types o opinions the auditor ordinarily would issue and List B represents the report modifications (i any) that would be necessary. Select as the best answer or each situation (items 1 through 6) the type o opinion and alterations, i any, the auditor would normally select. Replies may be selected once, more than once, or not at all.
Required
(AICPA, adapted) List A: Types of Opinions A. Unmodified B. Qualified C. Adverse D. Disclaimer E. Qualified or adverse F. Qualified or disclaimer G. Disclaimer or adverse
LO 3, 4, 5
17–30.
List B: Report Alteration H. Add an emphasis of matter paragraph—prior to opinion paragraph. I. Add an emphasis of matter paragraph—after opinion paragraph. J. Add a basis for modification paragraph—prior to opinion paragraph. K. Add a basis for modification paragraph—after opinion paragraph. L. Modifications other than addition of a paragraph. M. Issue standard auditors’ report without alteration.
Simulation *
For each o the ollowing brie scenarios, assume that you are reporting on a client’s financial statements. Reply as to the type(s) o opinion (per below) possible or the scenario. In addition: •
Unless stated otherwise, assume the matter involved is material. I the problem doesn’t tell you whether a misstatement pervasively misstates the financial statements or doesn’t list a characteristic that indicates pervasiveness, two reports may be possible (i.e., replies 6 to 9).
•
Do not read more into the circumstances than what is presented.
•
Do not consider an auditor discretionary circumstance or modifi cation o the audit report unless the situation explicitly suggests that the auditor wishes to emphasize a particular matter.
Types of Opinion
1. Standard unmodified. 2. Unmodified with an emphasis o matter paragraph. 3. Qualified. 4. Adverse. 5. Disclaimer. 6. Unmodified with an emphasis o matter paragraph or disclaimer. 7. Qualified or adverse. 8. Qualified or disclaimer. 9. Adverse or disclaimer. 10. Other. *
Note that this simulation has more parts than one would expect in a particular CPA exam simulation. We present it to provide examples of many types of reporting situations in one problem.
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Situation 1. A company has not followed generally accepted accounting principles in the recording of its leases. 2. A company has not followed generally accepted accounting principles in the recording of its leases. The amounts involved are immaterial. 3. A company valued its inventory at current replacement cost. Although the auditor believes that the inventory costs do approximate replacement costs, these costs do not approximate any GAAP inventory valuation method. 4. A client changed its depreciation method for production equipment from the straight-line method to the unitsof-production method based on hours of utilization. The auditor concurs with the change. 5. A client changed its depreciation method for production equipment from the straight-line to a units-of-production method based on hours of utilization. The auditor does not concur with the change. 6. A client changed the depreciable life of certain assets from 10 years to 12 years. The auditor concurs with the change. 7. A client changed the depreciable life of certain assets from 10 years to 12 years. The auditor does not concur with the change. Confined to fixed assets and accumulated depreciation, the misstatement is not considered pervasive. 8. A client changed from the method it uses to calculate postemployment benefits from one acceptable method to another. The effect of the change is immaterial this year, but expected to be material in the future. 9. A client changed the salvage value of certain assets from 5 percent to 10 percent of original cost. The auditor concurs with the change. 10. A client uses the specific identification method of accounting for valuable items in inventory, and LIFO for less valuable items. The auditor concurs that this is a reasonable practice. 11. Due to recurring operating losses and working capital deficiencies, an auditor has substantial doubt about an entity’s ability to continue as a going concern for a reasonable period of time. The notes to the financial statements adequately disclose the situation. 12. Due to recurring operating losses and working capital deficiencies, an auditor has substantial doubt about an entity’s ability to continue as a going concern for a reasonable period of time. The notes to the financial statements do not adequately disclose the substantial doubt situation, and the auditor believes the omission fundamentally affects the users’ understanding of the financial statements. 13. An auditor reporting on group financial statements decides to take responsibility for the work of a component auditor who audited a 70 percent owned subsidiary and issued an unmodified opinion. The total assets and revenues of the subsidiary are 5 percent and 8 percent, respectively, of the total assets and revenues of the entity being audited. 14. An auditor reporting on group financial statements decides not to take responsibility for the work of a component auditor who audited a 70 percent owned subsidiary and issued an unqualified opinion. The total assets and revenues of the subsidiary are 5 percent and 8 percent, respectively, of the total assets and revenues of the entity being audited. 15. An auditor was hired after year-end and was unable to observe the counting of the year-end inventory. She is unable to apply other procedures to determine whether ending inventory and related information are properly stated. 16. An auditor was hired after year-end and was unable to observe the counting of the year-end inventory. However, she was able to apply other procedures and determined that ending inventory and related information are properly stated. 17. An auditor discovered that a client made illegal political payoffs to a candidate for president of the United States. The auditor was unable to determine the amounts associated with the payoffs because of the client’s inadequate record-retention policies. The client has added a note to the financial statements to describe the illegal payments and has stated that the amounts of the payments are not determinable. 18. An auditor discovered that a client made illegal political payoffs to a candidate for president of the United States. The auditor was unable to determine the amounts associated with the payoffs because of the client’s inadequate record-retention policies. Although there is no likelihood that the financial statements are pervasively misstated, they may be materially misstated. The client refuses to disclose the payoffs in a note to the financial statements. 19. In auditing the long-term investments account of a new client, an auditor finds that a large contingent liability exists that is material to the consolidated company. It is probable that this contingent liability will be resolved with a material loss in the future, but the amount is not estimable. Although no adjusting entry has been made, the client has provided a note to the financial statements that describes the matter in detail. 20. In auditing the long-term investments account of a new client, an auditor finds that a large contingent liability exists that is material to the consolidated company. It is probable that this contingent liability will be resolved with a material loss in the future, and this amount is reasonably estimable as $2,000,000. Although no adjusting entry has been made, the client has provided a note to the financial statements that describes the matter in detail and includes the $2,000,000 estimate in that note.
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Situation
Report
21. A client is issuing two years of comparative financial statements. The first year was audited by another auditor who is not being asked to reissue her audit report. (Reply as to the successor auditors’ report.) 22. A client is issuing two years of comparative financial statements. The first year was audited by another auditor who is being asked to reissue her audit report. (Reply as to the successor auditors’ report.) 23. A client’s financial statements follow GAAP, but the auditor wishes to emphasize in his audit report a significant related party transaction that is adequately described in the notes to the financial statements. 24. A client’s financial statements follow GAAP except that they do not include a note on a significant related party transaction.
LO 3, 4
17–31.
Simulation
Last year, Johnson & Barkley, CPAs, audited the consolidated financial statements o Jordan Company (a nonpublic company) or the year ended December 31, 20X0, and expressed a standard unmodified report. Johnson & Barkley also audited Jordan’s this year’s financial statements—or the year ended December 31, 20X1. These consolidated financial statements are being presented on a comparative basis with those o the prior year, and an unmodified opinion is being expressed. Smith, the engagement supervisor, instructed Abler, an assistant on the engagement, to drat the auditors’ report. In drating the report below, Abler considered the ollowing: •
Jordan changed its method o accounting or inventory rom LIFO to FIFO in 20X1.
•
Larkin & Lake, CPAs, audited the financial statements o BX, Inc., a consolidated subsidiary o Jordan, or the year ended December 31, 20X1. The subsidiary’s financial statements reflected total assets and revenues o 2 percent and 3 percent, respectively, o the consolidated totals. Larkin & Lake expressed an unmodified opinion and urnished Johnson & Barkley with a copy o the auditors’ report. Johnson & Barkley has decided to assume responsibility or the work o Larkin & Lake insoar as it relates to the expression o an opinion on the consolidated financial statements taken as a whole and has applied the necessary audit procedures.
•
Jordan is a deendant in a lawsuit alleging patent inringement. This is adequately disclosed in the notes to Jordan’s financial statements, but no provision or liability has been recorded because the ultimate outcome o the litigation cannot presently be determined.
Abler drated the ollowing audit report:
Auditors’ report We have audited the accompanying consolidated financial statements of Jordan Company and its subsidiaries, which comprise the consolidated balance sheets as of December 31, 20X1 and 20X0, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for the years then ended, and the related notes to the financial statements. Auditors’ Responsibility
Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditors’ judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditors considers internal control relevant to the entity’s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements.
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Auditors’ Reports
691
We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. Emphasis of Matter
As discussed in Note 2 to the consolidated financial statements, the Company adopted the firstin-first- out method of inventory valuation in 20X1. Our opinion is not modified with respect to this matter. Opinion
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Jordan Company and its subsidiaries as of December 31, 20X1 and 20X0, and the results of their operations and their cash flows for the years then ended in accordance with accounting principles generally accepted in the United States of America.
Johnson & Barkley, CPAs Phoenix, Arizona December 31, 20X1
Smith reviewed Abler’s drat and stated in the Supervisor’s Review Notes below that there were deficiencies in Abler’s drat. Items 1 through 10 represent the deficiencies noted by Smith. For each deficiency, indicate whether Smith is correct or incorrect in the criticism o Abler’s drat.
Required
1. The report’s title is incorrect as it should include the word “independent.” 2. The report should have an addressee such as the board o directors. 3. There should be a section entitled Management’s Responsibility or the Financial Statements. 4. The first sentence o the Auditors’ Responsibility section should state that “Our responsi bility is to provide assurance . . .,” not “Our responsibility is to express an opinion . . .” 5. The Auditors’ Responsibility and the Opinion sections should both reer to the component auditors. 6. The third paragraph under the Auditors’ Responsibility section is not required—let’s omit it. 7. The emphasis o matter paragraph should ollow the opinion paragraph. 8. The Opinion section should indicate that the principles were consistently applied except or the change in method o inventory valuation. 9. The report should be dated as o the date sufcient appropriate audit evidence has been gathered, not as o year-end. 10. The names o the individual financial statements should be included in the Opinion section.
Problems
All applicable problems are available with McGraw-Hill’s Connect TM Accounting .
LO 1, 3
17–32.
The auditors’ report that ollows was drated by a sta accountant o Williams & Co., CPAs, at the completion o the audit o the financial statements o Lenz Corporation (nonpublic com pany) or the year ended December 31, 20X1. Assume that there is s ubstantial doubt about the entity’s ability to continue as a going concern, and that this doubt is properly disclosed in the financial statements.
Independent Auditors’ Report To the Board of Directors and Stockholders of Lenz Corporation: We have audited the accompanying consolidated financial statements of Lenz Corporation and its subsidiaries, and the related notes to the financial statements. Management’s Responsibility for the Financial Statements
Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with accounting principles generally accepted in the United States of America; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of consolidated financial statements that are free from material misstatement, whether due to fraud or error.
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692 Chapter Seventeen
Auditors’ Responsibility
Our responsibility is to express an opinion on these consolidated financial statements based on our audit. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are in conformity with accounting principles generally accepted in the United States of America. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditors’ judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditors considers internal control relevant to the entity’s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Emphasis of Matter
The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company has suffered negative cash flows from operations and has an accumulated deficit that raises substantial doubt about the Company’s ability to continue as a going concern beyond a reasonable time . Management’s plans in regard to these matters are also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. Our opinion is modified with respect to this matter. Opinion
In our opinion, except for the effects of the matter described in the preceding paragraph, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Lenz Corporation and its subsidiaries and the results of their operations and their cash flows for the year then ended in accordance with accounting principles generally accepted in the United States of America applied on a basis consistent with that of the preceding year.
Williams & Co., LLP Phoenix Arizona February 15, 20X2
Identiy deviations rom the appropriate nonpublic company audit report.
Required
LO 2
17–33.
The auditors’ report that ollows was drated by a sta accountant o Smith & Co., CPAs, at the completion o the audit o the financial statements o Lenses Co. (a public company) or the year ended December 31, 20X1.
Report of Registered Public Accounting Firm To the Management of Lenses Co.: We have examined the accompanying consolidated balance sheet of Lenses Co. as of December 31, 20X1 and 20X0, and the related consolidated statement of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 20X1. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. All PCAOB requirements were met on this audit. We conducted our audits in accordance with the standards of generally accepted auditing standards (United States). Those standards require that we plan and perform the audit to obtain positive assurance about whether the financial statements are free of all misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present, in all material respects, the consolidated financial position of Lenses Co. at December 31, 20X1 and 20X0, and the consolidated results of its operations and its cash flows for each of the three years in the period ended
First Pages
Auditors’ Reports
693
December 31, 20X1, in conformity with U.S. generally accepted accounting principles applied on a consistent basis. We also have reviewed, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Lenses Co.’s internal control over financial reporting as of December 31, 20X1, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated February 15, 20X2, expressed an unmodified opinion thereon. Dallas, Texas February 15, 20X2
Identiy deviations rom the public company standard report.
Required
LO 4
Smith & Co. CPAs
17–34.
Sturdy Corporation (a nonpublic company) owns and operates a large ofce building in a desirable section o New York City’s financial center. For many years, management o Sturdy Corporation has modified the presentation o its financial statement by: 1. Reflecting a write-up to appraisal values in the building accounts. 2. Accounting or depreciation expense on the basis o such valuations. Wyley, CPA, was asked to audit the financial statements o Sturdy Corporation or the year ended December 31, 20X3. Ater completing the audit, Wyley concluded that, consistent with prior years, an adverse opinion would have to be expressed because the material misstatements were considered pervasive. a. Describe in detail the appropriate content o the basis or modification section o the auditors’ report on the financial statements o Sturdy Corporation or the year ended December 31, 20X3. Do not discuss deerred taxes.
Required
b. Write a drat o the opinion paragraph o the auditors’ report on the financial statements o Sturdy Corporation or the year ended December 31, 20X3.
LO 1, 3, 4
17–35.
•
Excelsior is a nonpublic company that presents only current-year financial statements.
•
Roscoe was unable to perorm normal accounts receivable confirmation procedures, but alternate procedures were used to satisy Roscoe as to the validity o the receivables.
•
Excelsior Corporation is the deendant in litigation, the outcome o which is highly uncertain. I the case is settled in avor o the plainti, Excelsior will be required to pay a substantial amount o cash that might require the sale o certain assets. The litigation and the possible eects have been properly disclosed in Note 11. Roscoe wishes to include discussion o this matter in the audit report.
•
During 20X1 Excelsior changed its method o accounting or long-term construction contracts and properly reflected the eect o the change. Roscoe is satisfied with Excelsior’s justification or making the change. The change is discussed in Note 12.
•
Excelsior issued debentures on January 31, 20X1, in the amount o $10 million. The unds obtained rom the issuance were used to finance the expansion o plant acilities. The debenture agreement restricts the payment o uture cash dividends to earnings ater December 31, 20X1. Excelsior declined to disclose these data in the notes to the financial statements. Roscoe considers this a material, but no pervasive omission.
•
Roscoe gathered sufcient appropriate audit evidence as o February 10, 20X2, and planned a report release date o February 16, 20X2.
Consider all acts given and prepare an auditors’ report in an acceptable and complete ormat, incorporating any necessary departures rom the standard report.
Required
LO 2, 3, 4
Roscoe & Jones, Ltd, a CPA firm in Silver Bell, Arizona, has completed the audit o the financial statements o Excelsior Corporation as o, and or, the year ended December 31, 20X1. Findings related to the financial statements and the audit include:
17–36.
Rotter & Co, Ltd, a CPA firm in Silver Bell, Arizona, has completed the audit o the financial statements o Exchecker Corporation as o, and or, the year ended December 31, 20X1. Findings related to the financial statements and the audit include: •
Exchecker is a public company that presents two years o balance sheets and three years o the other financial statements in accordance with SEC reporting requirements.
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694 Chapter Seventeen
LO 3, 4, 5
During 20X1, Exchecker changed its method o accounting or long-term construction contracts and properly refl ected the eect o the change. Rotter is satisfied with Exchecker’s justification or making the change. The change is discussed in Note 12.
•
Rotter was unable to perorm normal accounts receivable confirmation procedures, but alternate procedures were used to satisy Rotter as to the validity o the receivables.
•
Exchecker Corporation is the deendant in litigation, the outcome o which is highly uncertain. I the case is settled in avor o the plainti, Exchecker will be required to pay a substantial amount o cash that might require the sale o certain assets. The litigation and the possible eects have been properly disclosed in Note 11. Rotter wishes to include discussion o this matter in the audit report.
•
Rotter gathered suf cient appropriate audit evidence as o February 10, 20X2, and planned a report release date o February 16, 20X2.
Consider all acts given, and prepare an auditors’ report in an acceptable and complete ormat incorporating any necessary departures rom the standard report.
Required
In-Class Team Cases
•
17–37.
For each o the ollowing brie scenarios, assume that you are the CPA reporting on the client’s financial statements. Using the orm included with this problem, describe the reporting circumstance involved, the type or types o opinion possible in the circumstance, and the appropriate report alterations. Since more than one report may be possible in several o the circumstances, a second “type o opinion” and “report alteration” row is added or each circumstance. For example, i the problem doesn’t tell you whether a misstatement pervasively misstates the financial statements or doesn’t list a characteristic that indicates pervasiveness, two reports may be possible. In most cases, you will not need to use the second row. Do not read more into the circumstance than what is presented, and only reply “emphasis o matter” in auditor discretionary circumstances such as those suggested in the chapter. Unless stated otherwise, assume that the inormation presented is material to the financial statements.
Circumstance
Type of Opinion
Report Alteration
GC
Going concern
U Unmodified
EOM
Emphasis of matter paragraph added
CON
Consistency
Q Qualified
OM
Other matter paragraph added
EMPH
Auditor discretionary emphasis of matter
D Disclaimer
BFM
Basis for modification paragraph added
A Adverse
OTHER Other alteration, but no paragraph added
GROUP Group audit GAAP
Departure from GAAP
SCOPE
Scope limitation
NO
COMP
Comparative financial statements
NONE
No circumstance
No alteration
1. Your client has declined to depreciate its assets this year because the depreciation expense would reduce the year’s small income to a loss. 2. A client’s financial statements ollow GAAP, but you wish to emphasize that the client is a subsidiary o Webster Corporation in the audit report. 3. In auditing the long-term investments account o a new client, you are unable to obtain audited financial statements or the investee located in a oreign country. You conclude that sufcient appropriate audit evidence regarding this inv estment cannot be obtained. 4. Due to a very major lawsuit, you have substantial doubt about a client’s ability to continue as a going concern or a reasonable period o time. The financial statement disclosures related to this lawsuit are adequate. 5. You decide not to take responsibility or the work o the component auditors who audited a 70 percent owned subsidiary and issued an unmodified opinion. The total assets and revenues o the subsidiary are 5 percent and 8 percent, respectively, o the total assets and revenues o the entity being audited. 6. You decide to take responsibility or the work o the component auditors who audited a 70 percent owned subsidiary and issued an unmodified opinion. The total assets and revenues o the subsidiary are 5 percent and 8 percent, respectively, o the total assets and revenues o the entity being audited.
First Pages
Auditors’ Reports
695
7. A company has changed the remaining lie o a significant asset rom 12 to 10 years. You believe that the change is reasonable. 8. A company changes rom FIFO to LIFO or inventory valuation and you concur with the change. The change has an immaterial eect on the entity’s financial statements this year, but it is expected to have a material eect in the uture. 9. Your client is a deendant in a major lawsuit. It is probable that the company will experience a material loss due to the lawsuit, although it is impossible to calculate the likely amount. The financial statements include a note adequately describing the matter. You decide that a standard report is inappropriate. 10. Predecessor auditors audited last year’s financial statements and you audited the current year. You have decided not to ask the predecessor to reissue that audit report. Comparative financial statements are being issued on the two years. Circumstance
Type Opinion(s)
Report Alteration
1
2
3
4
5
6
7
8
9
10
LO 3, 4, 5
17–38.
For each o the ollowing brie scenarios, assume that you are reporting on a client’s current year financial statements. Reply as to the type or types opinion possible in the circumstance. S
Standard unmodified
U
Unmodified with emphasis o matter or other matter paragraph
Q
Qualified
D
Disclaimer
A.
Adverse
Since more than one report may be possible in several o the circumstances, a second “opinion” column is added or each circumstance. In certain cases you will not need to use the second column. Do not read more into the circumstance than what is presented, and do not consider the possibility o an auditors’ discretionary emphasis o matter paragraph being added to the audit report. Unless stated otherwise, assume that the inormation presented is material to the financial statements. I the situation doesn’t tell you whether a misstatement pervasively misstates the financial statements or doesn’t list a characteristic that indicates pervasiveness, two reports may be possible.
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696 Chapter Seventeen
Situation
Opinion
Opinion
1. A company in its first year of existence values its inventory at current replacement cost. Although you believe that the inventory costs do approximate replacement costs, these costs do not approximate any GAAP inventory valuation method. The difference involved is material, but not pervasively material to the financial statements. 2. Due to recurring operating losses and working capital deficiencies, you have substantial doubt about an entity’s ability to continue as a going concern for a reasonable period of time. The notes to the financial statements adequately disclose the substantial doubt situation. 3. You have discovered that a client made illegal payoffs to a candidate for president of the United States. You are unable to determine the amounts associated with the payoffs because of the client’s inadequate record retention policies. The client has added a note to the financial statements to describe this information, and has stated that the amounts of the payments are not determinable. 4. In auditing the long-term investments account of a new client, you find that a $2,000,000 contingent liability exists that is material to the consolidated company. It is a reasonably possible that this contingent liability will be resolved with a material loss in the future. Although no adjusting entry has been made, the client has provided a note to the financial statements that describes the matter in detail and includes the $2 million estimate. 5. A client is issuing two years of comparative financial statements. The first year was audited by other auditors who are not being asked to reissue their audit report. 6. An entity changes its depreciation method for production equipment from the straight-line to the units-of-production method based on hours of utilization. You concur with the change. 7. A client has changed the method it uses to calculate postemployment benefits from one acceptable method to another acceptable method. The effect of the change is immaterial this year, but is expected to be material in the future. 8. Component auditors have audited a subsidiary of your client as a part of a group audit. You have decided to rely upon the component auditors’ work. 9. A client omits note disclosure related to significant accounting policies that the auditors believe to be fundamental to users’ understanding of the financial statements. 10. A client does not count its year-end inventory. The auditors are unable to obtain sufficient appropriate audit evidence related to the inventory, and they consider inventory to represent an extremely substantial proporti on of the financial statements.
Research LO 3, 4 and Discussion Case
11–39.
Your firm audits Metropolitan Power Supply (MPS). The issue under consideration is the treatment in the company’s financial statements o S700 million in capitalized construction costs relating to Eagle Mountain, a partially completed nuclear power plant. Seven years ago, MPS began construction o Eagle Mountain, with an original cost estimate o $400 million and completion expected within five years. Cost overruns were enormous, and construction has been repeatedly delayed by litigation initiated by the antinuclear lobby. At present, the project is little more than 50 percent complete, and construction has been halted because MPS does not have the unds to continue. I Eagle Mountain is ultimately completed, the state utilities commission will determine the extent to which MPS may recover its construction costs through its rate structure. The commission’s rulings are difcult to predict, but it is quite possible that the commission will not allow MPS to include all o the Eagle Mountain construction costs in its “rate base.” I Eagle Mountain were abandoned today, none o the construction costs would be recoverable. The related write-o would amount to over 70 percent o MPS’s stockholders’ equity, but the company would survive. MPS’s management, however, remains committed to the completion o the Eagle Mountain acility. Management has obtained authorization rom the company’s stockholders to issue $500 million in bonds and additional shares o common stock to finance completion o the project. I MPS incurs this additional debt and is still not able to make Eagle Mountain ully operational, it is doubtul that the company can avoid bankruptcy. In short, management has elected to gamble—all its chips are riding on Eagle Mountain.
