Audit Chapter 12
Summary Financial Statements In some cases, users may engage auditors to examine and report on summary financial statements. Auditors can do so only if they have audited the full financial statements. The report on summary financial statements parallels the auditors' report on the financial statements illustrated throughout this chapter and must refer to the auditors' report on the full financial statements, giving the date and the type of opinion expressed
The auditors' conclusion on summary financial statements will not express an opinion on the summary financial statements but will indicate whether the information in the summary financial statements is fairly stated in all material respects in relation to the complete financial statements.
The Standard Report
The auditors' report on the financial statements expresses an opinion on whether the financial statements present the entity's financial position, results of operations, and cash flows in accordance with GAAP (or other applicable financial reporting framework).
Refer to Exhibits 12.7 and 12.8 for examples of reports when scope limitations are encountered.
The failure to take physical counts of inventory could have been based on a request from the client's management (client imposed), or it could have resulted from other circumstances such as the entity not anticipating the need for an audit and appointing the auditors after the latest year-end (circumstance imposed).
"Going-Concern" Uncertainties Questions raised about the entity's ability to continue in operation and meet its obligations as they become due are known as going-concern uncertainties
The most common report issued when going-concern uncertainties exist is an unmodified opinion with an emphasis-of-matter paragraph following the opinion paragraph that directs users' attention to management's disclosures about going-concern uncertainties and specifically includes the words "substantial doubt" and "going concern."
This qualification identifies a particular departure but indicates that the financial statements are otherwise in accordance with GAAP.
The nature of the GAAP departure must be explained in a separate paragraph in the report, as shown in Exhibit 12.4.8
Scope Limitations A GAAS audit presumes that auditors are able to gather sufficient appropriate evidence on which to base their opinion. Two situations may create scope limitations when auditors are unable to obtain sufficient appropriate evidence
The two arise from (1) management's deliberate refusal to provide auditors access to evidence or to otherwise limit the auditors' application of auditing procedures (known as a client-imposed scope limitation) and (2) circumstances beyond the auditors' and client's control such as the late appointment of the auditors that lead to auditors' inability to perform certain auditing procedures (known as a circumstance-imposed scope limitation). The auditors' reporting options depend on the nature and materiality of the scope limitation (see Exhibit 12.6).
Same Auditors, Same Opinions for Comparative Years When auditors issue a report on the current-year financial statements, they are required to update their report on the prior years' financial statements by considering whether the opinions on the prior years' financial statements are still appropriate.
The updated report is based not only on the prior-year audits, but also on information that has come to the auditors' attention since then (particularly in the course of the most recent audit). An updated report carries the most recent date of the auditors' report, and the auditors' responsibility for the comparative financial statements now extends to this date.
For both public and nonpublic entities, the auditors' report on financial statements and related disclosures provides (or disclaims) an opinion on whether the entity's financial statements and related disclosures are presented in accordance with GAAP.
This opinion is based on the tests of controls and substantive procedures that have been performed during the audit engagement and discussed throughout this text.
As an alternative to issuing separate reports on the financial statements (as shown in Exhibit 12.2) and internal control over financial reporting, the audit team could choose to issue a single report that expresses opinions on Dunder-Mifflin Inc.'s financial statements and internal control over financial reporting.
This report (sometimes referred to as an integrated report) essentially combines the report on Dunder-Mifflin Inc.'s financial statements (shown in Exhibit 12.2) with a report on its internal control (for examples, see Chapter 5).
An updated report differs from a reissued report
When auditors reissue a report, they simply provide additional copies of a previously issued report or grant entities permission to use a previously issued report in another document sometime after its original date. However, auditors do not attempt to update the report or otherwise consider events that have occurred since the date of the original report. The date of a reissued report is the same as that for the original report, indicating a cutoff date for the auditors' responsibility.
Required Supplementary Information Auditors are required to perform limited procedures (inquiring of management, comparing information for consistency with the financial statements, and obtaining written representations from management) with respect to the required supplementary information.
When companies present required supplementary information, auditors are required to expand their report on the financial statements to include an other-matter paragraph that identifies the supplementary information, describes any procedures performed with respect to this information, and identifies any issues related to this information. However, the paragraph specifically disclaims an opinion or any form of assurance on the supplementary information.
Types of Opinions Auditors may issue four types of opinions:
1. An unmodified opinion in which the conclusion is that the financial statements present the financial condition, results of operations, and cash flows in accordance with GAAP. (Until recently, this type of opinion was referred to as an unqualified opinion). The auditors' standard (unmodified) report in Exhibit 12.1 is an example of an unmodified opinion; however, unmodified opinions can be issued in forms other than the standard (unmodified) report.
All standard (unmodified) reports contain four major sections:
1. Introduction. The introductory paragraph identifies the financial statements and years examined by the audit team. The report in Exhibit 12.1 identifies the balance sheet, income statement, statement of changes in shareholders' equity, and statement of cash flows for the year ended December 31, 2017, as the financial statements and years examined.
2. A qualified opinion in which the conclusion is that, with the exception of one or more issues, the financial statements present the financial condition, results of operations, and cash flows in accordance with GAAP. Qualified opinions use the phrase except for in describing the issues that give rise to the qualification. Interestingly, although the term "qualified" normally has a positive connotation, qualified opinions are issued when one or more issues are encountered during the audit.
3. An adverse opinion, in which the conclusion is that the financial statements do not present the financial condition, results of operations, and cash flows in accordance with GAAP. 4. A disclaimer of opinion, in which the auditors do not express an opinion on the fairness of the entity's financial statements.
2. Management's Responsibility for the Financial Statements. The paragraph in this section explicitly indicates that the entity's management is responsible for both the fairness of the financial statements and the design, implementation, and maintenance of internal control under which those statements are prepared.
3. Auditor's Responsibility. This section includes three paragraphs that (a) identify the audit team's responsibility to conduct an audit under generally accepted auditing standards (GAAS), (b) provide a brief description of an audit, and (c) indicate that the audit evidence provides a basis for the audit team's opinion.
The group auditors must first obtain information about the independence and professional reputation of the component auditors. If the group auditors are satisfied with these qualities, they must next communicate with the component auditors and decide whether to refer to their work in the group auditors' report.
As shown in Exhibit 12.9, the group Page 554auditors may decide to make no reference and issue the standard (unmodified) report. In this case, the group auditors assume full responsibility for the component auditors' work.
Supplementary Information Similar to summary financial statements, users may engage auditors to examine and report on supplementary information. The auditors' conclusion will not express an opinion on the supplementary information but will indicate whether it is fairly stated, in all material respects, in relation to the financial statements as a whole.
Auditors may report on this information either by adding an other-matter paragraph to their report on the financial statements (following the opinion paragraph) or by preparing a separate report on the supplementary information. For example, KPMG added a paragraph to its 2016 report on its audit of General Electric that references "... consolidating information appearing on pages 129, 133, and 135 [of General Electric's annual report]" and indicates that this information "... is fairly stated in all material respects in relation to the consolidated financial statements taken as a whole
AUDITS OF GROUP FINANCIAL STATEMENTS Many large entities prepare consolidated financial statements that include more than one component (division, subsidiary, or other segment); these financial statements are referred to as group financial statements
In some cases, principal auditors (known as the group engagement team or group auditors) perform the audit of a material portion of the consolidated entity's assets, liabilities, revenues, and expenses, and other independent auditors (known as component auditors) may be engaged to audit divisions, subsidiaries, or components that are included in the group financial statements
Different Auditors in Comparative Years Assume that Michael Scarn became the auditor of Dunder-Mifflin in 2017 and another (predecessor) firm had examined the 2015 and 2016 financial statements and issued an unmodified opinion (standard report) on these statements.
In this case, Michael Scarn's report should indicate that he audited the 2017 financial statements and expressed an opinion on the 2017 financial statements. However, how should the results of the other firm's audit of the 2015 and 2016 financial statements be communicated?
AUDITORS' REPORTS REFERENCING OTHER MATTERS ENCOUNTERED DURING THE AUDIT In other cases, situations encountered during the audit involve adding a paragraph to the standard (unmodified) report shown in Exhibit 12.1 to describe the matter. These paragraphs are labeled as follows:
Paragraphs that provide information fundamental to users' understanding of the entity's financial statements are known as emphasis-of-matter paragraphs. Paragraphs that provide information relating to users' understanding of the audit, auditors' responsibility, or auditors' report are known as other-matter paragraphs.
Because the entity's management is responsible for preparing its financial statements, the auditors' examination (and report on that examination) plays an important role in users' ability to rely on the financial statements when making economic decisions.
Public entities (those entities that offer registered securities for sale to the general public) are required to file certain financial information with the Securities and Exchange Commission (SEC) within 60 to 90 days (depending upon their size) of their fiscal year-end. This information, which includes audited financial statements, footnotes, and other required disclosures related to the financial statements, is filed using Form 10-K.
Because of the audit requirement for public entities, the report is addressed to the entity's board of directors and shareholders. As shown in Exhibit 12.2, the auditors' report on the financial statements references their report and opinion on internal control
Similarly, when separate reports on internal control are provided, their report on internal control will reference their report and opinion on the financial statements.
On the other hand, the group auditors may decide to refer to the work and reports of the component auditors; this is referred to as a division of responsibility
Such a reference is not in itself a scope limitation and the report should not be considered to be inferior to a standard (unmodified) report that does not contain such a reference. The explanation should disclose the extent of the component auditors' work by indicating the percent or amount of assets, revenues, and expenses related to their work.
Other Modifications Beyond the wording in the standard (unmodified) report, auditors can enrich the information content in their reports by adding one or more paragraphs to emphasize something they believe readers should consider important or useful.
Although auditing standards place no official limits on the content of these paragraphs, auditors often use them to describe circumstances that present some business or information risk. Matters that may be emphasized include a warning that a bankruptcy filing may be imminent, a description of the auditee as a subsidiary of a larger entity, the effects of business events on the comparability of financial statements, the interaction of the auditee with related parties, and the effect of events that occur after the date of the financial statements (commonly referred to as subsequent events).
One option would be to add an other-matter paragraph (following the introductory paragraph) that summarizes the predecessor auditors' responsibility and report.
An example of this type of paragraph follows. If the predecessor auditors issued an opinion other than the standard (unmodified) opinion, the paragraph should be expanded to provide information about the report modification. The predecessor auditors' report would also be included along with the comparative financial statements.
Same Auditors, Different Opinions for Comparative Years Auditors can express different opinions on comparative years' financial statements in the same report. For example, assume that Dunder-Mifflin incorrectly recorded a $30 million provision for uncollectible receivables in the 2016 financial statements instead of in 2015.
As a result, both years' financial statements were not prepared in accordance with GAAP, so Michael Scarn issued an adverse opinion in those two years. However, Scarn concluded that an unmodified opinion was appropriate in 2017. The report shown in Exhibit 12.11 would be appropriate in the circumstances.
As with any issue, a departure from GAAP may not be material to the entity's financial statements. Recall the wording of the opinion paragraph in the auditors' standard (unmodified) report: "In our opinion, the financial statements referred to above present fairly, in all material respects..." [emphasis added].
As a result, if a departure from GAAP is immaterial, the auditors would treat the departure as if it did not exist. In this case, they can express an unmodified opinion and issue the standard (unmodified) report.
Although the reports shown in Exhibits 12.4 and 12.5 reflect the appropriate wording if departures from GAAP necessitate the issuance of qualified and adverse opinions, under the provisions of Regulation S-X, public companies are not permitted to file financial statements with the SEC if these statements would be false or misleading.
As a result, if a material departure from GAAP is noted during an audit examination of a public entity, the auditors' report must be modified to identify that departure as noted in the preceding subsections. However, the entity's financial statements and accompanying auditors' report would be classified as a "deficient" filing by the SEC and would not satisfy its reporting requirements.
On the other hand, if the GAAP departure is pervasive, affecting numerous accounts and financial statement relationships, or is material to the point that the financial statements as a whole are misleading, the auditors must issue an adverse opinion.
As noted earlier, in an adverse opinion, auditors conclude that the financial statements do not present fairly the financial position, results of operations, and cash flows in accordance with GAAP. As with the qualified opinion, all substantive reasons must be disclosed in the report.
Same Auditors with Modification of Previously Issued Opinion Auditors should modify the opinion expressed on prior years' financial statements if circumstances have changed in the intervening period. For example, consider the departure from GAAP shown in Exhibit 12.11 and discussed in the preceding section.
In 2017, if Dunder-Mifflin restated its 2015 and 2016 financial statements to record the provision in the appropriate year (2015), all three years of financial statements would now be in accordance with GAAP. Therefore, an unmodified opinion (standard report) on all three years would now be appropriate.
One additional consideration in evaluating reporting options when scope limitations exist is the nature of the limitation. Auditors should carefully consider the implications of a client-imposed scope limitation because such restrictions on the audit may cast doubt on management's integrity.
(Why would management restrict the auditor's engagement?) Because of these implications, auditors normally disclaim an opinion or even withdraw from the engagement in these situations. Any client-imposed scope limitation should be communicated to those charged with the entity's governance.
Auditors' Reports for Public Entities Although the length of the report and format slightly varies from the report shown Exhibit 12.1, you should see many similarities in the general content and message communicated by the two reports. Some noteworthy differences are:
- In describing the standards under which the audit is conducted, the AS 3101 report references "standards of the Public Company Accounting Oversight Board (United States)" (because these audits are conducted under PCAOB standards) rather than "auditing standards generally accepted in the United States of America." The AS 3101 report has a paragraph that references the audit team's report and opinion on the entity's internal control over financial reporting, which is required in the audit of a public entity (a similar requirement does not exist for the audit of a nonpublic entity).
In addition to the auditors' report on financial statements and related disclosures, public entities are subject to additional reporting requirements. The Sarbanes-Oxley Act of 2002 and Auditing Standard 3101 (AS 3101) have mandated two additional types of reports:
A report, prepared by the entity's management, on the effectiveness of the entity's internal control over financial reporting. A report, prepared by the auditors, on the effectiveness of the entity's internal control over financial reporting.
If the scope limitation is not material or the auditors can perform alternative procedures, the standard (unmodified) report can be issued. This report does not need to reference the inability to perform certain procedures or the alternative procedures performed.
If the scope limitation is material and alternative procedures cannot be performed, auditors issue either a qualified opinion or disclaimer of opinion, depending upon the materiality and pervasiveness of the scope limitation.
Emphasis-of-matter and other-matter paragraphs may be collectively referred to as explanatory paragraphs
In most cases, the auditors' reporting responsibility is exception-based reporting, which means that the report will refer only to these matters if an issue is noted during the audit.
Following the opinion paragraph, the auditors' report should
Be signed using the firm's name. Be dated using the date when the auditors have obtained sufficient appropriate evidence to support the opinion (the date of the auditors' report).
The report should be titled independent auditor's report (or other suitable title stressing the independence of the auditors). The report is typically addressed to the board of directors and shareholders but may also be addressed to an individual lender, creditor, or investor who requested the audit
Because the Auditing Standards Board (ASB) prescribes the format and contents of the report for nonpublic entities, these reports are sometimes referred to as the Auditing Standards Board (or ASB) report. See Exhibit 12.1 for an example of a standard (unmodified) report issued for a nonpublic entity. This report is appropriate when no material issues are encountered during the audit and the financial statements are prepared in accordance with GAAP.
If the departure is sufficiently material to affect users' decisions that are based on the financial statements but the departure can be compartmentalized, the auditors must qualify the opinion.
By "compartmentalized," we mean that the departure can be isolated to a particular account group (e.g., accounts receivable not valued at net realizable value) or transactions (e.g., failure to capitalize leases) without affecting other accounts to a material extent. In other words, this departure would not be considered pervasive.
Disclaimers of Opinion Auditors may be engaged to conduct an audit but subsequently discover a relationship involving the firm that results in a lack of independence
In other cases, auditors may consent to the use of their name in some form of communication containing the entity's financial statements or submit to their clients or others (such as third-party users) financial statements they have prepared or assisted in preparing. These situations are referred to as being associated with financial statements.
Consistency The concept of consistency is based on the importance of permitting users to appropriately compare an entity's financial statements across years. GAAS require that the auditors' report be modified by adding an emphasis-of-matter paragraph (following the opinion paragraph) for the following issues related to consistency:
Changes in accounting principles (from one GAAP method to another GAAP method). Changes in the form of the reporting entity (other than that resulting from a transaction or event). Changes in an accounting principle that is not a generally accepted accounting principle to one that is a generally accepted accounting principle (which is considered to be an adjustment to correct a misstatement in previously issued financial statements). Changes in accounting principles inseparable from changes in estimates.
OTHER REPORTING TOPICS Comparative Financial Statements The SEC requires public entities to present balance sheets for two years and statements of income, changes in shareholders' equity, and cash flows for three years in comparative (side-by-side) format
Financial statement footnotes also contain disclosures in comparative form. Together, these comparative financial statements and footnotes are the subject of the auditors' work and report. Although nonpublic companies are not subject to similar requirements, users may request that entities provide multiple years of financial statements in comparative form.
In contrast, nonpublic entities are not subject to these filing or audit requirements.
However, third-party users may demand audited financial statements as a condition for certain lending or investing activities or for use in monitoring the entity's activities. In addition, regulatory bodies other than the SEC may require audits for governmental and other types of nonpublic entities.
Other Information Accompanying Audited Financial Statements Similar to consistency and going-concern uncertainties, other information accompanying audited financial statements is subject to "exception-based" reporting (i.e., auditors' reports mention the other information only if inconsistencies or misstatements exist).
If misstatements or inconsistencies exist with respect to other information and the entity chooses not to revise the other information, the auditors should (1) notify the client in writing of their views, (2) consult with legal counsel about appropriate action to take, and (3) consider whether this inconsistency affects the opinion on the financial statements.
