Chapter 17 Audit
It is acceptable to express an unqualified opinion on one statement while
expressing a qualified or adverse on the others Example: Auditors retained after client has taken its beginning inventory. A disclaimer may be issued on the income statement (the auditor doesn't know if income is reasonably stated), but an unqualified opinion may be issued on the year-end balance sheet.
comparative financial statements, are financial statements for
one or more prior periods of the same company for comparison with the financial statements of the current period.
Emphasis-of-Matter location
For a nonpublic company the section is placed at an appropriate location after the Basis for Opinion section For a public company the section follows the Opinion section.
Not all material weaknesses in internal control are also critical audit matters. T/F
True. Not all material weaknesses are CAMs
The types of unmodified and modified opinions include:
(1) Unmodified opinion. (2) Unmodified opinion with an emphasis-of-matter paragraph. (3) Unmodified opinion with an other-matter paragraph. (4) Unmodified opinion with divided responsibility on group financial statements. (5) Qualified opinion. (6) Adverse opinion. (7) Disclaimer of opinion
A material departure from generally accepted accounting principles will result in auditor consideration of: (1) Whether to issue an adverse opinion rather than a disclaimer of opinion. (2) Whether to issue a disclaimer of opinion rather than a qualified opinion. (3) Whether to issue an adverse opinion rather than a qualified opinion. (4) Nothing, because none of these opinions is applicable to this type of exception.
(3) When the auditors take exception to the application of accounting principles in the client's financial statements, they will issue either a qualified or adverse opinion, depending on whether the misstatement is considered pervasive.
Assume that the opinion paragraph of an auditors' report begins as follows: "With the explanation given in Note 6, . . . the financial statements referred to above present fairly . . ." This is: (1) An unmodified opinion. (2) A disclaimer of opinion. (3) An "except for" opinion. (4) An improper type of reporting.
(4) This phrase does not give the reader of the report a clear-cut indication of the auditors' opinion. The phrase appears to modify the opinion paragraph, but is not forceful enough to constitute qualifying language.
Key Audit Matter (Nonpublic)
(Must say yes to each) 1. Matter communicated to those charged with governance 2.Matter requires significant audit attention, such as: -Areas of higher assessed risk of material misstatement or significant risk -Areas involving significant auditor judgment, including estimates with high uncertainty -Events or transactions with a significant effect on the audit
Critical Audit Matter (Public)
(Must say yes to each) 1. Matter communicated or required to be communicated to audit committee 2. Matter relates to accounts or disclosures that are material to the financial statements 3. Matter involves especially challenging, subjective, or complex judgement
Reports on the financial statements ordinarily include an opinion that is on both the:
1. Financial statements themselves: -Balance sheet -Income statement -Statement of cash flows -Statement of retained earnings (equity) 2. Financial statement disclosures -The notes to the financial statements are considered an integral part of the financial statements
Group auditor alternatives
1. Make no reference to the component auditors. 2. Make reference to the component auditors.
The auditors believe that the financial statements have been presented in conformity with generally accepted accounting principles in all respects, except that a loss contingency that should be disclosed through a note to the financial statements is not included. While they consider this a material omission, they do not believe that it pervasively affects the financial statements.
A lack of disclosure leads to either a qualified opinion or an adverse opinion. Since the effect is material, but not pervasive, a qualified opinion is appropriate.
Form 8-K
A report filed upon the occurrence of a specified significant event. If the event is a significant acquisition or disposal of assets, Form 8-K will be accompanied by pro forma financial information. An 8-K report is used to report a change in auditors.
Situation: Previously issued financial statements contained a material misstatement and are being reissued.
A report with an unmodified opinion with additional information is appropriate. -The additional section includes a statement that the previously issued financial statements have been restated for correction of a material misstatement and a reference to the entity's disclosure of the correction in the notes to the financial statements
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.
A scope restriction results in either a qualified opinion or a disclaimer of opinion. Because we have no information on whether a possible misstatement could pervasively misstate the financial statements, either type of opinion is possibly appropriate.
Client-imposed restrictions significantly limit the scope of the auditors' procedures, and they are unable to obtain sufficient appropriate audit evidence. The possible effects on the financial statements of undetected misstatements, if any, could be both material and pervasive.
Disclaimer, because the possible effects on the financial statements of undetected misstatements, if any, could be both material and pervasive, a disclaimer is appropriate.
Placement of Consistency Section - Public
Following the Opinion section, before Basis for Opinion section.
Placement of Going Concern Section - Public
Following the Opinion section, before Basis for Opinion section.
Overview of Key and Critical Audit Matters, Figure 17.2
In PowerPoint
Placement of Auditor Discretionary
In either a nonpublic or public company report the section is added at a point following the Basis for Opinion section.
When no critical audit matters are identified in an audit, there will be no Critical Audit Matters section in a public company audit report. T/F
Incorrect. A Critical Audit Matters section is included indicting that none were identified.
All matters communicated to those charged with governance of a public company are critical audit matters. T/F
Incorrect. A wide range of matters are communicated to those charged with governance that do not meet the definition of a critical audit matter.
Most frequent attestation service (Audit Report)
Providing an independent and expert opinion on the fairness of financial statements through an audit
Critical audit matters are selected from matters communicated to those charged with governance. T/F
True. Charged with governance
The client has changed from LIFO to FIFO for inventory valuation purposes; the auditors concur with this change. The effect is considered material to the financial statements, although inventory is not a large part of total assets.
Since the auditor concurs that the change is desirable, an unmodified opinion with an emphasis-of-matter (explanatory, per PCAOB) paragraph is appropriate.
Forms S-l through S-11
These are the "registration statements" for clients planning to issue securities to the public; they are accompanied by comparative audited financial statements.
Forms SB-1 and SB-2
These forms are more simplified registration forms for small businesses.
Form 10-Q
This form includes quarterly financial statements reviewed by the company's auditors.
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.
This is a departure from GAAP that will either lead to a qualified opinion if the misstatement is material but not pervasive or an adverse opinion if it is material and pervasive. Note disclosure does not compensate for improper balance sheet presentation.
Form 10-K
This report is filed annually by publicly owned companies and includes audited financial statements, reports on internal control over financial reporting, and other detailed financial information.
Unmodified opinion—with additional financial statement related information
To emphasize a matter appropriately presented in the financial statements (e.g., a change in accounting principles). -Substantial doubt about the company's going-concern status -Generally accepted accounting principles not consistently applied -Reissued financial statements correcting a misstatement -Other circumstances that the auditors believe should be emphasized
The function of notes to financial statements is to provide
adequate disclosure when information in the financial statements is insufficient to attain this objective.
Emphasis-of-Matter (Explanatory) section that describes the
change and makes reference to the financial statement note explaining the nature of and justification for the change in the method of valuing the inventories and the effect of such change upon the financial statements.
Auditors are required to indicate in the report when a company has
changed accounting principles resulting in a material effect on the financial statements being reported on -This requirement pertains to changes in accounting principles but not changes in accounting estimates
Report should cover
current year as well as prior period audited by their firm. -Can express different opinions on different years -Auditor should update the report for all prior periods presented for comparison.
Reference to a component auditor in a group audit report, in itself, does not represent a qualification. Rather, this form of opinion merely
divides the auditors' overall responsibility for the engagement between two or more CPA firms.
While the term basis for opinion is used for reports with unmodified opinions, the terms (1) basis for qualified opinion, (2) basis for adverse opinion and (3) basis for disclaimer of opinion are used for
reports of those types of opinions.
While generally accepted accounting principles (GAAP) is a frequently used financial reporting framework, generally accepted auditing standards (GAAS) is a
set of auditing standards for audits of nonpublic companies, not a financial reporting framework.
A disclaimer of opinion
states that due to a significant scope limitation, the auditors were unable to form an opinion or did not form an opinion on the financial statements.
An adverse opinion
states that the financial statements are not presented fairly in conformity with generally accepted accounting principles.
A qualified opinion
states that the financial statements are presented fairly in conformity with generally accepted accounting principles "except for" the effects of some matter.
If the misstatement is immaterial, an unmodified opinion may be issued. If it is material,
the auditors issue either a qualified opinion or an adverse opinion depending upon whether they believe the misstatement is pervasive.
A public company audit report, issued under PCAOB standards, must be addressed to
the shareholders and the board of directors of the company or equivalents for companies not organized as corporations. It may include additional addressees.
When the matter is properly disclosed in the financial statements of a nonpublic company, the likely result of substantial doubt about the ability of the client to continue as a going concern is the issuance of which of the following audit opinions? Qualified Unmodified with an Additional Paragraph (1)Yes Yes (2)Yes No (3)No Yes (4)No No
(3) Substantial doubt about a client's ability to continue as a going concern results in either an unqualified report with an additional paragraph (or, less frequently, a disclaimer of opinion). A qualified report is not appropriate.
What type or types of audit opinion are appropriate when financial statements are materially and pervasively misstated? Qualified Adverse (1)Yes Yes (2)Yes No (3)No Yes (4)No No
(3) When a misstatement is pervasive, an adverse opinion is appropriate.
Conditions Requiring a Modification of the Auditors' Report
1.Conditions, although not departures from GAAP, about which the readers of the financial statements should be informed 2.Material departure from GAAP in the client's financial statements 3.Material scope limitation (and auditor unable to obtain sufficient appropriate audit evidence)
Placement of Consistency Section - Nonpublic
At an appropriate point following the Basis for Opinion section.
Each year's financial statements "stand alone." Thus, the CPAs may issue
different types of opinions on the financial statements of successive years when reporting on comparative statements.
Critical Audit Matters sections are not included in audit reports with an adverse opinion or a disclaimer of opinion. T/F
True. Only with an adverse or disclaimer.
A client can avoid an opinion being qualified because of
inadequate disclosure merely by making the appropriate disclosure in the financial statements.
When reporting on comparative statements, CPAs should update their report on the prior year's statements to determine whether
it is still the proper type of report to accompany those statements. For example, a departure from GAAP that existed last year, resulting in a report qualification, might have been corrected. In this case, it is appropriate for the auditors to revise their report on the prior year's statements to an unmodified (unqualified) report. That report will include an other matter paragraph describing the circumstances.
The client has changed from LIFO to FIFO for inventory valuation purposes; the auditors do not concur with this change. The effect is considered material and pervasive.
Because the auditor does not concur with the change it is a departure from GAAP. Because the amount is material and pervasive, an adverse opinion is appropriate.
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.
Because the misstatements could be material, but could not pervasively misstate the financial statements, a qualified opinion is appropriate
A lack of consistent application of accounting principles results in an emphasis-of-matter section, such as:
Change in Accounting Principle
When performing an audit, the auditors gather evidence to
obtain reasonable assurance that the statements are in conformity with GAAP
Ordinarily, adverse opinions do the client no good. Presumably, creditors and stockholders would not
provide debt or equity capital and, if the client is under SEC jurisdiction, the SEC might launch an investigation of management for violations of the federal securities acts -client usually will make whatever changes in the financial statements that the auditors require in order to avoid receiving an adverse opinion
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.
Either a qualified or an adverse opinion is required. Valuation of properties at appraised values is not in accordance with generally accepted accounting principles. Since the difference between appraised value and cost is significant, an unmodified (unqualified) opinion would not be appropriate.
When comparative financial statements are presented, the Critical Audit Matters section must include those matters for all years of audited financial statements included. T/F
Incorrect. Ordinarily critical audit matters are only included for the most recent year, although they may be included for multiple years.
All significant risks identified in an audit constitute critical audit matters. T/F
Incorrect. Some significant risks will not meet the definition of a critical audit matter (e.g., a significant risk may in some circumstances not involve significant auditor judgment).
Critical audit matters are not included in public company audit reports with qualified opinions. T/F
Incorrect. They are included.
In addition to being included in audit reports, critical audit matters are communicated to the PCAOB. T/F
Incorrect. While critical audit matters are included in the audit report, they are not communicated to the PCAOB.
Consolidated Parent Company (Audited by Group Auditor)
Subsidiary A (Audited by Group Auditor) Subsidiary B (Audited by Group Auditor) Subsidiary C (Audited by Component Auditor)
In an audit report on combined financial statements, reference to the fact that a portion of the audit was performed by a component auditor is: (1) Not to be construed as a qualification, but rather as a division of responsibility between the two CPA firms. (2) Not in accordance with generally accepted auditing standards. (3) A qualification that lessens the collective responsibility of both CPA firms. (4) An example of a dual opinion requiring the signatures of both auditors.
(1) Reference to the work of a component auditor is not, in itself, a qualification of the group audit report. This reference does not lessen the auditors' collective responsibility. Rather, it merely divides this responsibility among two or more CPA firms.
The auditors who wish to draw reader attention to a financial statement note disclosure on significant transactions with related parties should disclose this fact in: (1) An emphasis-of-matter paragraph to the auditors' report. (2) A footnote to the financial statements. (3) The body of the financial statements. (4) The "Summary of Significant Accounting Policies" section of the financial statements.
(1) The auditor communicates through the auditors' report. Note that the client will include a discussion of the related party transactions in a note to the financial statements.
An audit report for a public client indicates that the audit was performed in accordance with: (1) Generally accepted auditing standards (United States). (2) Standards of 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).
(2) An audit report of a public client indicates that the audit was performed in accordance with standards of the Public Company Accounting Oversight Board (United States).
Critical audit matters are most likely to include those matters that: (1) Are communicated to the Public Company Accounting Oversight Board. (2) Involve challenging, subjective or complex auditor judgment. (3) Are material weaknesses in internal control. (4) Involve significant risks.
(2) By definition critical audit matters involve challenging, subjective or complex auditor judgment. While material weaknesses (answer 3) and significant risks (answer 4) will often be considered critical audit matters, not all are, and the answers are less complete than answer (2).
The auditors' report should be dated as of the date the: (1) Report is delivered to the client. (2) Auditors have accumulated sufficient appropriate evidence. (3) Fiscal period under audit ends. (4) Peer review of the working papers is completed.
(2) The audit report should be dated no earlier than when the auditors have accumulated sufficient appropriate evidence. This date is often the last day of fieldwork.
A nonpublic company's change in accounting principles that the auditors believe is not justified is likely to result in which of the following types of audit opinions? Qualified Unmodified with Emphasis-of-Matter (1)Yes Yes (2)Yes No (3)No Yes (4)No No
(2) When an unjustified change in accounting principles occurs, either a qualified or adverse opinion is appropriate as this represents a departure from generally accepted accounting principles. An adverse opinion is appropriate, but not a disclaimer of opinion.
An audit report for a public client indicates that the financial statements were prepared in conformity with: (1) Generally accepted auditing standards (United States). (2) Standards of 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).
(3) An audit report for a public client indicates that the financial statements are presented in conformity with generally accepted accounting principles (United States). The PCAOB does not issue accounting standards.
Which of the following is least likely to result in an additional paragraph being added to an audit report? (1) The company is a component of a larger business enterprise. (2) An unusually important significant event. (3) A decision not to confirm accounts receivable. (4) A risk or uncertainty.
(3) An emphasis-of-matter paragraph is appropriate when an auditor wishes to emphasize a matter concerning the financial statements, but not a matter concerning the scope of the audit engagement. An emphasis-of-matter paragraph is not appropriate since confirming accounts receivable relates to the scope of the audit.
The two circumstances resulting in modified opinions are
(a) materially misstated financial statements (a "departure from GAAP") (b) inability to obtain sufficient appropriate audit evidence (a "scope limitation").
Conditions indicative of going concern problem:
-Negative cash flows from operations -Defaults on loan agreements -Adverse financial ratios -Work stoppages -Legal proceedings -Loss of a key franchise, customer, or supplier -An uninsured catastrophe -Dividend arrearages
Disclaimer of Opinion
1. Auditor has no opinion 2.Issued whenever the auditor is unable to form an opinion as to fairness of financial statements 3. Circumstances resulting in a disclaimer are those in which the possible misstatements are material and pervasive. -Multiple uncertainties may also lead to a disclaimer 4.Not an alternative to adverse opinion
If prior period audited by another (predecessor) CPA firm
1. Current year opinion only covers years the CPA firm audited. 2. For financial statements audited by predecessor auditor either: -Predecessor auditor reissues report with original date, or -Current auditor refers to report of other auditor.
Adverse Opinion
1. Financial statements do not present fairly the financial position, results of operations, and cash flows of client in conformity with GAAP 2. Material and pervasive departures from GAAP 3. Auditor believes departure causes financial statements taken as a whole to be misleading
For each Critical Audit Matter, the auditors must include:
1. Identification of the CAM. 2. Description of the principal considerations that led the auditor to determine that the matter is a CAM. 3.Description of how the CAM was addressed in the audit. 4. Reference to the relevant financial statement accounts and disclosures that relate to the CAM.
Qualified Opinion-Lack of Sufficient Appropriate Audit Evidence (Scope Limitations)
1. Scope limitations -Imposed by circumstances -Important accounting records destroyed 2. Due to nature of audit -Engaged too late in year to observe client's beginning inventory 3. Imposed by client -Client refused to allow auditors to send confirmations to customers -Often results in a disclaimer as opposed to a qualification
The wording of a report with an unmodified opinion might be modified by:
1. Substantial doubt about an entity's ability to continue as a going concern exists. 2. Principles of accounting have not been consistently applied in relation to the prior year. 3. The auditors wish to emphasize some matter in the financial statements (e.g., significant related party transactions, subsequent events, uncertainties). 4. A group auditor makes reference to a component auditor.
Effects of misstatements become pervasive when, in the auditor's judgment, they meet one or more of the following three criteria:
1. They are not confined to specific elements, accounts, or items of the financial statements 2. If confined, they represent or could represent a substantial proportion of the financial statements 3. In relation to disclosures, they are fundamental to users' understanding of the financial statements
Additional Emphasis-of-Matter Situations—Auditor Discretionary
1.A risk or uncertainty 2.Significant related party transactions described in a note to the financial statements. 3.The company is a component of a larger business enterprise. 4.Unusually important significant events. 5.Accounting matters affecting comparability (other than changes in accounting principles) of financial statements with those of the preceding year.
Forms filed with SEC which include audited financial statements
1.Forms S-1 through S-11 (registration statements) 2.Forms SB-1 and SB-2 (registration for small businesses) 3.Form 8-K (current report) 4.Form 10-Q (quarterly report) 5.Form 10-K (annual report) Auditors should be well versed on requirements of each form
Qualified Opinion—Departure from GAAP
1.Immaterial - unmodified 2.Material - qualified 3.Material and pervasive—Adverse
Auditors' Unqualified Report - Public Clients
1.Includes the words "Registered" and "Independent" in the title. 2.Must be addressed to shareholders and board of directors (additional parties are allowable). 3.Indicates audit performed following standards of the PCAOB. 4.Sections: -Opinion -Basis for Opinion (auditor and management responsibilities) -Critical Audit Matters 5.If appropriate, includes a paragraph indicating that the auditors have also issued a report on the client's internal control over financial reporting, or is a combined report on both the financial statements and internal control. 6.Includes a Critical Audit Matters section. 7.Includes statement on year audit firm began serving the client. 8.Signed with name of CPA firm not individual partner 9.Includes the City of the office with responsibility for the audit 10.Dated no earlier than the date on which the auditors obtained sufficient appropriate audit evidence to support their opinion
Communicate with component auditors
1.Inform component auditors how their work will be used. 2.Communicate ethical requirements. 3.Provide list of related parties. 4.Communicate significant risks of misstatement.
Going Concern Requirements
1.Management must evaluate whether there is substantial doubt about the company's ability to continue in existence for a reasonable period of time (a year from the date of issuance of the financial statement) -Alternatively, a disclaimer of opinion may be issued. 2.Auditor not required to perform procedures specifically designed to test going-concern assumption but must evaluate the assumption
Misstatements become pervasive when any one of the following applies:
1.Not confined to specific accounts. 2.If confined, they represent a substantial proportion of the financial statements. 3.In relation to disclosures, they are fundamental to users' understanding of the financial statements.
Two or More Report Modifications
1.Qualified for two or more reasons Example: Qualified because of both a scope limitation and separate departure from GAAP 3.Wording of report would include appropriate qualifying language and explanatory paragraphs for both types of qualifications 4.Auditor should consider cumulative effects - disclaimer of opinion may be appropriate
In accepting the change, the auditors should evaluate whether
1.The newly adopted principle is generally accepted 2.The method of accounting for the effect of the change is in conformity with generally accepted accounting principles 3.The disclosures related to the change are adequate 4.Management has justified that the new accounting principle is preferable.
Auditors' Unmodified Report - Nonpublic Clients
1.Title that includes the word independent 2.Ordinarily addressed to the company itself, the shareholders, the audit committee, and/or the board of directors 3.Sections: -Opinion -Basis for Opinion -Key Audit Matters (when in terms of engagement) -Management Responsibilities -Auditor Responsibilities 4.Signed with name of CPA firm not individual partner unless the firm is structured as a sole practitioner 5.Dated no earlier than the date on which the auditors obtained sufficient appropriate audit evidence to support their opinion
Group engagement team should obtain understanding of
1.Whether component auditors are competent and understand and will comply with ethical requirements. 2.Extent of group engagement team involvement with component auditors. 3.Whether group engagement team will be able to obtain necessary information on the consolidation process. 4.Whether component auditors operate in a regulatory environment that actively oversees auditors.
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.
An unmodified should be issued.
Generally accepted accounting principles assume that a company is a going concern
Assets and liabilities are valued on the assumption that the company will continue to operate for a reasonable period of time
Placement of Going Concern Section - Nonpublic
At an appropriate point following the Basis for Opinion section.
Unmodified (Unqualified) opinion
This report may be issued only when the auditors have obtained sufficient appropriate audit evidence to conclude the financial statements are not misstated and there is no need to alter the report
Unmodified opinion—with additional audit-related information included.
To emphasize a matter other than those presented or disclosed in the financial statements (e.g., reporting on comparative statements when thee is a predecessor auditor involved).
A Critical Audit Matters section follows at an appropriate point after the Basis for Opinion section in an audit report. T/F
True. It follows Basis for Opinion
The auditors decide not to make reference to the report of a component auditor that audited a portion of group financial statements.
When no reference is made to the component auditors an unmodified report is issued.
Unmodified opinion on group financial statements
When two or more CPA firms are involved in an audit and the group auditor (the firm that performs majority of the work) does not wish to take responsibility for the work of the component auditors.
If auditors have not been able to form an opinion on the financial statements taken as a whole, they must issue
a disclaimer of opinion.