Chapter 3 Audit Reports

Introductory Paragraph

- makes the simple statement that the CPA firm has done an audit - lists the financial statements that were audited, including the balance sheet dates and the accounting periods for the income statement and statement of cash flows

Decide the appropriate type of report for the Condition, Given the Materiality Level

After making the first two decisions, it is easy to decide the appropriate type of opinion by using a decision aid

Three levels of materiality are used for determining the type of opinion to issue.

Amounts are Immaterial When a misstatement in the financial statements exists but is unlikely to affect the decisions of a reasonable user, it is considered to be immaterial. An unmodified opinion is therefore appropriate

2) substantial doubt about going concern

Auditor must judge whether client will be able to continue operations for a period of one year from B/S date. If cannot, auditor must modify audit opinion -Explanatory paragraph -Disclaimer permitted if there is substantial doubt - rare!

LO7 Draft appropriately modified audit reports under a variety of circumstances

Auditor's Scope Has Been Restricted Statements are Not in Conformity with Gaap Auditor Is Not Independent

Justified Departure from Gaap

Determining whether statements are in accordance with GAAP can be difficult. The Accounting Principles Rule in the AICPA Code of Professional Conduct permits a departure from generally accepted accounting principles when the auditor believes that adherence to these would result in misleading financial statements, although this circumstance is rare. When the auditor decides that adherence to GAAP would result in misleading statements, there should be a complete explanation in an added paragraph.

3. the auditor Is Not Independent

Independence ordinarily is determined by the AICPA Code of Professional Conduct. When any of the three conditions requiring a departure from an unmodified opinion exists and is material, the opinion in the audit report must be modified. Three main types of audit reports are issued under these conditions: qualified opinion, adverse opinion, and disclaimer of opinion.

Disclaimer of opinion

issued when the auditor has been unable to satisfy himself or herself that the overall financial statements are fairly presented. The necessity for disclaiming an opinion may arise because of a severe limitation on the scope of the audit or a nonindependent relationship under the AICPA Code of Professional Conduct between the auditor and the client.

LO5 Identify the types of audit reports that can be issued when an unmodified opinion is not justified.

qualified opinion, adverse opinion, disclaimer of opinion

Audit report address

report is usually addressed to the company, its stockholders, or the board of directors

qualified, adverse, or disclaimer report,

the auditor either has not been able to perform a satisfactory audit, is not satisfied that the financial statements are fairly presented, or is not independent.

When the financial statements are fairly stated but the auditor concludes there is substantial doubt whether the client can continue in existence, the auditor should issue a(n)

unmodified opinion with explanatory paragraph.

An entity changed from the straight-line method to the declining-balance method of depreciation for all newly acquired assets. This change has no material effect on the current year's financial statements but is reasonably certain to have a substantial effect in later years. If the change is disclosed in the notes to the financial statements, the auditor should issue a report with a(n)

unmodified opinion.

Qualified Opinion Report

can result from a limitation on the scope of the audit or failure to follow generally accepted accounting principles. A qualified opinion report can be used only when the auditor concludes that the overall financial statements are fairly stated

The date of the CPA's opinion on the financial statements of the client should be the date of the

completion of all important audit procedures

The auditor's report contains the following: "We did not audit the financial statements of EZ, Inc., a wholly owned subsidiary, which statements reflect total assets and rev- enues constituting 27 percent and 29 percent, respectively, of the consolidated totals. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for EZ, Inc., is based solely on the report of the other auditors." These sentences

indicate a division of responsibility

An adverse opinion and a disclaimer of opinion:

indicate situations in which there are material departures from the standards

As compared to an unmodified opinion, an opinion qualified due to a material departure from generally accepted accounting principles would:

indicate that, except for the problem noted, the financial statements are fairly presented

first paragraph in auditor's responsibility

indicated that their responsibility is to express an opinion on the statements based on an audit conducted in accordance with the standards and the audit provides reasonable assurance that financials are free of material misstatement

third paragraph in auditor's responsibility

indicates that the auditor believes the audit evidence is sufficient and appropriate to provide a basis for the audit opinion

More than One Condition requiring a Departure or Modification

Auditors may encounter situations involving more than one of the conditions requir- ing a departure from an unmodified opinion audit report or revisions to the standard report wording. In these circumstances, the auditor should modify his or her opinion for each condition unless one has the effect of neutralizing the others. For example, if there is a scope limitation and a situation in which the auditor is not independent, the scope limitation should not be revealed. The following situations are examples when more than one modification should be included in the report: • The auditor is not independent and the auditor knows that the company has not followed generally accepted accounting principles. • There is a scope limitation and there is substantial doubt about the company's ability to continue as a going concern. • There is a substantial doubt about the company's ability to continue as a going concern and information about the causes of the uncertainties is not adequately disclosed in a footnote. • There is a deviation in the statements' preparation in accordance with GAAP and another accounting principle was applied on a basis that was not consistent with that of the preceding year.

5) reports involving other auditors

CPAs often rely on a different CPA firm to perform part of the audit when the client has widespread operations. The primary auditor issuing the opinion on the financial statements is called the principal auditor under PCAOB auditing standards and the group engagement partner under AICPA auditing standards. The other auditor who performs work on the financial information of a component is called the component auditor under AICPA auditing standards.

The unmodified opinion audit report with emphasis-of-matter paragraph or nonstandard report wording

meets the criteria of a complete audit with satisfactory results and financial statements that are fairly presented, but the auditor believes it is important to draw the reader's attention to certain matters or the auditor is required to provide additional information.

1) Lack of Consistent Application of GAAP - Consistency vs. Comparability

Consistency-related changes include (EP required): -Changes in accounting principles. -Changes in reporting entities. -Corrections of errors involving principles, by changing from an accounting principle that is not generally acceptable to one that is generally acceptable, including correction of the resulting error. Comparability-related changes include (No EP required): -Changes in an estimate. -Error corrections not involving principles, such as a previous years' math error. -Variations in format and presentation of financial information. -Changes related to new endeavors/events.

A disclaimer or an adverse report

must be used if the auditor believes that the condition being reported on is highly material to the financial statements as a whole. Therefore, the qualified opinion is considered the least severe type of departure from an unmodified opinion audit report.

If a principal auditor decides to refer in his or her report to the audit of another uditor, he or she is required to disclose the

portion of the financial statements audited by the other auditor

Adverse opinion

used only when the auditor believes that the overall financial statements are so materially misstated or misleading that they do not present fairly the financial position or results of operations and cash flows in conformity with GAAP. The adverse opinion report can arise only when the auditor has knowledge, after an adequate investigation, of the absence of conformity. This is uncommon and thus the adverse opinion is rarely used

What are the three alternative opinions that may be appropriate when the client's financial statements are not in accordance with GAAP? Under what circumstance is each appropriate?

​(1) unmodified​ opinion, (2) qualified as to opinion​ only, (3) adverse opinion Circumstance: Deviation from GAAP is material, but nothighly material. Opinion: Qualified as to opinion only Circumstance: Deviation from GAAP is highly material. Opinion: Adverse Circumstance: The auditor agrees with the client's departure from GAAP. Opinion: Unmodified with explanatory paragraph Circumstance: GAAP departure is immaterial. Opinion: Standard unmodified

LO 9 Understand use of international accounting and auditing standards by U.S. companies.

Currently, U.S. public companies are required to prepare financial statements that are filed with the Securities and Exchange Commission (SEC) in accordance with generally accepted accounting principles in the United States. The SEC has been working on a plan to determine whether to incorporate IFRS into the U.S. financial reporting system. An auditor may be engaged to report on financial statements prepared in accor- dance with IFRS. When the auditor reports on financial statements prepared in con- formity with IFRS

LO8 Determine the appropriate audit report for a given audit situation

Determine Whether any Condition exists requiring a Departure from a Standard Unmodified Opinion report: The most important conditions are identified in Table 3-2. Auditors identify these conditions as they perform the audit and include information about any condition in the audit files as discussion items for audit report- ing. If none of these conditions exist, which is the case in most audits, the auditor issues a standard unmodified opinion audit report.

Auditor Is Not Independent

If the auditor is not independent as specified by the AICPA Code of Professional Conduct, a disclaimer of opinion is required even though all the audit procedures considered necessary in the circumstances were performed. The wording in Figure 3-12 is recommended when the auditor is not independent. The lack of independence overrides any other scope limitations. Therefore, no other reason for disclaiming an opinion should be cited. There should be no mention in the report of the performance of any audit procedures.

reasonable assurance

Intended to indicate that an audit cannot be expected to completely eliminate the possibility that a material misstatement will exist in the financial statements. In other words, an audit provides a high level of assurance, but it is not a guarantee.

Relationship of Materiality to Type of Opinion

Materiality Level: Immaterial Significance in Terms of Reasonable Users' Decisions: Users' decisions are unlikely to be affected. Type of Opinion: Unmodified

LO6 Explain how materiality affects audit reporting decisions

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

Write the audit report

Most CPA firms have computer templates that include precise wording for different circumstances to help the auditor write the audit report. Also, one or more partners in most CPA firms have special expertise in writing audit reports. These partners typically write or review all audit reports before they are issued.

Auditor's Responsibility

Must include the heading "Auditor's Responsibility" followed by three paragraphs that describe the auditor's responsibility.

Management's Responsibility

Must include the heading "Management's Responsibility for the Financial Statements" and a paragraph that describes management's responsibility for the financial statements. - indicates that the financial statements are the responsibility of management, including selecting appropriate accounting principles and maintaining internal control over financial reporting

Report title

Must include the word independent. The requirement that the title include the word independent conveys to users that the audit was unbiased in all aspects

LO3 Understand reporting on financial statements and internal control under PCAOB auditing standards

PCAOB Auditing Standard 5 requires the audit of internal control to be integrated with the audit of the financial statements. However, the auditor may choose to issue separate reports, such as the separate report on internal control over financial reporting shown in Figure 3-4, or in a combined report. The combined report on financial statements and internal control over financial reporting addresses both the financial statements and management's report on internal control over financial reporting.

1) lack of consistent application of GAAP

The 2nd reporting standard requires the auditor to call attention to circumstances where accounting principles have NOT been consistently observed. GAAP requires that changes in accounting principles or their method of application: -be to a preferable principle, and -the nature and impact of the change be adequately disclosed.

3) auditor agrees with a departure from promulgated accounting principles

The AICPA Code of Professional Conduct states that in unusual situations, a departure from a generally accepted accounting principle may not require a qualified or adverse opinion. However, to justify an unmodified opinion, the auditor must be satisfied and must state and explain, in a separate paragraph or paragraphs in the audit report, that adhering to the principle would produce a misleading result in that situation.

LO 9

The International Auditing and Assurance Standards Board (IAASB) issues International Standards on Auditing (ISAs). Auditing standards in the United States now allow an auditor to perform an audit of financial statements of a nonpublic U.S. entity in accordance with both generally accepted auditing standards. in the U.S. and the ISAs. The auditor's scope paragraph is modified to indicate that the audit was conducted in accordance with auditing standards generally accepted in the United States of America and in accordance with International Standards on Auditing.

Audit report date

The appropriate date for the report is the one on which the auditor completed the auditing procedures needed to obtain sufficient appropriate audit evidence. This date is important to users because it indicates the last day of the auditor's responsibility for the review of significant events that occurred after the date of the financial statements.

second paragraph in auditor's responsibility

- scope paragraph - a factual statement about what the auditor did in the audit - briefly describes important aspects, including procedures dependent on the auditor's judgment and assessment of the risks of material misstatements - indicates that auditor considers the entity's internal control - the last sentence indicates that the audit includes evaluating the appropriateness o accounting policies selected, the reasonableness of accounting estimates, and the overall financial statement presentation

Opinion Paragraph

- the final paragraph in the standard report - states the auditor's conclusions based on the results of the audit - must include the title "Opinion"

Reports Involving Other Auditors

1) Make No reference in the audit report When no reference is made to the other auditor, a standard unmodified opinion is given unless other circumstances require a departure.

LO4 Describe the five circumstances when an emphasis-of-matter explanatory paragraph or nonstandard wording is appropriate to include in an unmodified opinion audit report.

1) lack of consistent application of GAAP, 2) substantial doubt about going concern, 3) auditor agrees with a departure from promulgated accounting principles, 4) emphasis of other matters, 5)reports involving other auditors The first four reports all require the addition of an explanatory paragraph. In each case, the standard report paragraphs, including the opinion paragraph, are presented without changes in wording, and a separate explanatory paragraph follows the opinion paragraph.

1. What are the eight parts of a standard unmodified opinion audit report for a nonpublic entity and what is the main content provided in each part?

1. Report Title 2. Audit report Address 3. Intro Paragraph 4. Management's Responsibility 5. Auditor's Responsibility 6. Opinion paragraph 7. Signature and address of CPA Firm 8. Audit report date

2. When should the auditor include an explanatory paragraph in an unmodified opinion audit report?

The auditor should include an explanatory paragraph in an unmodified opinion audit report when the audit is completed with satisfactory results and the financial statements are fairly​ presented, but the auditor believes it is important to draw the​ reader's attention to certain matters or the auditor is required to provide additional information.

What are the three conditions that require a departure from an unmodified opinion audit report? Give an example of each.

1. The scope of the audit has been restricted.2. The financial statements have not been prepared in accordance with GAAP.3. The auditor is not independent.

Specify the conditions required to issue the standard unmodified opinion audit report.

1. includes all financial statements 2. sufficient appropriate evidence accumulated 3. financial statements are presented fairly in accordance with GAAP or other framework 4. no circumstances requiring the addition of an emphasis-of-matter paragraph or modification

Describe the parts of the standard unmodified opinion audit report for nonpublic entities under AICPA auditing standards

1. report title, 2. audit report address, 3. introductory paragraph, 4. management's responsibility, 5. auditor's responsibility, 6. opinion paragraph, 7. signature and address of CPA firm, 8. audit report date

Three conditions requiring a modification to the opinion

1. the Scope of the audit has Been restricted (Scope Limitation) 2. the Financial Statements have Not Been prepared in accordance with Generally accepted accounting principles (Gaap Departure) 3. the auditor Is Not Independent

Nature of the item

The decision of a user may also be affected by the kind of misstatement. The following may affect a user's decision and therefore the auditor's opinion in a different way than most misstatements: 1. Transactions are illegal or fraudulent. 2. An item may materially affect some future period, even though it is immaterial when only the current period is considered. 3. An item has a "psychological" effect (for example, the item changes a small loss to a small profit, maintains a trend of increasing earnings, or allows earnings to exceed analysts' expectations). 4. An item may be important in terms of possible consequences arising from contractual obligations (for example, the effect of failure to comply with a debt restriction may result in a material loan being called).

Materiality Decisions - Measurability

The dollar amount of some misstatements cannot be accurately measured. The materiality question the auditor must evaluate in such situations is the effect on statement users of the failure to make the disclosure.

Materiality Decisions

The evaluation of materiality also depends on whether the situation involves a failure to follow GAAP or a scope limitation. Materiality Decisions—Non-Gaap Condition When a client has failed to follow GAAP, the audit report will contain an unmodified opinion, a qualified opinion only, or an adverse opinion, depending on the materiality of the departure. Dollar amounts Compared with a Benchmark The primary concern in measuring materiality when a client has failed to follow GAAP is usually the total dollar misstatement in the accounts involved, compared with some benchmark or base. misstatements must be compared with some measurement base before a decision can be made about the materiality of the failure to follow GAAP. When comparing potential misstatements with a base, the auditor must carefully consider all accounts affected by a misstatement (pervasiveness)

Reports involving other auditors

2. Make reference in the report (modified wording report) This type of report is called a shared opinion or report. A shared unmodified opinion audit report is appropriate when the portion of the financial statements audited by the other CPA is material in relation to the whole.

Reports involving other auditors

3. Qualify the Opinion A qualified opinion or disclaimer, depending on materiality, is required if the principal auditor is not willing to assume any responsibility for the work of the other auditor. The principal auditor may also decide that a qualification is required in the overall report if the other auditor qualified his or her portion of the audit.

An auditor who qualified an opinion because of an insufficiency of audit evidence should refer to the scope limitation in the:

Auditor's responsibility paragraph: N Opinion paragraph: Y Note to the financial statements: N

Substantial Doubt About Going Concern - Factors That Give Rise To Doubt

The existence of one or more of the following factors causes uncertainty about the ability of a company to continue as a going concern: 1. Significant recurring operating losses or working capital deficiencies 2. Inability of the company to pay its obligations as they come due 3. Loss of major customers, the occurrence of uninsured catastrophes such as an earthquake or flood, or unusual labor difficulties 4. Legal proceedings, legislation, or similar matters that have occurred that might jeopardize the entity's ability to operate. When the auditor concludes that there is substantial doubt about the entity's ability to continue as a going concern, an unmodified opinion audit report with an explanatory paragraph is required, regardless of the disclosures in the financial statements.

Amounts are So Material or So pervasive that Overall Fairness of the Statements Is in Question

The highest level of materiality exists when users are likely to make incorrect decisions if they rely on the overall financial statements. When the highest level of materiality exists, the auditor must issue either a disclaimer of opinion or an adverse opinion, depending on which conditions exist. When determining whether an exception is highly material, the extent to which the exception affects different parts of the financial statements must be considered. This is called pervasiveness

Material

The inclusion of the word material conveys that auditors are only responsible to search for significant misstate- ments, not minor misstatements that do not affect users' decisions

Amounts are Material but Do Not Overshadow the Financial Statements as a Whole

The second level of materiality exists when a misstatement in the financial statements would affect a user's decision, but the overall statements are still fairly stated and therefore useful

Signature and address of CPA firms

The signature identifies the CPA firm or practitioner who performed the audit. Typically, the firm's name is used because the entire CPA firm has the legal and professional responsibility to ensure that the quality of the audit meets professional standards

Which of the following is not a required element of a standard unmodified opinion audit report issued in accordance with AICPA auditing standards?

The signature of the engagement partner

Auditor's Scope Has Been Restricted

Two major categories of scope restrictions exist: those caused by a client and those caused by conditions beyond the control of either the client or the auditor. When there is a scope restriction, the appropriate response is to issue a report with an unmodified opinion, a report with a qualification of scope and opinion, or a report with a disclaimer of opinion, depending on materiality The most common case in which conditions beyond the client's and auditor's control cause a scope restriction is when the auditor is appointed after the client's balance sheet date

4) emphasis of other matters

Under certain circumstances, the CPA may want to emphasize specific matters regarding the financial statements, even though he or she intends to express an unmodified opinion. Normally, such explanatory information should be included in a separate paragraph in the report.

2. the Financial Statements have Not Been prepared in accordance with Generally accepted accounting principles (Gaap Departure)

When U.S. generally accepted accounting principles or international financial reporting standards (IFRS) are referred to in this context, consideration of the adequacy of all informative disclosures, including footnotes, is especially important

Decide the Materiality for each condition

When a condition requiring a departure from a standard unmodified opinion exists, the auditor evaluates the potential effect on the financial statements. For departures from GAAP or scope restrictions, the auditor must decide among immaterial, material, and highly material. All other conditions, except for lack of auditor independence, require only a distinction between immaterial and material.

he or she must use the term except for in the opinion paragraph. The implication is that the auditor is satisfied that the overall financial statements are correctly stated "except for" a specific aspect of them

When an auditor issues a qualified report

1. the Scope of the audit has Been restricted (Scope Limitation)

When the auditor has not accumulated sufficient appropriate evidence to conclude whether financial statements are stated in accordance with the appropriate financial reporting framework, a scope restriction exists. There are two major causes of scope restrictions: restrictions imposed by the client and those caused by circumstances beyond either the client's or auditor's control.

Statements are Not in Conformity with Gaap

When the auditor knows that the financial statements may be misleading because they were not prepared in conformity with GAAP, and the client is unable or unwilling to correct the misstatement, he or she must issue a qualified or an adverse opinion, depending on the materiality of the item in question. The opinion must clearly state the nature of the departure from accepted principles and the amount of the misstatement, if it is known. When the amounts are so material or pervasive that an adverse opinion is required, the scope is still unlimited and the qualifying paragraph can remain the same, but the opinion paragraph might be as shown in Figure 3-11.

Materiality Decisions—Scope Limitations Condition

When there is a scope limitation in an audit, the audit report will be a standard unmodified opinion report, a report with a qualified scope and opinion, or a disclaimer report, depending on the materiality of the scope limitation. The auditor will consider the same three factors included in the previous discussion about materiality decisions for failure to follow GAAP, but they will be considered differently. The size of potential misstatements, rather than known misstatements, is important in determining whether an unmodified opinion report, a qualified scope and opinion report, or a disclaimer of opinion is appropriate for a scope limitation.

Standard Unmodified Opinion

When these conditions are met, the standard unmodified opinion audit report for an audit of a nonpublic company is issued. The standard unmodified opinion audit report is sometimes called a clean opinion because there are no circumstances requiring a modification of the auditor's opinion

Auditor report on the audit of internal control over financial reporting must include the following elements:

•A title that includes the word "independent." •The introductory, scope, and opinion paragraphs describe that the scope of the auditor's work and opinion is on internal control over financial reporting, and the introductory paragraph highlights management's responsibility for and its separate report that contains management's assessment of internal control over financial reporting. •The introductory and opinion paragraphs also refer to the framework used to evaluate internal control and that the audit was conducted in accordance with PCAOB standards. •The report includes a paragraph after the scope paragraph defining internal control over financial reporting. •The report also includes an additional paragraph before the opinion that addresses the inherent limitations of internal control. •Although the audit opinion on the financial statements addresses multiple reporting periods, the auditor's opinion about the effectiveness of internal control is as of the end of the most recent fiscal year. •The last paragraph of the report includes a cross-reference to the auditor's separate report on the financial statements.