AUDITING CHAPTER 3

Audit Reports
TOPICS Reports on audited financial statements Audit report opinions Modifications to audit reports Updated reports & reports for foreign countries Reports on attest & assurance services

Topic 1: Reports on audited financial statements

AUDIT REPORT DEFINED

Audit report is a letter communicating What was audited Managements responsibilities Auditors responsibilities What an audit entails Auditors opinion
1. a. b. c. d. In most all financial statement audits, independent auditors deliver a (an): Unqualified opinion Qualified opinion Adverse opinion Standard audit report
2

STANDARD AUDIT REPORT OPINION UNQUALIFIED OPINION

Unqualified opinion is independent auditors opinion that managements financial statements present fairly in all material respects the financial position, results of operations, & cash flows in conformity with GAAP Applies to quality of financial statements not to quality of entity as investment or credit risk

SARBANES-OXLEY
Managements responsibilities

Reviewed entire annual/quarterly report Report does not contain untrue statement of material fact or omit material fact Financial statements present fairly financial condition & results of operations Establish, maintain, evaluate effectiveness of internal controls Disclosed to auditors significant deficiencies, fraud

2. In all financial statements produced to the SEC, the chief executive and chief financial officers are required to certify in writing that they: a. Approved appointment of the independent auditor b. Reported to the audit committee any material fraud c. Evaluated disclosure controls and procedures d. Approved the companys policy on ethics
4

ELEMENTS OF REPORT
What are the components of an independent auditors report?

Title: Independent Auditors Report Addressee: shareholders, board of directors Introductory paragraph Scope paragraph Opinion paragraph Firm signature Date of report

INTRODUCTORY PARAGRAPH
Statement that Financial statements were audited Financial statements are managements responsibility Auditors responsibility is to issue opinion We have audited the accompanying consolidated balance sheets of The Procter & Gamble Company and subsidiaries as of June 30, 2004 and 2003, and the related consolidated statements of earnings, retained earnings, and cash flows for each of the three years in the period ended June 30, 2004. These financial statements are the responsibility of the companys management. Our responsibility is to express an opinion on these statements based on our audits.

SCOPE PARAGRAPH
Statement that Audit conducted in accordance with U.S. GAAS GAAS requires planning, performing audit to obtain reasonable assurance financial statements free from material misstatements Audit includes Examining evidence on test basis Evaluating accounting principles & estimates Evaluating overall financial presentation 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 audits 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.
7

MEANING OF SCOPE PARAGRAPH

Reasonable not absolute assurance implies auditor may Overlook immaterial misstatements Test samples rather than all transactions & events Implies auditor complied with all general standards Adequately trained & proficient Independent in mental attitude Exercised due professional care Implies auditor complied with all fieldworks standards Planned engagement & supervised assistants Obtained understanding of internal control Obtained sufficient, competent evidential matter
3. An independent auditors report on the financial statements of a public company would likely include a statement that the: a. Auditor was appointed by the audit committee of the board of directors. b. Audit was conducted in accordance with the standards of the Public Company Accounting Oversight Board. c. Auditor did or did not detect fraud. 8 d. Audit was conducted in accordance with generally accepted auditing standards.

OPINION PARAGRAPH
Statement of opinion Whether financial statements present fairly in all material respects Financial position Results of operations Cash flows In conformity with GAAP In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the companies at June 30, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended June 30, 2004, in conformity with accounting principles generally accepted in the United States of America.
9

USE OF STANDARD OPINION PARAGRAPH

Implies compliance with reporting standards Financial statements presented in accordance with U.S. GAAP Principles are applied consistently Disclosures are reasonably adequate Opinion applies to statements taken as a whole
6. Does an auditor make the following representation explicitly or implicitly in an unqualified audit report? (AICPA Adapted)

Consistent Application of Accounting Principles

a. b. c. d. Implicitly Implicitly Explicitly Explicitly

Examined Evidence on a Test Basis .

Explicitly Implicitly Explicitly Implicitly

10

SIGNIFICANCE OF AUDIT REPORT DATE

Last day of fieldwork Last day responsible for detecting subsequent events Dual dating: financial statements revised for subsequent event after fieldwork date but before report release Event date: date to which all responsibilities extended
19. The last day of audit field work is January 21, 2007, for the audit of ExPro Inc., which will include the following footnote in December 31, 2006, financial statements:

On November 20, 2004, the United States Bankruptcy Count for the Northern District of Illinios issued an Order that approved the claims of Boylston LLC against the Company. The First National Bank, as agent for the lenders under Boylstons $800 million Senior Secured Credit Agreement, filed four lawsuits against ExPro. On March 4, 2007, the company reached a settlement agreement with First National, pursuant to which all four of the cases, including ExPros counterclaim, were dismissed without prejudice. ExPro released to First National its claim to the $370 million that was previously paid into an escrow account in April 2006.
Which of the following is the most appropriate date for the auditors report? a. January 21, 2007 c. March 4, 2007 b. January 21, 2007, except for Note 9, March 4, 2007 d. December 31, 2006

11

Case 3-4 Audit Report Deficiencies

Timothy Ross completed field work on September 23, 2008, and issued the following report to the directors of the Rancho Corporation: To the Directors of the Rancho Corporation:
We have audited the balance sheet of the Rancho Corporation as of July 31, 2008 and the related statements of income and retained earnings. In accordance with your instructions, a complete audit was conducted.

We conducted our audit in accordance with generally accepted auditing standards. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. We believe that our audit was appropriate in the circumstances.
In many respects, this was an unusual year for the Rancho Corporation. The weakening of the economy in the early part of the year and the strike of plant employee in the summer of 2008 led to a decline in sales and net income. After making several tests of sales records, nothing came to our attention that would indicate that sales have not been properly recorded. In our opinion, with the explanation given above and the exception of some minor errors that are considered immaterial, the aforementioned financial statements present fairly, in all material respects, the financial position of the Rancho Corporation at July 31, 2008, and the results of its operations for the year then ended, in conformity with pronouncements of the Financial Accounting Standards Board. Timothy Ross, CPA, September 23, 2008 Required: List and explain deficiencies and omissions in Rosss report. Do not discuss the type of opinion (unqualified, qualified, adverse, or disclaimer). Organize your answer by paragraph (introductory, scope, explanatory, and opinion)
12

Topic 2: Audit report opinions

OTHER TYPES OF OPINIONS

What types of opinions do our authoritative permissions allow?

Departures from GAAP or scope limitation require other opinion

Qualified: sufficient evidence or assertions fairly presented except for certain matter(s) Adverse: assertions are not fairly presented Disclaimer: auditor does not express an opinion usually due to insufficient evidence (scope limitation)

13

QUALIFIED OPINION
Except for effects of a matter, financial statements present fairly in all other material respects Statements depart materially from GAAP Management unable to justify material change in accounting principle Scope of audit materially limited
In our opinion, except for the effects of the accounting treatment for good will as discussed in the preceding paragraph, the financial statements referred to above present fairly ..
10. The opinion paragraph to a qualified opinion could include the expression: a. With the exception b. When read in conjunction to note 10 to the financial statements c. With the foregoing explanation d. Subject to the departure from generally accepted accounting principles

14

ADVERSE OPINION
Managements financial statements do not present fairly Financial statements depart from GAAP Management unable to justify change in accounting principle Effects of departure so highly material that qualified opinion unwarranted
In our opinion, because of the effects of the matter discussed in the preceding paragraph, the financial statements referred to above do not present fairly in conformity with generally accepted accounting principles .

15

DISCLAIMER OF OPINION
Auditor does not express opinion Scope limitation so material auditor does not have reasonable basis to reach opinion Auditor is not independent of management
Because of the possible material effect of the matters discussed in the preceding paragraph, we are unable to express, and we do not express, an opinion on the financial statements referred to above.
4. Which of the following circumstances would most likely require a disclaimer of opinion? a. Management has denied the auditor access to evidence bearing on trade accounts receivable. b. Managements accounting for revenue recognition violates SEC Staff Accounting Bulletin No. 104, Revenue Recognition. c. The auditor detected an employee scheme that diverted funds to an off-shore company. d. The auditor disagrees with a change management implemented for long-term construction contract accounting.
16

Topic 3: Modifications to audit reports

STANDARD REPORT MODIFICATIONS

Under what circumstances and how? does an auditor depart from the standard wording of an unqualified opinion?
Circumstance Material Highly Material Paragraph(s) Modified Explanatory Paragraph

Opinion based partly on another auditor

Emphasize a matter Departure from GAAP Inconsistency: Management justifies

Unqualified
Unqualified Qualified Unqualified

Unqualified
Unqualified Adverse Unqualified

Introductory/Opinion
-Opinion --

No
Yes Yes Yes

Management does not justify

Scope limitation

Qualified
Qualified --

Adverse
-Disclaimer Unqualified Disclaimer

Opinion
Scope/Opinion Introductory/ Opinion (Omit scope) -Omit introductory, Scope, Opinion

Yes
Yes Yes Yes Yes

Going concern Lack of independence

Unqualified Disclaimer

17

MODIFICATIONS:
Another Auditor
Circumstance Material Highly Material Paragraph(s) Modified Explanatory Paragraph

Opinion based partly on another auditor

Unqualified

Unqualified

Introductory/Opinion

No

Principle auditor shares responsibility with another auditor Modified wording in introductory & opinion paragraphs (Introductory Paragraph) ... We did not audit the financial statements of the MacMillan/ McGraw-Hill School Publishing Company, a joint venture partnership, which statements reflect total assets of $1,332.4 million as of December 31 and total revenues of $286.4 million from the period of inception July 1 through December 31. Those statements were audited by other auditors, and our opinion, insofar as it relates to the data included for the MacMillan/McGraw-Hill School Publishing Company is based solely on the report of the other auditors. (Opinion Paragraph) In our opinion, based on our audits and the report of other auditors, ... 18

MODIFICATIONS:
Another Auditor
Circumstance Material Highly Material Paragraph(s) Modified Explanatory Paragraph

Opinion based partly on another auditor

Unqualified

Unqualified

Introductory/Opinion

No

18. An introductory paragraph reads in part as follows: We have audited the accompanying balance sheet of Hastings Company and subsidiaries as of December 31, 2007, and the related consolidated statements of operations, shareholders equity, and cash flows for the year then ended The accompanying 2006 and 2005 consolidated financial statements were audited by other auditors who have ceased operations. Those auditors expressed an unqualified opinion on those financial statements For the year ended December 31, 2007, the auditors report likely expresses: a. An unqualified opinion. b. An unqualified opinion that emphasizes the matter. c. A qualified opinion. d. No opinion on the 2006 financial statements.

19

MODIFICATIONS:
Emphasis of a Matter
Circumstance Material Highly Material Paragraph(s) Modified Explanatory Paragraph

Emphasize a matter

Unqualified

Unqualified

--

Yes

Auditor wishes to emphasize a matter & still issue an unqualified opinion Explanatory paragraph added after opinion paragraph

Example: (Explanatory Paragraph) As discussed in note 1 to the consolidated financial statements, effective October 6, INR Acquisition Corp acquired substantially all of the outstanding common stock of Insilco Corporation in a business combination accounted for as a purchase. As a result of the acquisition, the consolidated financial information for the periods after the acquisition is presented on a different cost basis than that for the periods before the acquisition and, therefore, is not comparable.
20

MODIFICATIONS:
Emphasis of a Matter
Circumstance Material Highly Material Paragraph(s) Modified Explanatory Paragraph

Emphasize a matter

Unqualified

Unqualified

--

Yes

16. An explanatory paragraph reads as follows: On October 15, 2007, the Company emerged from bankruptcy. As discussed in the notes to the financial statements, the Company accounted for the reorganization using fresh start accounting and, as a result, the post-reorganization financial statements are not comparable to the pre-reorganization financial statements. The paragraph likely is intended to: a. Qualify an opinion b. Emphasize a matter c. Report an inconsistency d. Indicate a departure from generally accepted accounting principles

21

MODIFICATIONS:
Departure from GAAP
Circumstance Material Highly Material Paragraph(s) Modified Explanatory Paragraph

Departure from GAAP

Qualified

Adverse

Opinion

Yes

With auditors agreement

Unqualified opinion Explanatory paragraph after opinion paragraph Material departure from GAAP in limited area Explanatory paragraph before opinion paragraph & qualified opinion Example: As discussed in Note 2, the Bank has charged goodwill to shareholders equity but GAAP requires an asset Pervasive departure from GAAP Explanatory paragraph before opinion paragraph & adverse opinion Example: The company carries property, plant, & equipment at appraisal values but GAAP requires values not exceed cost.
22

Without auditors agreement

MODIFICATIONS:
Inconsistency
Circumstance Inconsistency: Management justifies Management does not justify Material Unqualified Qualified Highly Material Unqualified Adverse Paragraph(s) Modified -Opinion Explanatory Paragraph Yes Yes

Justifiable Inconsistency Management changes accounting principle(s) and justifies change Explanatory paragraph after opinion paragraph Example: As discussed in Note 3, the company changed its method of accounting for goodwill & other intangibles Not Justified Management changes accounting principle(s) but fails to justify change Limited area - Explanatory paragraph before qualified opinion Pervasive - Explanatory paragraph before adverse opinion
23

MODIFICATIONS:
Inconsistency
15. An explanatory paragraph reads as follows: The Company has adopted the first-in, first-out method of determining inventory costs, whereas it previously used the last-in, first-out method. Although use of the first-in, first-out method is in conformity with generally accepted accounting principles, in our opinion the Company has not provided reasonable justification for seeking a change as required by Opinion No. 20 of the Accounting Principles Board. The paragraph likely appears in: a. An unqualified opinion. b. An unqualified opinion that emphasize the matter. c. A qualified opinion d. A disclaimer of opinion 17. A note to a public companys audited financial statements reads as follows: As of January 1, the Company adopted Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets. As a result of adopting SFAS No. 142, goodwill is no longer amortized, and intangible assets are to be tested at least annually for impairment. Goodwill amortization of $50 million is included in depreciation and amortization. The auditors report will likely include: a. An unqualified opinion b. An unqualified opinion and an explanatory paragraph c. A qualified opinion 24 d. An explanatory paragraph, depending on materiality

MODIFICATIONS:
Scope Limitation Limited Area
Circumstance Material Highly Material Paragraph(s) Modified Explanatory Paragraph

Scope limitation

Qualified
--

-Disclaimer

Scope/Opinion
Introductory/ Opinion (Omit scope)

Yes
Yes

Prevent auditor from performing 1 or more necessary auditing procedures Material Limitation
Modify scope paragraph Except as discussed in the following paragraph, we conducted our audit Explanatory paragraph before qualified opinion We were unable to obtain evidential matter supporting the Companys representations regarding the contingent liability as discussed in Note 8.
25

MODIFICATIONS:
Pervasive Scope Limitation
Circumstance Material Highly Material Paragraph(s) Modified Explanatory Paragraph

Scope limitation

Qualified
--

-Disclaimer

Scope/Opinion
Introductory/ Opinion (Omit scope)

Yes
Yes

Prevent auditor from performing 1 or more necessary auditing procedures Pervasive limitation Modify introductory paragraph Omit scope paragraph Explanatory paragraph before disclaimer of opinion Example The Company did not give effect to all adjustments to the carrying value of assets & classification of liabilities resulting from bankruptcy proceedings
26

MODIFICATIONS:
Going Concern
Circumstance Material Highly Material Paragraph(s) Modified Explanatory Paragraph

Going concern

Unqualified

Unqualified

--

Yes

When auditor retains substantial doubt as to ability of client to continue as a going concern (SAS 59) Explanatory paragraph after opinion paragraph Mack Trucks, Inc. (Explanatory Paragraph) The consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the liquidity of the Company has been adversely affected by recurring losses from operations, and the Company was in default under certain of its loan covenants at December 31, all of which raised substantial doubt about the Companys ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of the uncertainty. 27

MODIFICATIONS:
Lack of Independence
Circumstance Material Highly Material Paragraph(s) Modified Explanatory Paragraph

Lack of independence

Disclaimer

Disclaimer

Omit introductory, Scope, Opinion

Yes

Auditor is not independent of client SAS 26 requires a 1-paragraph explanation with disclaimer of opinion Example (Explanatory Paragraph) We are not independent with respect to the Trailways Company. . . .the balance sheet, statements of income, retained earnings, & cash flows were not audited by us. We do not express an opinion on them.

28

Case 3-8 Drafting an Opinion Paragraph

Sturdy Corporation owns and operates a large office building in a desirable section of New York Citys financial district. For many years the management of Sturdy Corporation has (a) written-up building accounts to appraisal values and (b) accounted for depreciation expense on the basis of appraised values. Wyley, the successor auditor, was engaged to audit Sturdys financial statements for the year ended December 31, 2008. After completing the audit, Wyley concluded that, consistent with prior year, an adverse opinion would have to be issued because of the materiality of the apparent departure from historical cost. Required: Describe in detail what Wyley should include in an explanatory paragraph Draft the opinion paragraph

29

Topic 4: Updated reports & reports for foreign countries

UPDATED REPORTS
When opinions differ Criteria for both opinions must be met with explanatory paragraphs When opinion updated Update opinion paragraph & add explanatory paragraph acknowledging change
20. Resolution in 2007 of a material departure from GAAP that drove a qualified opinion in 2006 would likely cause an independent auditor in 2007 to: a. Reissue the 2006 audit report with an unqualified opinion b. Include in the 2007 audit report an unqualified opinion on 2006 and an explanatory paragraph. c. Include in the 2007 audit report an unqualified opinion for 2006 but not an explanatory paragraph. d. Include in the 2007 audit report a qualified opinion for 2006.
30

REPORTS: FOREIGN COUNTRIES

When financial statements are used outside the U.S. only statements audited, basis of statement presented, audit made in accordance with U.S. auditing standards, and opinion on whether the statements are presented fairly in conformity with the basis described When financial statements are used outside and in the U.S standard audit report, modified for departures from U.S. GAAP separate paragraph to express an opinion on whether the financial statements are presented in conformity with GAAP in the other country

31

Topic 5: Reports on attest & assurance services

REPORTS ON ATTESTATION SERVICES

Letter communicating Managements & attesters responsibilities Attester's opinion Managements assertions (if written) Types of opinions Unqualified opinion in attestation report means managements assertions are fairly presented in the attester's opinion Departures from attestation standards or measurement criteria require other opinion Qualified: assertions fairly presented except for certain matter(s) Adverse: assertions are not fairly presented Disclaimer: attester does not express an opinion usually due to insufficient evidence What are the components of an attestation report?
32

Corporation (MCI) for the period September 28, 2000 through December 27, 2000. Our examination was made in accordance with standards established by the AICPA and, accordingly, included such procedures as we considered necessary in the circumstances. The Prove Positive Methodology and Statement are the responsibility of MCIs management. Our responsibility is to express an opinion on the methodology and statement based on our examination. (Scope Paragraph) The Proof Positive Methodology for comparing MCI Preferred billing charges between MCI and AT&T is footnoted in the You Save Money with MCI section of the enclosed customized Proof Positive Statement. The Proof Positive Methodology for comparing billing charges between alternative MCI services is footnoted in the You Always Get MCIs Best price section of the enclosed statement. The methodology was designed by MCI to compute the lowest telephone service cost under the MCI and most widely used AT&T programs indicated in the specified sections for each customers actual usage billed by MCI during the specified period. (Opinion Paragraph) In our opinion, the Proof Positive Methodology referred to above properly compares billing charges between MCI and AT&T and between alternative MCI services and accurately reflects the price differences for the period September 28, 2000 through December 27, 2000, as applied to actual usage billed by MCI PricewaterhouseCoopers, LLP
33

(Introductory Paragraph) We have examined the Proof Positive Methodology of MCI Telecommunications

ATTESTATION REPORT
5.

a. b. c. d.
7.

A report issued by a public accounting firm uses the language, In our opinion, the schedule presents, in all material respects The firms report is likely A standard audit report A qualified audit report An attestation report A qualified attestation report Does an accountant make the following representations explicitly or implicitly in an unqualified attestation report? Assertion is Capable of Evaluation Assertions are Against Reasonable Criteria Managements Responsibility Explicitly Explicitly Implicitly Implicitly Implicitly Explicitly Explicitly Implicitly

a. b. c. d.

34

REPORTS FOR ASSURANCE SERVICES

Not required

Short history of offering assurance services Traditionally, reports not required

Oscars Tony awards National book awards If issued, what are the components of an assurance service report?

35