ACCT 4240: Auditing

1. ACCT 4240: Auditing Audit Reports: Part I

2. Reports Accompanying Financial Statements • Report on financial statements and related disclosures (prepared by auditor) • Are financial statements and disclosures according to GAAP? • Report on internal control over financial reporting (prepared by management) • Has company maintained effective internal control over financial reporting? • Report on internal control over financial reporting (prepared by auditor) • Is management’s assessment of its internal control appropriate? • Has company maintained effective internal control over financial reporting?

3. The Purpose of the Audit Report • Definition of auditing: “... communicating results to interested users.” • Indicate whether the FS are in accordance with GAAP • Provide indication of what the FS would be like if GAAP were followed • Provide any company-omitted disclosures • Indicate any unusual aspects of the audit examination • Scope limitations • Division of responsibility • Indicate any unusual matters related to the company • Going concern uncertainty • Consistency • Emphasize a matter

4. Four Categories of Audit Reports • Standard unqualified (clean opinion) • Unqualified with explanatory paragraph or modified wording • Qualified • Adverse or disclaimer

5. Definitions: Webster’s New Unabridged Dictionary • Qualified: • Having met conditions or requirements set • Limited, modified • Unqualified: • Not having the usual or requisite talents, abilities, or accomplishments • Not modified, limited, or restricted by conditions or exceptions

6. Types of Audit Reports

7. Unqualified Reports

8. Standard Unqualified Report The five necessary conditions have been met: • All four required statements are included. • The three general standards have been followed in all respects on the engagement. • Sufficient evidence has been accumulated and the auditor has conducted the engagement in a manner that enables the conclusion that the three standards of field work have been met.

9. Standard Unqualified Report • 4. The financial statements are presented in accordance with GAAP (including adequate disclosures. • 5. There are no circumstances requiring the addition of an explanatory paragraph or modification of the report wording.

10. Standard Unqualified Audit Report(Nonlisted Companies) Title Report of Independent Auditor Address to client To the Board of Directors and stockholders of Any company Audit notice Audit notice We have audited the accompanying balance sheets of Any company as of December 31, 1990 and 1989, and the related statements of income, retained earnings, and cash flows for the year then ended. These financial statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. Management responsibility Identify the financial statements Auditor responsibility continued

11. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. Description of the audit No special mention of adequate disclosure or consistency Opinion on financial statements In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Any company as of December 31, 1990 and 1989, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles. Refer to GAAP Signature ___________________________________, CPA February 28, 1991 Date

12. Report Title Identification of Addressee Independent Auditor’s Report To the Board of Directors of Example Company Components of Auditor’s Report Item Example

13. Introductory Paragraph We have audited the accompanying balance sheets of Example Company as of December 31, 2001 and 2002, and the related statements of income, retained earnings, and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

14. Scope Paragraph We conducted our audits in accordance with generally accepted auditing standards. Those standards required that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.

15. Scope Paragraph (continued) 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.

16. Opinion Paragraph In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Example Company as of December 31, 2001 and 2002, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.

17. Name of CPA Firm Audit Report Date ANDERSON & ZINDER, P.C., CPAs February 28, 2003 Signatureand Date

18. PCAOB Auditing Standard No. 1:References in Auditor’s Reports to the Standards of the Public Company Accounting Oversight Board • AS No. 1 requires auditors to make reference to the standards of the PCAOB (United States) in their audit report, which replaces the previous reference to Generally Accepted Auditing Standards (GAAS). • AS. No. 1 is effective beginning May 24, 2004. • No reference to “compliance with applicable laws and regulations.” • No reference to “the effectiveness of internal control over financial statements.”

19. Source: PCAOB Release 2003-25, available at http://www.pcaobus.org.

20. Unqualified Opinion with Additional Explanation • Consistency • Going concern uncertainties • Emphasis of a matter • Reference to report on internal control over financial reporting

21. Circumstances that can Result in a Modification of the Standard Audit Report • The auditor’s opinion is based in part on the report of another auditor. • The auditor wishes to emphasize a matter included in the financial statements. • The financial statements are affected by a departure from an authoritative accounting principle promulgated by a body designated by the AICPA Council to establish such principles. • Accounting principles have not been consistently applied.

22. Circumstances that can Result in a Modification of the Standard Audit Report (cont.) • The financial statements are affected by uncertainties concerning future events, the outcome of which cannot be estimated at the date of the auditor’s report. • The scope of the auditor’s audit is limited with respect to one or more audit procedures considered necessary in the circumstances. • The financial statements are affected by a departure from a generally accepted accounting principle.

23. Standard Report Address Scope Paragraph Opinion Paragraph DEPARTURES FROM STANDARD REPORT • Scope limitation • Departure from GAAP • Lack of consistency • Uncertainties • Auditor not independent • Part of examination made by other independent auditor • Emphasis

24. Unqualified Reports with Modifications

25. Unqualified Audit Report with Explanatory Paragraph or Modified Wording A complete audit took place with satisfactory results and financial statements are fairly presented, but the auditor believes that it is important or required to provide additional information. • Lack of consistent application of GAAP • Uncertainties, such as doubt about going concern • Auditor agrees with departure from promulgated accounting principles • Emphasis of a matter • Reports involving other auditors

26. Inconsistent Application of GAAP • Examples of changes that affect consistency and require an explanatory paragraph, if material: • Changes in accounting principles, such as a change from FIFO to LIFO inventory valuation. • Changes in reporting entities, such as the inclusion of an additional company in combined financial statements. • Corrections of errors involving principles by changing from an accounting principle that is not generally accepted to one that is generally accepted, including correction of the resulting error.

27. Inconsistent Application of GAAP • Examples of changes that affect comparability but NOT consistency, and therefore need not be included in the audit report: • Changes in an estimate, such as a decrease in the life of an asset for depreciation purposes. • Error corrections not involving principles, such as a previous year’s mathematical error. • Variations in format and presentation of financial information. • Changes because of substantially different transactions or events.

28. Lack of Consistent Application of GAAP • Method of Disclosure • Three standard report paragraphs included without modification • Separate explanatory paragraph AFTER opinion paragraph • Example: • As discussed in Note 8 to the financial statements, the Company changed its method of computing depreciation in 1997

29. Uncertainties • The effect of certain events on the client’s financial position, results of operations, and cash flows cannot be reasonably estimated, such as: • Possible effects of litigation. • Possible effects of income tax assessments. • SAS No. 79 indicates the auditor may add an explanatory paragraph, but is not obligated to do so. • SAS No. 79 excludes going concern uncertainties and consistency changes.

30. Substantial Doubt About Going Concern • Factors causing uncertainty about client’s ability to: • Continue its operations. • Meet its obligations for a reasonable period of time (one year from the date of the financial statements being audited).

31. Substantial Doubt About Going Concern • Significant recurring operating losses or working capital deficiencies. • Inability of the company to pay its obligations as they become due. • Loss of major customers, the occurrence of uninsured catastrophes such as an earthquake or flood, or unusual labor difficulties. • Legal proceedings, legislation, or similar matters that have occurred that might jeopardize the entity’s ability to operate.

32. Substantial Doubt About Going Concern • Method of disclosure • Three standard report paragraphs included without modification. • Separate explanatory paragraph AFTER opinion paragraph. • A disclaimer of opinion is allowed, but not required (rare in actual practice).

33. Substantial Doubt About Going Concern: Example The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 11 to the financial statements, the Company has suffered recurring losses from operations and has a net capital deficiency that raises substantial doubt about the company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 11. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

34. Going Concern Uncertainties • The auditor has an active responsibility to evaluate, on all audit engagements, whether there is substantial doubt about the entity remaining a going concern for a reasonable time after year-end, not to exceed one year beyond F/S date. • Apply procedures and evaluate: • negative trends • defaults on debt obligations, restructuring of debt, arrearages of dividends • internal matters: work stoppages, dependence on one project • external matters: legal proceedings, changes in governmental regulations, natural disasters, etc. • If going concern problem, auditor may disclaim (e.g., if liquidation values unknown), else add explanatory paragraph after opinion. No standard language, but must include the words substantial doubtandgoing concern.

35. GAAP Departure Reports • Unjustified GAAP Departures • Qualified opinions • Adverse opinions • Justified GAAP Departures

36. Auditor Agrees with a Departure from a Promulgated Principle • In certain instances, unusual circumstances may require clients to depart from GAAP to prevent financial statements from being misleading. • SAS No. 58 suggests that an unqualified opinion can be given. • A separate paragraph is required, and may be placed either before or after the opinion paragraph.

37. Emphasis of a Matter • Auditor is allowed to emphasize some specific matters regarding the financial statements even though an unqualified opinion is given, such as: • The existence of significant related party transactions. • Important events occurring subsequent to the balance sheet date. • Matters affecting the comparability of the financial statements with those of the preceding year, such as acquisition of a subsidiary.

38. Emphasis of a Matter • Method of disclosure: • Three standard report paragraphs included without modification. • Separate explanatory paragraph AFTER opinion paragraph. • Example: As discussed in Note 12 to the financial statements, the Company entered into an agreement to sell the Horizons subsidiary, which represents 14 percent of its assets and 25 percent of its revenues.

39. Reports Involving Other Auditors • Common when the client has several widespread branches or subdivisions Parent Company Foreign Subsidiary

40. Reports Involving Other Auditors • Auditor must consider: • The materiality of the portion of the financial statements being audited in comparison to the portion other auditors have audited. • The auditor’s knowledge of the overall financial statements. • The importance of the components audited in relation to the whole.

41. Reports Involving Other Auditors Three methods of disclosure, depending on the degree of responsibility the principal or lead auditor decides to accept: • Make no reference to other auditors in the audit report (standard three paragraphs). • The other auditor audited an immaterial portion. • The other auditor is well known or closely supervised by the principal auditor. • The principal auditor has thoroughly reviewed the other auditor’s work.

42. Reports Involving Other Auditors • Make reference in the report to the other auditor (shared opinion or shared report). • All three paragraphs are modified to explain which portions were audited by which auditor. • Qualify the report or disclaim an opinion, depending on materiality.

43. Underlying reasons for the financial crisis • Crisis 1(Video) • Crisis 2 (Video)

44. Next Time Audit Reports Other Than Unqualified