Audit Reports Dr. Donald McConnell Jr, 11/17/2018

There Are Four Fundamental Types of Audit Reports Unqualified (the standard report) Qualified, due to material: Improper GAAP (the numbers or notes) Scope restriction: Imposed by circumstances Client imposed Adverse: extremely material GAAP impropriety Disclaimer: technically not an opinion 11/17/2018

The Unqualified Report (AU 508.08) The standard report (clean opinion) Issued when: Full and fair disclosure of all material facts No material scope restrictions Auditor is independent Has three paragraphs: Introductory paragraph Scope paragraph Opinion paragraph Analysis of the report: AU 508.08 11/17/2018

Very Common Types of CPA Exam Questions: identify the deficiencies in a presented audit report Less commonly, write an audit report based on a given set of circumstances Multiple-choice questions on reports tend to be extremely “picky” What does this suggest? 11/17/2018

Departures from Unqualified Opinions: Qualified, Adverse, and Disclaimer Know how they differ from one another and the standard report Know the conditions for issuing each type of report 11/17/2018

Qualified Opinions (AU 508.20) Expressed when there is a material GAAP departure Scope restrictions imposed by client or circumstances These are the “except for” opinions Must include a separate explanatory paragraph (s) preceding opinion paragraph: Explaining all substantive reasons for qualification Financial statement effects, if practicably determinable 11/17/2018

GAAP Departure Qualifications (AU 508.39) Note explanatory paragraph indicating reasons for qualification and effects Explanatory paragraph must precede the opinion paragraph “except for…” stated only once: in opinion paragraph 11/17/2018

Scope Restriction Qualifications (AU 508.26) “except for…” stated twice: once in scope paragraph and once in opinion paragraph “except for” wording in opinion paragraph should base qualification on possible effects to the F.S.’s, and not on the scope limitation itself Example: “in our opinion, except for the above mentioned limitation on scope…” is unacceptable 11/17/2018

What Is the Difference between Material and Extremely Material What Is the Difference between Material and Extremely Material? Some Examples: Assume client has $10 million total assets Client has capitalized $1 million of R & D expenditures. What opinion would auditor render? Material: qualified for GAAP departure $5 million? Extremely material: adverse opinion What if R & D expenditures are $10,000? Immaterial: unqualified opinion 11/17/2018

Adverse Opinions (AU 508.60) Only used for extremely material GAAP departures: F.S.’s rendered meaningless Extremely rare State that the financial statements do not present fairly Characterized by knowledge of F.S. effect Substantive reasons and effects (if determinable) must be in a paragraph(s) preceding opinion paragraph 11/17/2018

Disclaimer of Opinion (AU 508.63) Required for: Extremely material scope limitation, whether imposed by client or circumstances Auditor lacking independence Optional for extremely material uncertainty (AU 341.13, fn 4) Scope issues: Have not obtained sufficient competent evidential matter Substantive reasons for disclaimer must be in a paragraph preceding opinion paragraph 11/17/2018

Disclaimer of Opinion (AU 508.63) (con.) Report must disclose any other reservations concerning fair presentation in accordance with GAAP AU 508.63: note many significant differences from standard report A common “real world” cause for disclaimers: new audit client with material inventories (AU 508.67) 11/17/2018

Various Audit Report Issues What happens if there is an immaterial GAAP problem and/or immaterial scope problem? Unqualified report is issued In “real world,”nonstandard opinions are unusual. Why? Client imposed scope: what if F.S. effects potentially borderline between material and extremely material? Disclaimer. What’s a piecemeal opinion? (AU 508.64) 11/17/2018

Modified Unqualified Opinions (AU 508.11) A subset of unqualified opinions “Clean opinions” with modifying language or, more typically, modifying paragraph(s) Modifying paragraph(s) can precede or follow opinion paragraph except in case of: Substantial doubt about going concern status Material change in accounting principles (fn 8) Discussion of examples in AU 508.11 11/17/2018

Comparative Financial Statements (Au508.65) Usual convention is to report comparatively Fourth standard of reporting requires an opinion on all presented financial statements, unless clearly labeled unaudited Prior Period Financial statements may have been: Audited by our CPA firm Audited by another CPA firm 11/17/2018

Comparative F.S.’s Audited by Our CPA Firm (AU 508.67) The auditor may express a different opinion for one or more periods AU 508.67 shows an example of an unqualified opinion last year with a qualified opinion on the current year’s financial statements 11/17/2018

Comparative F.S.’s Audited by Our CPA Firm (Con.) (AU 508.68) The auditor might also change a previously issued opinion on a prior period. In such cases, auditor must: Indicate that the F.S.’s have been restated from last year Include an explanatory paragraph preceding the opinion paragraph indicating (508.69): Substantive reasons for opinion change and prior report date Type of opinion previously expressed Indicate updated opinion is different from the previous opinion 11/17/2018

Previous Year Financial Statements Audited by Another CPA Firm Predecessor auditor’s prior audit report usually not presented Less commonly, predecessor auditor reissues the previous report [SEC audits require this.] 11/17/2018

Predecessor Auditor Consents to Reissue Prior Report (Au 508.71) Usually only done for audits of public companies Predecessor auditor must: Determine that the prior opinion is still appropriate Read current period comparative F.S. presentation; compare with last year F.S.’s that prior CPA had reported upon Obtain rep letter from successor: no current matters effect last year’s F.S.’s Reissued report date would ordinarily be same as last year (Au 508.73) There will be two audit reports in the registration (IPO) filed with SEC 11/17/2018

Predecessor Auditor’s Report Not Presented (AU 508.74) This is more common: we simply make reference to the prior audit Note only current year F.S.’s opined upon in opinion paragraph Introductory paragraph of audit report is modified to: Indicate the prior F.S.’s were audited by another auditor The date and type of report which was issued Substantive reasons, if prior report was not standard 11/17/2018

Predecessor Auditor’s Report Not Presented (Con.) (AU 508.74) Introductory paragraph would be modified as follows: … our responsibility is to express an opinion on these financial statements based on our audit. [Note: not audits-only opining on current year F.S.’s] The financial statements of ABC as of December 31, 19x1 were audited by other auditors whose report dated March 1, 19x2 [was unqualified or] included an explanatory paragraph that described the change in the Company’s method of computing depreciation discussed in Note xx to the financial statements. 11/17/2018

Consistency of Application of GAAP ( AU 420) Second standard of reporting implies that comparability has not been affected by a change in accounting principles Accounting changes can: Affect consistency, or Affect comparability, but not consistency 11/17/2018

Accounting Changes Affecting Consistency (AU 420.06) Require an additional explanatory paragraph which must follow the opinion paragraph Examples requiring paragraph (.06-.14): Material change in accounting principle Change in reporting entity (presenting consolidated vs. individual F.S.’s, change in component subsidiaries) Change from an incorrect principle to a correct accounting principle Principle change inseparable from a change in estimate Change in definition of cash equivalents 11/17/2018

Accounting Changes Not Affecting Consistency (AU 420.06) Do not require an additional paragraph Will require footnote disclosure if material Examples include (.15-.21): Change in accounting estimate Error correction not involving principle (math mistake, misuse of facts) Changes in F.S.classifications First-time adoption of a new principle A change in principle not having a current material effect, but which is expected to become material 11/17/2018

Consistency of Application of GAAP: Other Considerations Inadequate client disclosure of accounting changes requires a qualified or adverse opinion (420.21) If auditor reports only on current period, must obtain sufficient, competent evidence about consistency of current GAAP with prior periods, even though prior period F.S.’s not presented (.22) Same is true concerning first-year audits. Must verify consistency of principles with prior year (420.24) If cannot (inadequate records or client limitations), would be unable to express opinion on current year’s financial statements: disclaimer (420.25) 11/17/2018