MODERN AUDITING 7th Edition Developed by: Gregory K. Lowry, MBA, CPA Saint Paul’s College John Wiley & Sons, Inc. William C. Boynton California Polytechnic State University at San Luis Obispo Raymond N. Johnson Portland State University Walter G. Kell University of Michigan

CHAPTER 20 REPORTING ON AUDITED FINANCIAL STATEMENTS u Standards of Reporting u The Auditor’s Report u Effects of Circumstances Causing Departures from the Standard Report

u Other Reporting Considerations CHAPTER 20 REPORTING ON AUDITED FINANCIAL STATEMENTS

Standards of Reporting First Standard of Reporting The first standard of reporting states: The report shall state whether the financial statements are presented in accordance with generally accepted accounting principles.

AU The meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles in the Independent Auditor’s Report (SAS 69), states that the auditor’s opinion as to conformity with GAAP should be based on his or her judgment as to whether: 1. The accounting principles selected and applied have general acceptance 2. The accounting principles are appropriate in the circumstances 3. The financial statements, including the related notes, are informative of matters that may affect their use, understanding, and interpretation Standards of Reporting

4. The information presented in the financial statements is classified and summarized in a reasonable manner 5. The statements reflect the underlying events and transactions in a manner that presents the financial position, results of operations, and cash flows within reasonable and practicable limits Standards of Reporting

Second Standard of Reporting The second standard of reporting states: The report shall identify those circumstances in which such principles have not been consistently observed in the current period in relation to the preceding period.

Accordingly, unless the report contains specific language to the contrary, the reader can conclude that accounting principles have been consistently applied. The objectives of this standard are: 1. to give assurance that the comparability of financial statements between accounting periods has not been materially affected by changes in accounting principles and 2. to require appropriate reporting by the auditor when comparability has been materially affected by such changes. Standards of Reporting

Third Standard of Reporting The third standard of reporting states: Informative disclosures in the financial statements are to be regarded as reasonably adequate unless otherwise stated in the report.

Standards of Reporting Fourth Standard of Reporting The third standard of reporting states: The report shall either contain an expression of opinion regarding the financial statements, taken as a whole, or an assertion to the effect that an opinion cannot be expressed. When an overall opinion cannot be expressed, the reasons therefor should be stated. In all cases where an auditor’s name is associated with financial statements, the report should contain a clear-cut indication of the character of the auditor’s work, if any, and the degree of responsibility the auditor is taking.

The Auditor’s Report Standard Report The auditor’s standard report consists of an introductory paragraph, a scope paragraph, an opinion paragraph, and standard language. The standard report has a heading that includes the word “independent” and contains an unqualified opinion.

The Auditor’s Report Departures from Standard Report Departures from the standard report occur when the auditor concludes that: 1. explanatory language should be added to the report while expressing an unqualified opinion or 2. a different type of opinion should be expressed on the financial statements.

The Auditor’s Report Other Types of Opinions The auditor may conclude that an unqualified opinion cannot be expressed. In such a case, AU indicates that the auditor may express on of the following other types of opinions: 1. A qualified opinion which states that, except for the effects of the matter(s) to which the qualification relates, the financial statements present fairly … in conformity with GAAP. 2. An adverse opinion which states that the financial statements do not present fairly … in conformity with GAAP. 3. A disclaimer of opinion which states that the auditor does not express an opinion on the financial statements.

Effects of Circumstances Causing Departures from the Standard Report Scope Limitation When the auditor cannot perform the necessary procedures or the procedures do not provide sufficient evidence, the auditor is said to have a scope limitation.

Effects of Circumstances Causing Departures from the Standard Report A scope limitation may be imposed by the client or result from circumstances. Examples of client restrictions are refusal to: 1. permit confirmation of receivables, 2. sign a client representation letter, or 3. Give the auditor access to the minutes of board of directors’ meetings.

Effects of Circumstances Causing Departures from the Standard Report Disclaimer of Opinion When a disclaimer of opinion is expressed: 1. The introductory paragraph is modified 2. The scope paragraph is omitted 3. An explanatory paragraph is included after the introductory paragraph explaining the reasons for the disclaimer of opinion 4. The third and concluding paragraph contains a denial of an opinion

Effects of Circumstances Causing Departures from the Standard Report Nonconformity with GAAP When the client’s financial statements contain a nonconformity with GAAP, the effects on the auditor’s report differ based on whether it is a necessary nonconformity with promulgated GAAP or other nonconformity with GAAP.

Effects of Circumstances Causing Departures from the Standard Report Explanatory Language with Unqualified Opinion When the auditor concurs that, due to unusual circumstances, nonconformity with a promulgated accounting principle is necessary to keep the client’s financial statements from being misleading, a standard report with explanatory language is issued. Specifically, the report contains: 1. Standard introductory and scope paragraphs 2. An explanatory paragraph preceding the opinion paragraph that explains the circumstances and states that the use of the alternative principle is justified 3. An unqualified opinion in a standard opinion paragraph

Effects of Circumstances Causing Departures from the Standard Report Qualified Opinion When a qualified opinion is issued, the auditor should: 1. Disclose in an explanatory paragraph(s), preceding the opinion paragraph, all of the substantive reasons for the opinion. 2. Disclose in the explanatory paragraph(s) the principle effects of the subject matter of the qualification on financial position, results of operations, and cash flows, if practicable. If not practicable, the report should so state. 3. Express a qualified opinion in the opinion paragraph with reference to the explanatory paragraph(s).

Effects of Circumstances Causing Departures from the Standard Report Adverse Opinion The effects on the auditor’s report of issuing an adverse opinion are similar but not identical to the effects of a qualified opinion. In this case: 1. the explanatory paragraph(s) should indicate the substantive reasons for the adverse opinion and the principal effects of the subject matter of the adverse opinion, if practicable, and 2. the opinion paragraph should state that, because of the effects of the matter(s) described in the explanatory paragraph(s), the financial statements do not present fairly.

Effects of Circumstances Causing Departures from the Standard Report Inconsistency in Accounting Principles The effect on the audit report of a change in accounting principles depends on whether the change has been accounted for in conformity with GAAP. A change in principle is made in conformity with GAAP when: 1. the new principle is a generally accepted accounting principle, 2. the changeis properly accounted for and disclosed in the financial statements, and 3. management can justify that the new principle is preferable.

Effects of Circumstances Causing Departures from the Standard Report Explanatory Language with Unqualified Opinion When the change is made in conformity with GAAP, the auditor should express an unqualified opinion on the financial statements and explain the change in an additional paragraph following the opinion paragraph. The effects on the standard report, and an example of the wording of the explanatory paragraph, are shown in Figure 20-6.

Standard Audit Report with Explanatory Paragraph Because of Inconsistency in Accounting Principles in Conformity with GAAP Figure 20-6 INDEPENDENT AUDITOR’S REPORT (Same first three paragraphs as the standard report.) As discussed in Note X to the financial statements, the Company changed its method of computing depreciation in 20X2.

Auditor’s Report with Qualified Opinion Because of Inconsistency in Accounting Principles Not in Conformity with GAAP Figure 20-7 INDEPENDENT AUDITOR’S REPORT (Same first and second paragraphs as the standard report.) As discussed in Note X to the financial statements, the Company adopted, in 20X2, the first-in, first-out method of accounting for its inventories, 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 as required by generally accepted accounting principles. In our opinion, except for the effects of the change in accounting principle discussed in the preceding paragraph, the financial statements referred to in the first paragraph present fairly, in all material respects, the financial position of X Company as of December 31, 20X2 and 20X1, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.

Effects of Circumstances Causing Departures from the Standard Report Inadequate Disclosure If the financial statements and accompanying notes fail to disclose information required by GAAP, the statements are not fairly presented. In such a case, the auditor should express a qualified opinion or an adverse opinion because of nonconformity with GAAP, and there is a departure from the standard report. If a company issued financial statements that purport to present financial position and and results of operations but omits the related statement of cash flows, the auditor will normally conclude that the omission requires qualification of the opinion.

Effects of Circumstances Causing Departures from the Standard Report If it is practicable, the essential information should be provided in one or more explanatory paragraphs of the auditor’s report, unless its omission from the report is recognized in an SAS. 2 omissions have been recognized — the auditor is not required to present: 1. a statement of cash flows when that statement is omitted by a client or 2. omitted segment information. In both instances, however, the auditor should identify the omitted data in an explanatory paragraph and express either a qualified or an adverse opinion on the financial statements.

Effects of Circumstances Causing Departures from the Standard Report The effects on the auditor’s report in expressing a qualified opinion because of inadequate disclosure are illustrated in Figure This report satisfies the third standard of reporting, which requires comment in the auditor’s report when management’s disclosures in the financial statements are not adequate for fair presentation.

Auditor’s Report with Qualified Opinion Because of Inadequate Disclosure Figure 20-8 INDEPENDENT AUDITOR’S REPORT (Same first and second paragraphs as the standard report.) The Company’s financial statements do not disclose [describe the nature of the omitted disclosures]. In our opinion, disclosure of this information is required by generally accepted accounting principles. In our opinion, except for the omission of the information discussed in the preceding paragraph...

Effects of Circumstances Causing Departures from the Standard Report Substantial Doubt about Going Concern Status In an audit, the entity is usually assumed to be a going concern that will continue in existence. However, the auditor has a responsibility to evaluate whether in fact the entity has the ability to continue as a going concern for a reasonable period of time, not to exceed one year beyond the date of the financial statements being audited.

Effects of Circumstances Causing Departures from the Standard Report AU , The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern (SAS 59), indicates that information contrary to the going concern assumption includes: 1. Negative trends such as recurring operating losses, working capital deficiencies, negative cash flows from operations, and adverse key financial ratios. 2. Other indications of possible financial difficulties such as defaulting on loan agreements, arrearages in dividends, restructuring of debt, and noncompliance with statutory capital requirements.

Effects of Circumstances Causing Departures from the Standard Report 3. Internal matters such as work stoppages, substantial dependence on the success of a particular project, and uneconomic long-term commitments. 4. External matters such as the loss of a key franchise, and uninsured losses from earthquake or flood.

Effects of Circumstances Causing Departures from the Standard Report The auditor is required to consider management’s plans for dealing with the adverse effects of the foregoing conditions and events. Management may plan to: 1. dispose of assets, 2. borrow money or restructure debt, 3. reduce or delay expenditures, or 4. increase ownership equity.

Effects of Circumstances Causing Departures from the Standard Report Explanatory Language with Unqualified Opinion When the circumstances about the entity’s ability to continue as a going concern are adequately disclosed in the notes to the financial statements, the auditor should: 1. express an unqualified opinion and 2. add an explanatory paragraph after the opinion paragraph that refers to the notes. The effects on the standard report are illustrated in Figure 20-9.

Standard Audit Report with Explanatory Language Because of Doubt About the Entity’s Ability to Continue as a Going Concern Figure 20-9 INDEPENDENT AUDITOR’S REPORT (Same first three paragraphs as the standard report.) The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note X to the financial statements, the Company has suffered recurring losses from operations and has a net capital deficiency that raise substantial doubt about its ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note X. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

Effects of Circumstances Causing Departures from the Standard Report Decision Not to Make Reference If the principal auditor is able to obtain satisfaction as to the: 1. independence and professional reputation of the other auditors and 2. scope and quality of the other auditors’ examination, reference to the other auditors is not normally made.

Effects of Circumstances Causing Departures from the Standard Report The principal auditor is would be able to reach this decision when: 1. The other auditors are associated or correspondent firms whose work is well known to the principal auditor. 2. The work is performed under the principal auditor’s guidance and control. 3. The principal auditor reviews the audit programs and working papers of the other auditors.

Effects of Circumstances Causing Departures from the Standard Report Decision to Make Reference The principal auditor may decide to make reference to another auditor when one or more of the foregoing factors are not present. The principal auditor may also decide to make reference whenever the portion of the financial statements examined by another auditor is material to the financial statements taken as a whole.

Effects of Circumstances Causing Departures from the Standard Report Explanatory Language with Unqualified Opinion When the auditor decides to make reference to another auditor, the report should clearly indicate the division of responsibility that exists between the auditors. This is accomplished by the following changes in the report: 1. In the introductory paragraph, the magnitude of the portion of the financial statements audited by the other auditors should be indicated. 2. In the scope paragraph, the reports of other auditors should be included in the sources of the auditor’s reasonable basis for an opinion. 3. In the opinion paragraph, reference should be made to the other auditor’s report.

Other Reporting Considerations This section discusses reporting responsibilities relating to 4 additional situations: 1. reporting when the CPA is not independent, 2. circumstances concerning comparative financial statements, 3. information accompanying audited financial statements, and 4. financial statements prepared for use in other countries.

CHAPTER 20 REPORTING ON AUDITED FINANCIAL STATEMENTS

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