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Chapter 3Audit Reports

Presentation OutlineI.I. The Standard Audit ReportThe Standard Audit Report

II.II. Section 404 of the Sarbanes-Oxley ActSection 404 of the Sarbanes-Oxley ActIII.III. Conditions Requiring an Explanatory Conditions Requiring an Explanatory

Paragraph or Modified Report WordingParagraph or Modified Report WordingIV.IV. Other Opinion PossibilitiesOther Opinion Possibilities

V.V. Scope LimitationScope LimitationVI.VI. GAAP DepartureGAAP Departure

VII.VII. Lack of IndependenceLack of IndependenceVIII.VIII. Other InformationOther Information

I. The Standard Audit Report

A.A. The Seven Parts of the Auditor’s Standard The Seven Parts of the Auditor’s Standard ReportReport

B.B. Five Conditions for the Standard ReportFive Conditions for the Standard Report

A. The Seven Parts of the Auditor’s Standard Report Report title – Must include the word independent. Audit report address – Customary to address to board of

directors and stockholders to demonstrate independence. Introductory paragraph – States that an audit has been

performed; identifies the financial statements and appropriate dates; states that the financial statements are the responsibility of the entity’s management.

Scope paragraph – States that auditor followed GAAS or PCAOB standards and indicates that the audit only provides reasonable assurance.

Opinion paragraph – Communicates the results of the audit. Name of CPA firm or practitioner. Audit report date showing last day of field work. Auditor is

held accountable only through this date

B. Five Conditions for the Standard Report

All 4 of the basic financial statements All 4 of the basic financial statements are included.are included.

Three General Standards have been Three General Standards have been followed.followed.

Sufficient evidence has been Sufficient evidence has been accumulated and three Field Work accumulated and three Field Work Standards have been followed.Standards have been followed.

Financial Statements are in accordance Financial Statements are in accordance with U.S. GAAP.with U.S. GAAP.

No circumstances require an No circumstances require an explanatory paragraph or modified explanatory paragraph or modified wording of the report.wording of the report.

II. Section 404 of the Sarbanes-Oxley Act

A.A. PCAOB Auditing Standard 2PCAOB Auditing Standard 2B.B. The Time Period CoveredThe Time Period Covered

C.C. The Audit ReportThe Audit Report

A. PCAOB Auditing Standard 2

Section 404 requires the auditor of a public Section 404 requires the auditor of a public company to attest to management’s report company to attest to management’s report

on the effectiveness of internal control over on the effectiveness of internal control over financial reporting.financial reporting.

PCOAB Auditing Standard 2 requires the PCOAB Auditing Standard 2 requires the audit of internal control to be integrated audit of internal control to be integrated

with the audit of the financial statements.with the audit of the financial statements.

B. The Time Period Covered

Although the audit Although the audit opinion on the opinion on the

financial statements financial statements addresses multiple addresses multiple reporting periods, reporting periods,

management’s management’s assertion about the assertion about the

effectiveness of effectiveness of internal control is as of internal control is as of

the end of the most the end of the most recent fiscal year.recent fiscal year.

C. The Audit Report The auditor may choose to The auditor may choose to

issue separate reports or a issue separate reports or a combined report, such as combined report, such as the one shown in Figure the one shown in Figure

3-3 on page 50.3-3 on page 50. The combined report on The combined report on

financial statements and financial statements and internal control over internal control over financial reporting financial reporting addresses both the addresses both the

financial statements and financial statements and management’s report on management’s report on

internal control over internal control over financial reporting.financial reporting.

III. Conditions Requiring an Explanatory Paragraph or Modified Report Wording

A.A. Lack of ConsistencyLack of ConsistencyB.B. Going Concern ProblemGoing Concern Problem

C.C. Auditor Agrees with a Departure from Auditor Agrees with a Departure from GAAPGAAP

D.D. Emphasis of a MatterEmphasis of a MatterE.E. Reports Involving Other AuditorsReports Involving Other Auditors

Note: The first four reports above require an explanatory paragraphfollowing the opinion paragraph. There is no change in the wording

of the three standard paragraphs. For reports involving otherauditors, the three standard report paragraphs are modified but

there is not a separate explanatory paragraph.

A. Lack of ConsistencyThe following affect consistency and require an explanatory

paragraph when material (See Fig. 3-4 on page 51): Change in accounting principles (i.e., FIFO to LIFO)

Change in reporting entities (i.e., change is companies in combined financial statements)

Corrections of changing from unacceptable to acceptable accounting principles.

The following affect comparability but not consistency. If material these items may require disclosure, but not a explanatory

paragraph: Change in accounting estimate (i.e., asset’s depreciable life) Error correction not involving accounting (i.e., math error)

Variations in format and presentation. Changes due to substantially different events such as the sale of a

subsidiary.

B. Going Concern Problem SAS No. 59SAS No. 59 requires requires

auditor to evaluate going auditor to evaluate going concern for a reasonable concern for a reasonable time (not over one year time (not over one year from date of financial from date of financial statements).statements).

Include an explanatory Include an explanatory paragraph that includes the paragraph that includes the phrases “substantial doubt” phrases “substantial doubt” and “going concern.” See and “going concern.” See Figure 3-5 on page 53.Figure 3-5 on page 53.

Note: SAS No. 59 permits but does not require a disclaimer of opinionwhen there is substantial doubt about ability to continue as a going

concern.

C. Auditor Agrees with a Departure from GAAP

An auditor may issue an An auditor may issue an unqualified opinion unqualified opinion

when a departure from when a departure from GAAP is necessary to GAAP is necessary to

prevent financials from prevent financials from being misleading.being misleading.

Modify report wording Modify report wording by adding an by adding an

explanatory paragraph.explanatory paragraph.

D. Emphasis of A Matter

The auditor may add an The auditor may add an explanatory paragraph to explanatory paragraph to emphasize items such as:emphasize items such as:

Significant related party Significant related party transactionstransactions

Important subsequent Important subsequent eventsevents

Factors affecting Factors affecting comparability of comparability of

financial statements.financial statements. Material uncertainties Material uncertainties

disclosed in the notes to disclosed in the notes to the financial statements.the financial statements.

E. Reports Involving Other AuditorsAssume ResponsibilityAssume Responsibility

If you accept responsibility for the other auditor’s work (and it If you accept responsibility for the other auditor’s work (and it is unqualified) the standard report may be issued without is unqualified) the standard report may be issued without modification.modification.

If the other auditors report is qualified and the qualification is If the other auditors report is qualified and the qualification is material to the financial statements taken as a whole, you must material to the financial statements taken as a whole, you must qualify your report.qualify your report.

Shared ResponsibilityShared Responsibility The opinion is unaffected (i.e. can be unqualified).The opinion is unaffected (i.e. can be unqualified). Modify all three paragraphs of the standard report (See Figure Modify all three paragraphs of the standard report (See Figure

3-6 on page 54).3-6 on page 54).

Assume No ResponsibilityAssume No ResponsibilityA qualified opinion or disclaimer, depending on materiality, is A qualified opinion or disclaimer, depending on materiality, is

required.required.

IV. Other Opinion Possibilities

A.A. Qualified OpinionQualified OpinionB.B. Adverse OpinionAdverse Opinion

C.C. Disclaimer of OpinionDisclaimer of Opinion

A. Qualified Opinion Use the term “except for” in Use the term “except for” in

the opinion paragraph to the opinion paragraph to exclude a specific item from exclude a specific item from the auditor’s opinion.the auditor’s opinion.

Qualified opinion is Qualified opinion is appropriate when there is a:appropriate when there is a: Material scope limitation Material scope limitation

(qualified scope, additional (qualified scope, additional paragraph, and qualified paragraph, and qualified opinion)opinion)

Material departure from Material departure from GAAP (additional GAAP (additional paragraph, qualified paragraph, qualified opinion)opinion)Note: Materiality is defined in Table 3-1 on page 57.

B. Adverse Opinion Financials as a whole Financials as a whole

are not fairly are not fairly presented. presented.

Used when auditor Used when auditor feels that financial feels that financial statements contain statements contain contain a highly contain a highly material departure material departure from GAAP.from GAAP.

An auditor may have to play the bad

guy to protect the

public

Note: Materiality is defined in Table 3-1 on page 57.

C. Disclaimer of Opinion Auditor can not Auditor can not

express an opinion.express an opinion. Disclaimer of opinion Disclaimer of opinion

is appropriate when:is appropriate when: There is a highly There is a highly

material scope material scope limitation.limitation.

There is a lack of There is a lack of independenceindependence

Note: Auditor has option to issue a disclaimerof opinion for a going concern problem.


V. Scope Limitation

A.A. Scope Limitation DefinedScope Limitation DefinedB.B. Effect of Scope Limitation on Audit Effect of Scope Limitation on Audit

Report – Qualified OpinionReport – Qualified OpinionC.C. Effect of Scope Limitation on Audit Effect of Scope Limitation on Audit

Report – Disclaimer of OpinionReport – Disclaimer of Opinion

A. Scope Limitation Defined An unqualified opinion can only be An unqualified opinion can only be

issued for an immaterial scope issued for an immaterial scope limitation.limitation.

If the scope is restricted by the If the scope is restricted by the client, the auditor will usually client, the auditor will usually disclaim an opinion.disclaim an opinion.

If scope is restricted by other If scope is restricted by other conditions:conditions: Qualified opinion if statements Qualified opinion if statements

“as a whole” are not affected.“as a whole” are not affected. Disclaimer if scope limitation Disclaimer if scope limitation

affects numerous financial affects numerous financial statement items.statement items.


B. Effect of Scope Limitation on Audit Report – Qualified Opinion

Introductory paragraph is same as in standard Introductory paragraph is same as in standard report.report.

Scope paragraph identifies limitation by adding Scope paragraph identifies limitation by adding “except as discussed in the following paragraph.”“except as discussed in the following paragraph.”

A separate explanatory paragraph is added to the A separate explanatory paragraph is added to the report to describe the scope limitation. report to describe the scope limitation.

Opinion paragraph wording is changed to express Opinion paragraph wording is changed to express an “except for” qualified opinion.an “except for” qualified opinion.

Note: See Figure 3-7 on page 59.

C. Effect of Scope Limitation on Audit Report – Disclaimer of Opinion

Introductory paragraph modified to say “We were Introductory paragraph modified to say “We were engaged to audit…” rather than “We have audited engaged to audit…” rather than “We have audited …”.…”.

Scope paragraph is omitted.Scope paragraph is omitted. A separate explanatory paragraph is added to the A separate explanatory paragraph is added to the

report to describe the scope limitation. report to describe the scope limitation. Opinion paragraph wording is changed to disclaim Opinion paragraph wording is changed to disclaim

an opinion.an opinion.


VI. GAAP Departure

A.A. GAAP Departure DefinedGAAP Departure DefinedB.B. Effect of GAAP Departure on Audit Effect of GAAP Departure on Audit

Report – Qualified OpinionReport – Qualified OpinionC.C. Effect of Scope Limitation on Audit Effect of Scope Limitation on Audit

Report – Adverse OpinionReport – Adverse Opinion

A. GAAP Departure Defined An unqualified opinion can An unqualified opinion can

only be issued if GAAP only be issued if GAAP departure is immaterial.departure is immaterial.

If financial statements “taken If financial statements “taken as a whole” are not as a whole” are not misleading, then a qualified misleading, then a qualified opinion can be issued. opinion can be issued. Required for omission of Required for omission of statement of cash flows (SAS statement of cash flows (SAS 58).58).

If financial statements “taken If financial statements “taken as a whole” are misleading, as a whole” are misleading, then an adverse opinion must then an adverse opinion must be issued. See Nature of Item be issued. See Nature of Item on page 58.on page 58.

How misleading

are the financial

statements?


B. Effect of GAAP Departure on Audit Report – Qualified Opinion


Scope paragraph is the same as the standard report.Scope paragraph is the same as the standard report. A separate explanatory paragraph is added to the A separate explanatory paragraph is added to the

report to describe the GAAP departure and its effect report to describe the GAAP departure and its effect on the financial statements. on the financial statements.

Opinion paragraph wording is changed to express Opinion paragraph wording is changed to express an “except for” qualified opinion.an “except for” qualified opinion.

Note: See Figures 3-9 and 3-11 on pages 60-61.

C. Effect of GAAP Departure on Audit Report – Adverse Opinion


Scope paragraph is the same as the standard report.Scope paragraph is the same as the standard report. Separate explanatory paragraphs are added to the Separate explanatory paragraphs are added to the

report to describe the GAAP departures and their report to describe the GAAP departures and their effects on the financial statements. effects on the financial statements.

Opinion paragraph wording is changed to express Opinion paragraph wording is changed to express an adverse opinion .an adverse opinion .


VII. Lack of Independence An accountant who is An accountant who is

not independent is not independent is required to issue a required to issue a special disclaimer of special disclaimer of opinion.opinion.

One paragraph report One paragraph report with no title (See with no title (See Figure 3-12 on page Figure 3-12 on page 61).61).

No opinion is No opinion is expressed.expressed.

VIII. Other Information In regard to other information In regard to other information

included with the audited included with the audited financial statements in the financial statements in the

annual report, the auditor is annual report, the auditor is required to read the required to read the

information to ensure that it is information to ensure that it is not materially inconsistent not materially inconsistent with the audited financial with the audited financial

statement.statement. Auditors are not currently Auditors are not currently responsible for information on responsible for information on a company’s web site, even if a company’s web site, even if it includes audited financial it includes audited financial

statements.statements.

Summary

ConditionCondition UnqualifiedUnqualified QualifiedQualified DisclaimerDisclaimer AdverseAdverseLimit on audit Limit on audit scopescope ImmaterialImmaterial MaterialMaterial

Highly Highly MaterialMaterial

Departure Departure from GAAPfrom GAAP ImmaterialImmaterial MaterialMaterial

Highly Highly MaterialMaterial

Lack of Lack of IndependenceIndependence

Only Only reportreport

Type of Report

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