chapter 11

A U D I T I N G A RISK-BASED APPROACH TO

CONDUCTING A QUALITY AUDIT

9th Edition

Karla M. Johnstone | Audrey A. Gramling | Larry E. Rittenberg

Copyright © 2014 South-Western/Cengage Learning

CHAPTER 15 AUDIT REPORTS ON FINANCIAL

STATEMENTS

Copyright © 2014 South-Western/Cengage Learning 15-2

LEARNING OBJECTIVES

1. Identify and describe the principles underlying audit reporting on financial statements

2. Describe the information that is included in a standard unqualified audit report on financial statements and list the requirements for issuing a standard unqualified report on financial statements

3. Describe financial statement audits requiring an unqualified report with explanatory language and identify the appropriate audit report modifications


LEARNING OBJECTIVES

4. Describe financial statement audits requiring a qualified report and identify the appropriate audit report modifications

5. Describe financial statement audits requiring an adverse report and identify the appropriate audit report modifications

6. Describe financial statement audits requiring a disclaimer of opinion and identify the communication the auditor is required to provide


LEARNING OBJECTIVES

7. Assess various reporting situations requiring other than a standard unqualified report and determine the appropriate audit report that should be issued

8. Describe the information that is included in a standard unqualified audit report on internal control over financial reporting and identify the appropriate audit report modifications for situations requiring other than an unqualified report on internal control over financial reporting


LEARNING OBJECTIVES

9. Apply the frameworks for professional decision making and ethical decision making to issues involving audit reporting situations


THE AUDIT OPINION FORMULATION PROCESS


PROFESSIONAL JUDGMENT IN CONTEXT - INVESTORS, AUDITORS, AND STANDARD SETTERS DEBATE CHANGES

IN AUDIT REPORTS

• Changes to the standard unqualified audit report that are being debated by auditing standard setters and investors • Addition of auditor commentary on matters significant

to users’ understanding of the audited financial statements

• More frequent use of Emphasis of Matter paragraphs • Disclosure of which engagement partner at the firm

supervised the audit and who from outside the audit firm participated in the audit



IN AUDIT REPORTS

• The Public Company Accounting Oversight Board (PCAOB) and the International Auditing and Assurance Standards Board (IAASB) have indicated that they will issue proposed standards on the auditor reporting model that may address some of these additional disclosures



IN AUDIT REPORTS

• What information is currently included in the standard unqualified audit report? (LO 2)

• How does the standard unqualified audit report issued for U.S. public companies differ from the standard report issued in other parts of the world or for U.S. nonpublic companies? (LO 2)

• What types of additional information could be included in the standard unqualified audit report? (LO 2)

• What circumstances require a deviation from the standard unqualified audit report? (LO 3, 4, 5, 6)


IDENTIFY AND DESCRIBE THE PRINCIPLES UNDERLYING AUDIT REPORTING ON FINANCIAL

STATEMENTS

L E A R N I N G O B J E C T I V E 1


PRINCIPLES UNDERLYING AUDIT REPORTING

• The American Institute of Certified Public Accountant’s (AICPA) first and seventh principles governing an audit conducted in accordance with generally accepted auditing standards (GAAS) describe the principles underlying audit reporting

• These principles require auditors to either: • Express an unqualified opinion on the entire set of

financial statements and related footnotes, or • State the reasons that such an opinion cannot be

expressed


PRINCIPLES UNDERLYING AUDIT REPORTING

• If there is a material deviation from generally accepted accounting principles (GAAP): • Auditor should explicitly state the nature of the

deviation and the dollar effects so that a user can appropriately modify the financial statements


DESCRIBE THE INFORMATION THAT IS INCLUDED IN A STANDARD UNQUALIFIED AUDIT REPORT ON FINANCIAL

STATEMENTS AND LIST THE REQUIREMENTS FOR ISSUING A STANDARD UNQUALIFIED REPORT ON FINANCIAL STATEMENTS



STANDARD UNQUALIFIED AUDIT REPORTS - U.S. PUBLIC COMPANIES

• Designed to promote clear communication between auditor and financial statement user by delineating: • Introductory paragraph • Scope paragraph • Opinion paragraph


STANDARD UNQUALIFIED AUDIT REPORTS - U.S. PUBLIC COMPANIES

• If a combined report on the financial statements and internal controls, two additional paragraphs are included • Definition paragraph - Defines what is meant by

internal control over financial reporting • Inherent limitations paragraph - Discusses why internal

control may not prevent or detect misstatements


OTHER IMPORTANT COMPONENTS OF AN AUDIT REPORT

•Includes the word ‘independent’

Title

•Board of directors or shareholders of the organization for public companies •Varies depending on the circumstances of the engagement

Addressee

•No earlier than the date on which the auditor has obtained sufficient appropriate evidence to support the opinion

Audit report date

Signature of audit firm

City/state from which the auditor’s report has been issued


EXHIBIT 15.2 - SEC REPORTING REQUIREMENTS


REQUIREMENTS FOR A STANDARD UNQUALIFIED AUDIT REPORT ON THE FINANCIAL STATEMENTS FOR U.S.

PUBLIC COMPANIES

• There should be no material violations of GAAP • Disclosures should be adequate • Auditor should be able to perform all of the necessary

procedures • There should be no change in accounting principles

that had a material effect on the financial statements • The auditor should not have significant doubt about

the client remaining a going concern • The auditor should be independent


MODIFICATION OF THE STANDARD UNQUALIFIED REPORT

• When the conditions are not present, auditor should modify the standard unqualified report

• Options include: • Issue an unqualified opinion with explanatory language • Qualify the audit opinion • Issue an adverse opinion • Issue a disclaimer


STANDARD UNQUALIFIED AUDIT REPORTS - U.S. NONPUBLIC COMPANIES

• Introductory paragraph - What was audited • Management’s responsibility paragraph -

Responsibilities of client management • Scope paragraph - Responsibilities of the auditor and

the nature of the audit process • Opinion paragraph - Auditor’s opinion on the

fairness of the financial statements • For some engagements, financial statements might

be audited in accordance with multiple auditing standards


NON-U.S. COMPANIES

• Auditors refer to ISA 700 for guidance • Consistent with the AICPA’s AU-C 700 with a few

terminology differences • True and fair view - Used in ISA 700; is not used in the

United States auditing standards • Present fairly, in all material respects - GAAS

continues to require the use of the term


DESCRIBE FINANCIAL STATEMENT AUDITS REQUIRING AN UNQUALIFIED REPORT WITH

EXPLANATORY LANGUAGE AND IDENTIFY THE APPROPRIATE AUDIT REPORT MODIFICATIONS



UNQUALIFIED AUDIT REPORTS WITH EXPLANATORY LANGUAGE

• Used to explain: • Justified departure from GAAP • Inconsistent application of GAAP • Substantial doubt about client being a going concern • Emphasis of some matter, such as unusually important

subsequent events, risks, or uncertainties associated with contingencies or significant estimates

• Reference to other auditors


EXPLANATORY LANGUAGE - JUSTIFIED DEPARTURE FROM GAAP

• Rule 203 of the AICPA Code of Professional Conduct permits auditor to issue an unqualified opinion when there has been a material departure from GAAP • Only if the client can demonstrate, and auditor agrees,

that due to unusual circumstances, the financial statements would have been misleading had GAAP been followed


EXPLANATORY LANGUAGE - JUSTIFIED DEPARTURE FROM GAAP

• Auditor should add: • An informational paragraph either before or after the

opinion paragraph to describe the departure from GAAP

• Its approximate effects • Reasons for which compliance with GAAP would result

in misleading statements


EXHIBIT 15.3 - EXAMPLE OF POSSIBLE AUDIT REPORT LANGUAGE DESCRIBING A JUSTIFIED DEPARTURE FROM

GAAP


EXPLANATORY LANGUAGE - INCONSISTENT APPLICATION OF GAAP • Change in accounting principles

• From one GAAP to another - FIFO to LIFO • From non-GAAP to GAAP - Cash basis to accrual basis

• Both changes would require auditor to add an explanatory paragraph to the audit report


EXPLANATORY LANGUAGE - INCONSISTENT APPLICATION OF GAAP • Changes in accounting estimates and accounting for

new transactions are not considered changes in accounting principles

• Change in estimate affected by an accounting principle requires an explanatory language in the audit report

• AS 6 requires an additional paragraph for the correction of an error not involving an accounting principle for public companies


EXPLANATORY LANGUAGE - INCONSISTENT APPLICATION OF GAAP • The explanatory paragraph serves as a flag directing the

user’s attention to the relevant footnote disclosure if client has:

• Changed an accounting principle • Reasonable justification for the change • Followed GAAP in accounting for and disclosing this

change


EXPLANATORY LANGUAGE - SUBSTANTIAL DOUBT ABOUT THE CLIENT BEING A GOING CONCERN

• Explanatory paragraph should be clearly worded to indicate: • Auditor’s substantial doubt about client’s continuing

as a going concern • Reference to management’s footnote(s) explaining the

problems and plans to overcome the problem • Auditor may not feel comfortable expressing any

opinion for some going-concern situations in which client is experiencing severe financial distress • Would issue a disclaimer


EXPLANATORY LANGUAGE - EMPHASIS OF A MATTER

• Significant transactions with related entities • Important subsequent events, such as a board-of-

director decision to divest a major segment of the business

• Important risks or uncertainties associated with contingencies or significant estimates


EMPHASIS-OF-MATTER PARAGRAPHS AND OTHER-MATTER PARAGRAPHS IN INDEPENDENT AUDITOR’S REPORT FOR

U.S. NONPUBLIC COMPANIES

• Paragraph included: • In the auditor’s report that is required by GAAS, or • At the auditor’s discretion, and that refers to a matter

appropriately presented or disclosed in the financial statements • This paragraph should be included immediately after the

opinion paragraph in the auditor’s report • Use the heading ‘Emphasis of Matter’ or other

appropriate heading


EMPHASIS-OF-MATTER PARAGRAPHS AND OTHER-MATTER PARAGRAPHS IN INDEPENDENT AUDITOR’S REPORT FOR

U.S. NONPUBLIC COMPANIES

• A clear reference to: • The matter being emphasized should be included • Where relevant disclosures that fully describe the

matter can be found in the financial statements should be included

• Auditor should indicate that auditor’s opinion is not modified with respect to the matter being emphasized


EXPLANATORY LANGUAGE - REFERENCE TO OTHER AUDITORS

• The principal auditor (group engagement partner) needs to decide whether to mention the other auditor in the overall audit report

• Care must be taken when relying on other auditors’ reports • Principal auditor should have participated in the audit

at a sufficient level • Regardless of reference being made in auditor’s report

to the report of another auditor, principal auditor is responsible for the overall opinion



• If the principal audit firm chooses to mention the other firm in the audit report • Wording of the standard report is modified • No additional paragraph is needed

• Change appears in: • Introductory paragraph to indicate the shared

responsibility for the overall opinion • Scope and opinion paragraphs modified to reference

the other auditor



• For nonpublic clients: • Extensive change would appear in the auditor’s

responsibility section • Opinion paragraph would include a reference to the

other auditor • If the other auditor’s report is qualified:

• Principal auditor must consider whether the subject of the qualification is of such nature and significance in relation to the overall financial statements that it would affect the overall opinion


EXHIBIT 15.6 - REPORTING REQUIREMENTS WHEN PART OF AN AUDIT IS PERFORMED BY OTHER INDEPENDENT

AUDITORS



AUDITORS (CONT.)


AUDITING IN PRACTICE - PROBLEMS WHEN SERVING AS A PRINCIPAL AUDITOR: INSIGHTS FROM THE PCAOB

• Many registered public accounting firms located in the United States issue audit reports on financial statements filed by issuers that have substantially all of their operations outside of the U.S

• Although it is not inappropriate, the Board’s inspection process suggests that some firms may not be conducting audits in accordance with PCAOB standards


QUALIFIED REPORTS, ADVERSE REPORTS, AND DISCLAIMERS

• When the auditor alters the wording of the standard unqualified report in a manner that affects the type of opinion expressed, the report cannot be issued as an unqualified opinion • Auditor will provide a modified opinion which

includes: • A qualified opinion • An adverse opinion, or • A disclaimer of opinion


AUDITING IN PRACTICE - LANGUAGE IN MODIFIED REPORTS FOR U.S. NONPUBLIC COMPANIES

• When an opinion on the financial statements is modified, auditor should include a basis for modification paragraph in the auditor’s report • It should provide a description of the matter giving rise

to the modification • Auditor should place this paragraph immediately

before the opinion paragraph and use a heading as appropriate: • Basis for Qualified Opinion • Basis for Adverse Opinion • Basis for Disclaimer of Opinion


DESCRIBE FINANCIAL STATEMENT AUDITS REQUIRING A QUALIFIED REPORT AND IDENTIFY THE APPROPRIATE

AUDIT REPORT MODIFICATIONS



QUALIFIED AUDIT REPORTS

• Situations in which an auditor will issue a qualified report • A material unjustified departure from GAAP that is not

pervasive • Inadequate disclosure that is not pervasive • A scope limitation such that the possible effects on the

financial statements of undetected misstatements, if any, could be material but not pervasive


QUALIFIED REPORT - MATERIAL UNJUSTIFIED DEPARTURE FROM GAAP THAT IS NOT PERVASIVE

• Qualified opinion will be expressed if a client has a departure from GAAP that can be isolated to one item

• Pervasive GAAP departures, affecting more than one item, would result in an adverse opinion • Pervasive: Describes the effects or the possible effects

on the financial statements of misstatements that are undetected due to an inability to obtain sufficient appropriate audit evidence


QUALIFIED REPORT - INADEQUATE DISCLOSURE

• If client refuses to make appropriate disclosures, auditor should: • Express a qualified or adverse opinion, depending on

pervasiveness of omitted disclosures • Provide the omitted information in the audit report, if

practicable • Explanatory paragraph - Should describe the nature

of the omitted disclosures • Opinion paragraph - Should be modified to describe

nature of qualification


EXHIBIT 15.7 - OPINION QUALIFICATION BECAUSE OF INADEQUATE DISCLOSURE


QUALIFIED REPORT - SCOPE LIMITATION

• Restrictions on scope of audit, whether imposed by client or by circumstances beyond the auditor’s or client’s control, may require auditor to qualify an opinion • In some situations circumstances may be such that a

disclaimer would be more appropriate

• Circumstances that may limit the audit scope • Timing of the fieldwork • Inability to gather sufficient appropriate evidence • Inadequacy in the accounting records


DESCRIBE FINANCIAL STATEMENT AUDITS REQUIRING AN ADVERSE REPORT AND IDENTIFY THE APPROPRIATE

AUDIT REPORT MODIFICATIONS



ADVERSE AUDIT REPORTS

• Adverse report is appropriate when financial statements contain: • Pervasive and material unjustified departure from

GAAP • Lack of important disclosures that is pervasive • When a significant number of items in the financial

statements violate GAAP


EXHIBIT 15.9 - EXAMPLE OF POSSIBLE AUDIT REPORT LANGUAGE DESCRIBING A JUSTIFIED DEPARTURE FROM

GAAP


ADVERSE REPORT - LACK OF IMPORTANT DISCLOSURES THAT IS PERVASIVE

• Auditor can issue an adverse opinion if: • Client’s financial statements have omitted disclosures,

such that • Financial statements taken as a whole are not presented

fairly in conformity with GAAP


DESCRIBE FINANCIAL STATEMENT AUDITS REQUIRING A DISCLAIMER OF OPINION AND IDENTIFY THE

COMMUNICATION THE AUDITOR IS REQUIRED TO PROVIDE



AUDIT REPORTS WITH A DISCLAIMER OF OPINION

• An auditor issues a disclaimer of opinion report when: • Scope limitation exists • Substantial doubt exists about the client being a going

concern • There is lack of independence


DISCLAIMER - SCOPE LIMITATION

• Scope limitations caused by circumstances are such that it is not possible to form an opinion • Introductory paragraph’s wording modified for a

scope limitation • Scope paragraph is omitted • Additional paragraph is inserted to describe the scope

limitation(s) • Last paragraph states that no opinion can be expressed


DISCLAIMER - SCOPE LIMITATION FOR NON-U.S. COMPANIES

• ISA 705 requires auditor to withdraw from audit when auditor is unable to obtain sufficient appropriate audit evidence because of a management-imposed limitation, and • Auditor concludes that possible effects on financial

statements of undetected misstatements could be both material and pervasive


DISCLAIMER - SCOPE LIMITATION FOR NON-U.S. COMPANIES

ISA 705

Auditors required to withdraw from audit

If auditor concludes that possible effects of undetected

misstatements could be both material and pervasive

U.S. Standards

Auditors required to consider withdrawal from the

engagement

Auditor should consider whether to withdraw or disclaim an

opinion on the financial statements


DISCLAIMER - SUBSTANTIAL DOUBT ABOUT THE CLIENT BEING A GOING CONCERN

• Auditor may issue a disclaimer of opinion if there is a substantial doubt about the client continuing as a going concern

• In such cases, auditor would believe that an additional paragraph to an unqualified opinion is not appropriate


DISCLAIMER - AUDITOR LACKING INDEPENDENCE

• When auditors lack independence with respect to a client: • They cannot perform an audit in accordance with

professional auditing standards • They are precluded from expressing an opinion on the

financial statements • In such cases, a one-paragraph disclaimer should be

issued stating the lack of independence • Auditor omits the reasons for lack of independence


DISCLAIMER - AUDITOR LACKING INDEPENDENCE

• Report would have no title or salutation • Such a situation should rarely occur

• It could happen when it is discovered late in the audit that one of the auditors on the engagement had a financial interest in the client


ASSESS VARIOUS REPORTING SITUATIONS REQUIRING OTHER THAN A STANDARD UNQUALIFIED REPORT AND

DETERMINE THE APPROPRIATE AUDIT REPORT THAT SHOULD BE ISSUED



COMPARISONS OF MODIFICATIONS TO THE STANDARD UNQUALIFIED AUDIT REPORT

• Deciding on the type of opinion is important • This is particularly true of the decisions based on:

• Materiality level and pervasiveness of GAAP violations • Significance of scope limitations • Likelihood of the entity being a going concern

• Issuing an inappropriate opinion can lead to legal problems

• Report decision often involves consultation


EXHIBIT 15.11 - SUMMARY OF AUDIT REPORT MODIFICATIONS FOR U.S. PUBLIC COMPANIES


DESCRIBE THE INFORMATION THAT IS INCLUDED IN A STANDARD UNQUALIFIED AUDIT REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING AND IDENTIFY

THE APPROPRIATE AUDIT REPORT MODIFICATIONS FOR SITUATIONS REQUIRING OTHER THAN AN UNQUALIFIED REPORT ON INTERNAL CONTROL OVER FINANCIAL

REPORTING



AUDIT REPORTS ON INTERNAL CONTROL OVER FINANCIAL REPORTING (ICFR)

• Auditor evaluates identified control deficiencies individually, and in aggregate, to assess material weakness in ICFR

• Auditor issues an: • Unqualified opinion when it is determined that there

are no material weaknesses in ICFR • Adverse opinion when it is determined that there is

one or more material weaknesses in ICFR



• PCAOB AS 5 identifies situations in which the auditor modifies audit report on ICFR effectiveness • Elements of management’s annual report on internal

control are incomplete or improperly presented • There is a restriction on the scope of the engagement • Auditor decides to refer to the report of other auditors

as the basis, in part, for the auditor’s own report



• There is other information contained in management’s annual report on ICFR

• Management’s annual certification pursuant to section 302 of the Sarbanes-Oxley Act is misstated


ELEMENTS OF MANAGEMENT’S ANNUAL REPORT ON INTERNAL CONTROL ARE IMPROPERLY PRESENTED

• If the management’s report does not describe an identified material weakness, the auditor’s report will include an explanatory paragraph that describes the reasons for this determination


RESTRICTION ON THE SCOPE OF ENGAGEMENT

• If there are restrictions placed on the scope of the engagement the auditor will either: • Withdraw from the engagement • Disclaim an opinion


AUDITOR REFERS TO REPORT OF OTHER AUDITORS AS BASIS, IN PART, FOR AUDITOR’S OWN REPORT

• In certain situations audit report on ICFR may include a reference by the auditor to work performed by another auditor • The other auditor might be performing the ICFR audit

work at a subsidiary, division, branch, or component of the company

• Such a decision might differ from the corresponding decision as it relates to audit of financial statements


OTHER INFORMATION CONTAINED IN MANAGEMENT’S ANNUAL REPORT ON ICFR

• In addition to information required to be provided, in some instances, management may choose to include additional information in its report on ICFR • In such a case, the auditor will disclaim an opinion on

that additional information


MANAGEMENT’S ANNUAL CERTIFICATION PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT IS

MISSTATED

• As a result of the audit of ICFR, auditors might believe that modifications to the disclosures about changes in ICFR are necessary • For annual certifications to be accurate • To comply with the requirements of Section 302 of

Sarbanes-Oxley • Auditor should modify the report on ICFR to include

an explanatory paragraph • Describing reasons auditor believes management’s

disclosures should be modified

chapter 11

Documents

audit copyright

audit firm

quality audit

standard unqualified

audit reports changes

financial reporting

learning objectives

financial statements