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1.1. Auditing & Attestation - Lecture 1 |
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Auditing & Attestation 1
Auditing & Attestation 1
1. Audited financial statements—the basics ...........................................................................
3
2. Professional standards....................................................................................................
4
3. Reports on audited financial statements ..........................................................................
13
4. Reports on comparative financial statements ...................................................................
41
5. Events occurring after year-end .....................................................................................
46
6. Reporting on other information ......................................................................................
50
7. Appendix: GAAP sources for nongovernmental entities ......................................................
58
8
. Simulation.................................................................................................................. 59
9. Class questions ...........................................................................................................
71
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2
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AUDITED FINANCIAL STATEMENTS—THE BASICS
I. THE INDEPENDENT AUDIT FUNCTION
A. WHAT IS AN AUDIT?
An audit consists of a methodical review and objective examination of an enterprise's
financial statements.
the financial statements.
The objective of the auditor's examination is to express an opinion onThis expression takes the form of an audit report.
B. RESPONSIBILITIES
The financial statements of an enterprise are prepared by the management of the enterprise,
not by the independent auditor. Further, the financial statements are the product and
property of the enterprise; the independent auditor merely audits and expresses an opinion
on them. The expression of an opinion by the independent auditor is known as the "audit
function."
1. Company's Management = Financial Statements
2. Auditors = Expression of Opinion
C. THE AUDIT FUNCTION ADDS "CREDIBILITY"
The auditor's report gives credibility to the financial statements. The auditors, as a group
independent of management, have an objective view and can report on a company's
activities without bias or conflict of interest. Without a report from an independent auditor, a
company's financial statements would be meaningless, because the public would have little
faith in financial statements issued by the inherently biased company.
D. AN EXAMINATION IS MADE OF A COMPANY'S FINANCIAL STATEMENTS
1. The auditor carries out this examination by following the ten Generally Accepted
Auditing Standards (GAAS) and all of the official pronouncements that explain and
interpret GAAS.
2. The auditor must be:
a. Independent
b. Expert
(1) As to accounting (knowledge of GAAP)
(2) As to auditing (knowledge of GAAS)
(3) As to industry (particular business)
3. The audit should be planned and performed with an attitude of "professional
skepticism," whereby the auditor neither assumes management is dishonest nor
assumes unquestioned honesty.
E. THE AUDITOR MUST THEN REPORT HIS OR HER FINDINGS BASED UPON THE
EVIDENCE EXAMINED
1. The primary assertion is whether the statements are "presented fairly" in accordance
with GAAP (Generally Accepted Accounting Principles).
a. This decision as to fair presentation is a judgment call by the auditor. The
American Institute of Certified Public Accountants (AICPA) defines
presentation
transactions of the company in a manner that represents the financial statements
within a range of acceptable limits.
b. GAAP sources are further discussed in the Appendix.
2. Most audits are performed not only for the primary benefit of the stockholders, but also
for any other interested outside parties.
fairas follows: the financial statements reflect the underlying
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PROFESSIONAL STANDARDS
I. AUDITING STANDARDS
A. GENERALLY ACCEPTED AUDITING STANDARDS
The auditor is responsible for the performance of a properly planned and executed audit.
The criteria for such an audit are the ten generally accepted auditing standards (GAAS).
Statements on Auditing Standards (SASs) are interpretations of GAAS issued by the Auditing
Standards Board (ASB) of the AICPA. Note that compliance with GAAS is mandatory on all
audit engagements.
B. GENERALLY ACCEPTED GOVERNMENT AUDITING STANDARDS
Audits of government organizations, programs, activities, and of entities that receive
government funds should be conducted in accordance with generally accepted government
auditing standards (GAGAS), as covered later in the course.
C. THE PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD
The Public Company Accounting Oversight Board (PCAOB) was established pursuant to the
Sarbanes-Oxley Act of 2002. The PCAOB establishes auditing and related professional
practice standards to be used in the preparation and issuance of audit reports for "issuers."
1. "Issuers" consist of entities subject to the rules of the SEC (primarily public
companies).
2. The PCAOB is comprised of five full-time, financially literate members.
a. Two members must be (or have been) CPAs, and the other three must not be (or
must not have been) CPAs.
b. A CPA can only act as the Chair of the Board if he or she has not practiced as a
CPA for the past five years.
c. No members of the Board can receive payments from a public accounting firm
(other than fixed continuing payments, such as retirement payments).
3. Public accounting firms must register with the PCAOB in order to audit a public
company. Registered firms are subject to Board inspection, disciplinary proceedings,
and sanctions.
4. PCAOB Standards
a. The PCAOB adopted, on an initial, interim basis, ASB standards, but continues
to review each standard to evaluate whether it should be modified, repealed,
replaced, or permanently adopted. At present, the PCAOB has issued five of its
own auditing standards, which replace ASB Standards for audits of issuers.
These standards will be covered throughout the course.
??????
Be sure to visit the Becker website for possible updates to this area.
b. Note that the ASB retains the authority to set performance and reporting
standards for audits of financial statements of nonissuers.
SAS
GAGAS
PCAOB
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SSAE
II. STANDARDS FOR ENGAGEMENTS OTHER THAN AUDITS
An audit is merely one type of engagement an accountant may be called upon to perform. Each
type of engagement has a different set of applicable professional standards, and the requirements,
responsibilities, and limitations vary with the nature and scope of the engagement. Below is an
overview of these various sets of standards.
A. STATEMENTS ON STANDARDS FOR ATTESTATION ENGAGEMENTS
Statements on Standards for Attestation Engagements (SSAE) are issued by senior
technical bodies of the AICPA. These standards apply to attest engagements, covered later
in the course.
B. STATEMENTS ON STANDARDS FOR ACCOUNTING AND REVIEW SERVICES
The Accounting and Review Services Committee was established by the AICPA to
regulate standards for privately held companies not seeking audited statements. Statements
on Standards for Accounting and Review Services (SSARS) are issued by this committee,
and they are applicable to unaudited financial statements or unaudited financial information of
a nonpublic entity. SSARS are covered later in the course.
C. STATEMENTS ON STANDARDS FOR CONSULTING SERVICES
Statements for Standards for Consulting Services (SSCSs) are issued by the
Management Advisory Services Executive Committee, and they provide standards for a
broad range of consulting services.
D. STATEMENTS ON STANDARDS FOR TAX SERVICES
Statements on Standards for Tax Services provide guidelines for tax preparation
services.
III. OTHER GUIDELINES
A. CODE OF PROFESSIONAL CONDUCT
The AICPA Code of Professional Conduct provides members with guidelines for behavior in
the conduct of their professional affairs. In addition, it provides assurance to the public that
the profession intends to maintain high standards and to enforce compliance with these
standards by its members. The Code of Professional Conduct applies to all services
performed in the practice of public accounting. (
tested as part of the Regulation exam and is reviewed in the Regulation course.)
Note: The Code of Professional Conduct is
B. THE SECURITIES AND EXCHANGE COMMISSION (SEC)
1. The Securities Acts of 1933 and 1934 have given this governmental commission the
authority to set guidelines for publicly traded companies.
a. The SEC publishes their regulations in the Accounting Series Releases and in
Regulation S-K.
b. Final standards adopted by the PCAOB do not become effective unless and until
they are approved by the SEC.
SSARS
SSCS
SSTS
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C. THE SARBANES-OXLEY ACT
Under the Sarbanes-Oxley Act:
1. Auditors report to and are overseen by the issuer's audit committee.
2. All services (both audit and non-audit) must be preapproved by the audit committee.
3. A second partner review is required for every public company audit report.
4. Severe penalties apply to those who destroy records (or willfully fail to maintain them
for at least seven years), commit securities fraud, or fail to report fraud.
a. The statute of limitations for the discovery of fraud was extended by this Act, and
protections were provided for corporate "whistleblowers."
5. Anyone associated with a registered public accounting firm (e.g., individual
accountants) can be held responsible if their actions contribute to a firm's violation of
laws, rules, or professional standards.
The Sarbanes-Oxley Act also contains provisions related to auditor independence, which will
be covered later in the course.
IV. AUDITING GUIDANCE: THE GAAS HIERARCHY
There are three levels of auditing guidance.
A. STATEMENTS ON AUDITING STANDARDS (SASs)
1. Auditors (who are AICPA members) are required to comply with SASs published by the
Auditing Standards Board. The auditor should:
a. Use professional judgment in applying the SASs to a particular engagement.
b. Be prepared to justify any departures from presumptively mandatory
requirements (see below).
2. SASs generally apply only in situations where auditing services are being rendered.
However, a few SASs apply to other services, such as reviews of interim financial
information and letters for underwriters.
3. Specific language is used within the SASs to clarify the auditor's level of responsibility.
a. The terms "
must always be followed.
b. The term "
must always be considered; however, rare departures from the requirement are
permitted as long as there is appropriate justification, performance of sufficient
alternative procedures, and thorough documentation.
c. The terms "
not impose a professional requirement for performance.
must" or "is required" indicate an unconditional requirement, whichshould" indicates a presumptively mandatory requirement, whichmay," "might," and "could" indicate explanatory material that does
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B. INTERPRETIVE PUBLICATIONS
1. Interpretive publications are recommendations regarding how SASs should be applied
in specific situations. They are not considered to be auditing standards. The auditor
should:
a. Consider the guidance provided by these publications in performing an audit.
b. Be able to explain any departures, and how compliance with standards was
otherwise achieved.
2. Interpretive publications include SAS Interpretations, appendices to the SASs, AICPA
Audit and Accounting Guides, and AICPA auditing Statements of Position.
C. OTHER AUDITING PUBLICATIONS
1. Other auditing publications have no authoritative status but may be helpful to the
auditor.
2. Other auditing publications include auditing articles in the Journal of Accountancy (or
other professional journal), auditing articles in the AICPA CPA Letter, continuing
professional education materials, textbooks, etc.
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V. GENERALLY ACCEPTED AUDITING STANDARDS
The ten Generally Accepted Auditing Standards comprise the foundation of auditing. These
standards are qualitative in nature and set minimum requirements for the profession. Auditing
standards differ from auditing procedures in that "procedures" relate to acts to be performed,
whereas "standards" deal with measures of audit quality and the objectives to be achieved in an
audit. Auditing standards (as distinct from auditing procedures) concern themselves not only with
the auditor's professional qualities, but also with the judgment exercised in the performance of the
examination and in the auditor's report.
A. THE GENERAL STANDARDS
1. Training
"The auditor must have adequate technical training and proficiency to perform the
audit."
Comment
in auditing, and knowledge of the particular industry being audited.
: The auditor must have the education in accounting, the practical experience
2. Independence
"The auditor must maintain independence in mental attitude in all matters relating to the
audit."
Comment
necessary to add credibility to what we do. It is defined as independence in fact and
appearance. The auditor is judicially impartial.
: This standard is often called the cornerstone of the profession since it is
a. Independence in Fact and in Appearance
The auditor must be independent in fact and in appearance. Auditors must leave
no doubt as to their independence in the mind of the general public. Activities or
relationships that even suggest or imply a possible lack of independence must be
avoided by the auditor.
For example, assume the auditor owns an insignificant amount of the client's
common stock, and the auditor can in no way influence corporate policy. Thus,
in fact, the auditor is independent. However, the appearance of independence is
nonetheless impaired. Any direct ownership of a company, no matter how small,
will impair independence. (An indirect financial interest that is immaterial does
not impair independence.)
b. Sarbanes-Oxley
Under the Sarbanes-Oxley Act of 2002, an accounting firm may not provide audit
services to a public company if a top official of that company is also a previous
employee of the accounting firm who worked on the audit during the last year.
G
ENERAL
S
TANDARDS
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3. Professional Care
"The auditor must exercise due professional care in the planning and performance of
the audit and the preparation of the report."
Due professional care imposes a responsibility upon each person within an
independent auditor's organization to observe the standards of fieldwork and reporting.
The auditor will be held to exercise the same components of professional care as a
reasonable auditor would exercise, which include good faith, integrity, and diligence,
but due professional care does not imply infallibility. Due professional care is
concerned with what the auditor does and how well it is done. The exercise of due
professional care implies that the auditor will obtain sufficient appropriate audit
evidence to limit audit risk to a low level. The high level of assurance expected to be
obtained is referred to as "reasonable assurance"; absolute assurance is not possible.
Due professional care also requires the auditor to exercise professional skepticism.
Professional skepticism
throughout the audit, including a questioning mind and a critical assessment of audit
evidence. The auditor neither presumes management dishonesty nor presumes
unquestioned management honesty. The auditor needs to exercise professional
skepticism throughout the audit process, from engagement planning through
conducting fieldwork.
can be defined as the maintenance of an objective attitude
Comment
average auditor would do and never less, including review of work performed by
assistants and maintaining an attitude of professional skepticism. Evidence of "due
professional care" is indicated by critical management reviews of work performed at
every level of supervision.
: Often called the "average auditor" concept. The auditor should do what the
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B. THE STANDARDS OF FIELDWORK
1. Planning and Supervision
"The auditor must adequately plan the work and must properly supervise
any assistants."
Comment
of staff auditors should be reviewed by a qualified auditor.
: Audit programs are designed to enumerate appropriate action, and all work
2. Internal Control, Entity, and Environment
"The auditor must obtain a sufficient understanding of the entity and its environment,
including its internal control, to assess the risk of material misstatement of the financial
statements whether due to error or fraud, and to design the nature, extent, and timing
of further audit procedures."
Comment
material misstatements will be prevented or detected on a timely basis.
a. Strong controls imply the auditor will require less evidence.
b. Weak controls imply the auditor will require more evidence.
: Appropriate internal controls provide the auditor with confidence that
3. Evidence
"The auditor must obtain sufficient appropriate audit evidence by performing audit
procedures to afford a reasonable basis for an opinion regarding the financial
statements under audit."
Comment
specific audit evidence is required. The auditor applies his or her judgment.
: All specific audit work is performed in order to gather evidence. Virtually no
S
TANDARDS OF
F
IELDWORK
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C. THE STANDARDS OF REPORTING
1. Accounting = GAAP
"The auditor must state in the auditor's report whether the financial statements are
presented in accordance with generally accepted accounting principles (GAAP)."
Comment
: Explicit statement in auditor's report.
2. Consistency
"The auditor must identify in the auditor's report those circumstances in which such
principles have not been consistently observed in the current period in relation to the
preceding period."
Comment
: Implicit in auditor's report.
3. Disclosure
"When the auditor determines that informative disclosures are not reasonably
adequate, the auditor must so state in the auditor's report."
Comment
: Implicit in auditor's report.
4. Express Opinion
"The auditor must either express an opinion regarding the financial statements, taken
as a whole, or state that an opinion cannot be expressed, in the auditor's report. When
the auditor cannot express an overall opinion, the auditor should state the reasons
therefor in the auditor's report. In all cases where an auditor's name is associated with
financial statements, the auditor should clearly indicate the character of the auditor's
work, if any, and the degree of responsibility the auditor is taking, in the auditor's
report."
Comment:
Explicit statement in auditor's report.
S
OF
TANDARDSREPORTING
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PASS KEY
The examiners test on which reporting standards are explicit (Accounting is GAAP & Express Opinion) and which standards
are implicit (Consistency & Disclosure).
a. The objective of the fourth standard of reporting is to prevent misinterpretation of
the degree of responsibility the auditor is assuming when his/her name is
associated with financial statements.
(1) The auditor, when associated with the financial statements, has two major
choices:
(a) To render an opinion on the financial statements taken as
a whole; or
(b) To disclaim an opinion (e.g., because not enough audit work was
done, or because the auditor was not independent).
(2) Taken as a whole applies equally to a complete set of financial statements,
and to an individual financial statement, such as a balance sheet.
(a) The auditor may express an unqualified opinion on one of the
financial statements (e.g., a balance sheet), while rendering a
qualified opinion or disclaimer of opinion on another financial
statement, such as the income statement (covered later).
(b) The auditor may report on one basic financial statement and not the
others, as long as access is not limited to information underlying the
basic financial statement. This is considered a "limited" reporting
engagement.
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REPORTS ON AUDITED FINANCIAL STATEMENTS
I. THE AUDITOR'S STANDARD REPORT (UNQUALIFIED OPINION)
The auditor's unqualified report states that the financial statements are presented fairly in all
material respects. The three-paragraph standard report includes all of the following:
A. TITLE
"Independent" (auditor's report) must be included in the report title.
B. ADDRESSEE
The report is generally addressed to the company, its stockholders and/or its board of
directors. It generally is not addressed to management.
C. INTRODUCTORY PARAGRAPH
The introductory paragraph contains the following:
1. A statement that the financial statements as identified in the report were audited; and
2. A statement that the financial statements are the
the auditor's
responsibility of management and thatresponsibility is to express an opinion.
D. SCOPE PARAGRAPH
The scope paragraph contains the following:
1. A statement that the
a. For audits of issuers, reference is made to PCAOB standards instead of United
States GAAS (covered later).
2. A statement that the audit was
that the financial statements are free from
3. Statements that the audit included
audit was conducted in accordance with United States GAAS;planned and performed to obtain reasonable assurancematerial misstatement;examining evidence on a test basis; assessing the
accounting principles
evaluating the overall presentation; and
4. A statement that the audit provides a reasonable basis for an opinion.
used and significant estimates made by management; and
E. OPINION PARAGRAPH
The opinion paragraph of the report contains the following:
1. A statement referring to the financial statements specifically identified in the
introductory paragraph;
2. An opinion as to the fair presentation of the financial statements (ACD
3. A statement regarding conformity with United States generally accepted accounting
principles. (
O); andACDO)
F. FIRM NAME
The firm's name, either printed or signed, must appear in the report.
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G. REPORT DATE
The date of the audit report must be included in the report.
1. The report should be dated on or after the date on which appropriate audit evidence,
sufficient to support the opinion, has been obtained. Sufficient appropriate audit
evidence includes evidence that:
a. Audit documentation has been reviewed,
b. Financial statements have been prepared, and
c. Management has taken responsibility for the financial statements.
2. The report date shows the final date of the auditor's responsibility.
3. For comparative statements, the date appropriate for the most recent audit should be
used.
II. UNQUALIFIED OPINION
A. SAMPLE REPORT—THE UNQUALIFIED OPINION (REPORTING ON A
SINGLE YEAR)
Heading Intro Scope Opinion
INDEPENDENT AUDITOR’S REPORT
We have audited the accompanying balance sheet of ABC Company as of December 31,
20XX, and the related statements of income, retained earnings, and cash flows for the year
then ended. These financial statements are the
Our
We conducted our
States of America. Those standards require that we
reasonable assurance about whether the financial statements are free of
An audit includes
the financial statements. An audit also includes
significant estimates
presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects,
the financial position of ABC Company as of (at) December 31, 20XX, and the results of its
operations and its cash flows for the year then ended in conformity with accounting principles
generally accepted in the United States of America.
(Name)
(Date)
responsibility of the Company’s management.responsibility is to express an opinion on these financial statements based on our audit.audit in accordance with auditing standards generally accepted in the Unitedplan and perform the audit to obtainmaterial misstatement.examining, on a test basis, evidence supporting the amounts and disclosures inassessing the accounting principles used andmade by management, as well as evaluating the overall financial statement
Sign
A
UDITOR'S
S
REPORT
TANDARD
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B. SAMPLE REPORT – THE UNQUALIFIED OPINION (REPORTING ON A SINGLE
FINANCIAL STATEMENT)
(Unqualified) Opinion on Balance Sheet Only
I
NDEPENDENT AUDITOR'S REPORT
We have audited the accompanying
responsibility of the Company's management. Our responsibility is to express an opinion on this financial statement based
on our audit.
We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those
standards require that we plan and perform the audit to obtain reasonable assurance about whether the
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.
In our opinion, the
Company as of (at) December 31, 20XX, in conformity with accounting principles generally accepted in the United States of
America.
balance sheet of X Company as of December 31, 20XX. This financial statement is thebalance sheet isbalance sheet referred to above presents fairly, in all material respects, the financial position of X
C. PCAOB STANDARDS
1. Audits of Issuers
PCAOB Auditing Standard No. 1 requires the auditor's report to include a reference to
the standards of the Public Company Accounting Oversight Board (United States).
a. An auditor reporting on the audit of financial statements of an issuer should state
in the scope paragraph:
"
Company Accounting Oversight Board (United States).
require that we plan and perform the audit…"
b. An auditor's report on the financial statements of an issuer should also include
identification of the city and state (or country) from which the report was issued.
Generally, this information is included with the signature and date.
We conducted our audits in accordance with the standards of the PublicThose standards
2. Audits of Nonissuers
An auditor may (but is not required to) conduct the audit of a nonissuer in accordance
with both GAAS and the auditing standards of the PCAOB. Additional language may
be added to the scope paragraph to describe this situation:
"We conducted our audit in accordance with generally accepted auditing
standards as established by the Auditing Standards Board (United States) and in
accordance with the auditing standards of the Public Company Accounting
Oversight Board (United States).
the audit…"
Those standards require that we plan and perform
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PASS KEY
When the examiners require CPA candidates to respond to questions concerning the standard audit report, you must
remember:
GAAS Scope Paragraph
GAAP Opinion Paragraph
EXAMPLE
Which paragraphs of an auditor's standard report on financial statements should refer to Generally Accepted Auditing
Standards (GAAS) and Generally Accepted Accounting Principles (GAAP)?
GAAS GAAP
a. Opening Scope
b. Scope Scope
c. Scope Opinion
d. Opening Opinion
Solution:
scope paragraph. The auditor expresses an opinion on the financial statements' conformity with U.S. GAAP in the
opinion paragraph.
Choice "c" is correct. The auditor states that the audit was conducted in accordance with U.S. GAAS in the
III. THE TYPES OF OPINIONS ARE:
A. UNQUALIFIED (CLEAN) OPINION
An unqualified opinion states that the financial statements present fairly, in all material
respects, the financial position, results of operations, and cash flows of the entity in
conformity with United States GAAP. This is the opinion expressed in the standard report.
1. Explanatory Language (Modified Unqualified Opinion)
Explanatory language may be added to the auditor's standard (unqualified) report.
Certain circumstances, even those not affecting the auditor's unqualified opinion on the
financial statements, may require that the auditor add an explanatory paragraph (or
other explanatory language) to the report.
B. QUALIFIED OPINION (EXCEPT FOR)
A qualified opinion states that, "except for" the effects of the matter(s) to which the
qualification relates, the financial statements present fairly, in all material respects, the
financial position, results of operations, and cash flows of the entity in conformity with United
States GAAP.
C. ADVERSE OPINION
An adverse opinion states that the financial statements do not present fairly the financial
position, results of operations, or cash flows of the entity in conformity with United States
GAAP.
D. DISCLAIMER OF OPINION
A disclaimer of opinion states that the auditor does not express an opinion on the financial
statements because he or she was not able to perform an audit sufficient in scope to render
an opinion.
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IV. BRIEF SUMMARY OF WHEN TO USE DIFFERENT OPINIONS
(Covered in greater detail later):
Materiality of
Problem
Conformity
with GAAP
Adherence
to GAAS
None or immaterial = Unqualified Unqualified
Material = Qualified Opinion
(modify opinion
paragraph)
Qualified Opinion
(modify scope and
opinion paragraphs)
Highly Material = Adverse Opinion Disclaimer of Opinion
V. AUDITOR'S REPORT: OPINION DECISION TREE
UNQUALIFIED OPINION
DISCLAIMER
GAAS
1. Uncertainty
2. Scope Limitation
3. Lack of Independence
4. Unaudited
WITHDRAW
False, Fraudulent, Deceptive or Misleading
ADVERSE
GAAP
1. Non-GAAP Change
2. Inadequate Disclosure
3. Unjustified Departure from GAAP
4. Unreasonable Acctg. Estimate
QUALIFIED
"EXCEPT FOR"
GAAS
1. Uncertainty
2. Scope Limitation
QUALIFIED
"EXCEPT FOR"
GAAP
1. Non-GAAP Change
2. Inadequate Disclosure
3. Unjustified Departure from GAAP
4. Unreasonable Acctg. Estimate
PASS KEY
A candidate must be able to identify the types of opinions available for GAAP issues (Qualified-"Except for" & Adverse) and
for GAAS issues (Qualified-"Except for" & Disclaimer).
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VI. UNQUALIFIED OPINION
UNQUALIFIED OPINION
DISCLAIMER
GAAS
1. Uncertainty
2. Scope Limitation
3. Lack of Independence
4. Unaudited
WITHDRAW
False, Fraudulent, Deceptive or Misleading
ADVERSE
GAAP
1. Non-GAAP Change
2. Inadequate Disclosure
3. Departure from GAAP
4. Unreasonable Acctg. Estimate
QUALIFIED
"EXCEPT FOR"
GAAS
1. Uncertainty
2. Scope Limitation
QUALIFIED
"EXCEPT FOR"
GAAP
1. Non-GAAP Change
2. Inadequate Disclosure
3. Departure from GAAP
4. Unreasonable Acctg. Estimate
A. UNCERTAINTY
1. General
An uncertainty involves a matter for which conclusive audit evidence concerning its
outcome is not currently available and will not be available until such time in the future
when the matter is resolved. (Note the use of the word "conclusive"; existing
conditions and events to date may provide some audit evidence; see below.)
Uncertainties include (but are not limited to) contingencies listed in SFAS 5.
2. Management's Responsibility
Management must analyze the existing conditions, and in accordance with GAAP,
either:
a. Estimate the effect of future events on the financial statements and record and
present this estimate, or
b. Determine that a reasonable estimate cannot be made and make the required
disclosures to that effect.
3. Auditor's Responsibility
The auditor's responsibility involves an assessment of whether the audit evidence that
is or should be available is sufficient to support management's analysis and
conclusions regarding presentation or disclosure of the uncertainty in the financial
statements (that is, management's assertion regarding the uncertainty).
a. If management's analysis is supported and properly reported or disclosed, the
auditor issues an unqualified opinion with no reference to the uncertainty in the
audit report.
Unqualified
Uncertainty
U
NCERTAINTIES
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b. If the auditor is unable to obtain sufficient audit evidence involving an uncertainty
and its presentation or disclosure in the financial statements, the auditor should
consider the need to express a qualified (GAAS) opinion or to disclaim an
opinion due to a limitation in scope.
c. If the auditor concludes that the financial statements are materially misstated due
to a departure from GAAP related to an uncertainty, the auditor should express a
qualified (GAAP) or adverse opinion. GAAP departures related to uncertainties
include inadequate disclosure, use of inappropriate accounting principles, and
use of unreasonable accounting estimates.
PASS KEY
A commonly tested area is the concept of uncertainty. The chart below will assist in your mastering this area.
Uncertainty
GAAP & Evidence
Auditor
agrees with
management
No Evidence
Auditor unable
to obtain
evidence
Non-GAAP
Auditor
disagrees with
management
Unqualified
Qualified
(GAAS)
or
Disclaimer
Qualified (GAAP)
or
Adverse
B. MODIFIED UNQUALIFIED OPINION
There are several situations in which an auditor must modify the standard unqualified report
to explain or emphasize a matter. This modification, however, does not constitute a qualified
opinion. Variations of the auditor's standard report will occur in several situations.
1. Modified Wording
Division of responsibility: The auditor's opinion is based in part on the report of another
auditor.
2. Explanatory Paragraph
a. Necessary and justified departure from GAAP: Due to unusual circumstances, a
GAAP departure prevents the financial statements from being misleading.
b. Going concern: There is substantial doubt about the entity's ability to continue as
a going concern.
c. To emphasize a matter regarding the financial statements, the auditor may add
an explanatory paragraph.
d. A justified lack of consistency is caused by a material change in GAAP between
periods or a change in the method of the application of accounting principles.
e. Required SEC regulation S-K quarterly financial data has been omitted or has
not been reviewed.
f. Supplementary information required by GAAP has been omitted or departs
materially from GAAP, or the auditor is unable to complete prescribed
procedures or to remove substantial doubts about the presentation of such
information.
g. Other information in a document containing audited financial statements is
materially inconsistent with information appearing in the financial statements.
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PASS KEY
You will probably have questions involving the "modified" unqualified opinion. We will cover each of these examples later. It
is important to note, however, that this still represents an unqualified opinion. The additional language is used to highlight the
above circumstances.
C. GENERAL RULE ON POSITION OF EXPLANATORY PARAGRAPH
1. Unqualified opinion:
The explanatory paragraph generally would follow the opinion paragraph.
2. Qualified, adverse, and disclaimer of opinion:
The explanatory paragraph generally would precede the opinion paragraph.
3. Exceptions:
The following are exceptions to the general rules above. The explanatory paragraph
may be placed either before or after the opinion paragraph.
a. Justified GAAP departure
b. Emphasis of a matter
D. RELIANCE ON WORK OF OTHER AUDITORS—OPINION BASED IN
PART ON REPORT OF ANOTHER AUDITOR
When part of an examination, such as the audit of a subsidiary, has been performed by
another auditor, the principal auditors must decide whether their own participation
permits them to act as the principal auditor and, if so, whether reference should be
made to the other auditor. This decision is a matter of professional judgment and
should be based on the materiality of the portions examined by each of the auditors along
with their knowledge of the overall financial statements. After a decision is reached to act as
the principal auditor, they must further decide whether to refer to the other auditor in their
report or to assume responsibility for the report themselves.
1. Responsibilities
Regardless of the decision of the principal auditor:
a. The other auditors remain responsible for their own work and report, and
b. The principal auditor must always be satisfied regarding the reputation and
independence of the other auditor.
2. Division of Responsibility (reference in report)
When the principal auditor decides to mention the work done by other auditors, the
report will express a division of responsibility. The principal auditor will mention this
division in all three paragraphs.
a
permission and the report of the other auditor is presented.
b. The work done by the other auditors is expressed in terms of percentages, total
assets, total revenue, or other appropriate criteria, and is set forth in the
introductory paragraph.
. The name of the other auditor is not mentioned unless that auditor gives express
Modified
Unqualified
Another CPA
Justified
Non-GAAP
Going Concern
Emphasis Matter
Consistency
Other
O
PINION BASED IN
P
ART ON REPORT OF
A
NOTHER AUDITOR
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c. Sample Report—Division of Responsibility
INDEPENDENT AUDITOR'S REPORT
We have audited the
consolidated balance sheets of ABC Company as of December 31, 20X1 and 20X0, and the related
consolidated
are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial
statements based on our audit.
whose statements reflect total assets of $_____ and $_____ as of December 31, 20X1 and 20X0, respectively, and
total revenues of $_____ and $_____ for the years then ended. Those statements were audited by other auditors
whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for B
Company, is based solely on the report of the other auditors.
statements of income, retained earnings, and cash flows for the years then ended. These financial statementsWe did not audit the financial statements of B Company, a wholly owned subsidiary,
We conducted our audit in accordance with auditing standards generally accepted in the United States of America. 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
audits
In our opinion,
above present fairly, in all material respects, the financial position of ABC Company as of (at) December 31, 20X1 and 20X0,
and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally
accepted in the United States of America.
(Name)
(Date)
and the report of other auditors provide a reasonable basis for our opinion.based on our audits and the report of other auditors, the consolidated financial statements referred to
3. Assumption of Responsibility (no reference to other CPA)
When the principal auditor accepts responsibility for the work performed by another
auditor, the principal auditor does not refer to the other auditor in the auditor's report.
a. Additional Investigation of the Other Auditor Step
If the principal auditors decide not to make reference, they must assure
themselves of the independence, professional competency, and reputation of the
other auditor. The principal auditors should:
(1) Visit with the other auditor and discuss the audit procedures.
(2) Review the audit program, audit documentation, and evaluation of internal
control performed by the other auditor. (Note that PCAOB rules contain
specific additional requirements regarding documentation that the principal
auditor must obtain, review, and retain.)
If the other auditor's opinion is qualified, the principal auditors must decide
whether the subject of the qualification is material in relation to the consolidated
statements, and, if not, they need not make reference in their report to the
qualification.
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D
EPARTURE FROM A
P
ROMULGATED
A
CCOUNTING
P
RINCIPLE
E. NECESSARY/JUSTIFIED DEPARTURE FROM GAAP
Rule 203 of the AICPA Code of Professional Conduct states that the auditor may not
express an opinion indicating that the financial statements of an entity are presented
fairly if they are not in conformity with generally accepted accounting principles. The
exception to this rule occurs under unusual circumstances, when adherence to GAAP
would make the financial statements more misleading than they would be under another
accounting treatment. In these cases, the auditor expresses an unqualified opinion and adds
an explanatory paragraph either before or after the opinion paragraph.
1. Explanatory Paragraph
The explanatory paragraph should contain a description of the departure, its
approximate effects (if possible), and the reasons why adherence to the generally
accepted principle would make the financial statements misleading.
Note:
accounting principle, an unqualified opinion is no longer appropriate. The auditor
would express a qualified or adverse opinion. This is covered in more detail later.
If the auditor does not agree with the departure from a generally accepted
F. THE AUDITOR'S CONSIDERATION OF AN ENTITY'S ABILITY TO CONTINUE AS A
GOING CONCERN
On every audit engagement, the auditor is responsible for evaluating aggregate audit
evidence to determine whether there is substantial doubt about the entity's ability to continue
as a going concern for a reasonable period of time. If there is a substantial doubt, the
auditors would state their concerns in an explanatory paragraph after the opinion paragraph
of their unqualified report. The going concern period (i.e., the "reasonable period of time")
should not exceed one year from the date of the financial statements being audited.
1. Procedures
The auditor examines information that is contrary to the basic principle of going
concern. The auditor should perform the following procedures:
a.
b.
agreements
c.
director meetings
d.
e.
arrangements
f.
Analytical proceduresDebt compliance: the auditor should review the terms of debt and loanMinutes: the auditor should review minutes from stockholder and board ofInquiry of client's legal counselThird parties: the auditor should confirm the details of financial supportSubsequent events review
Modified
Unqualified
Another CPA
Justified
Non-GAAP
Going Concern
Emphasis Matter
Consistency
Other
Modified
Unqualified
Another CPA
Justified
Non-GAAP
Going Concern
Emphasis Matter
Consistency
Other
G
OING
C
ONCERN
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2. Conditions and Events
Based on the procedures performed, the auditor identifies conditions and events that
may be indicative of substantial doubt.
a.
credit, debt restructuring, noncompliance with capital requirements, new
financing sources or methods, disposal of substantial assets
b.
particular project, uneconomic long-term commitments, significant revision of
operations
c.
flows, adverse financial ratios
d.
license, or patent, loss of a principal customer or supplier, natural disasters
Financial difficulties: loan defaults, dividend arrearages, denial of usual tradeInternal matters: work stoppages, labor difficulties, substantial dependence on aNegative trends: recurrent losses, working capital deficiencies, negative cashExternal matters: legal proceedings, new legislation, loss of a key franchise,
3. Mitigating Factors
The auditor looks for mitigating factors.
a. Plans to borrow money or restructure debt
b. Plans to sell assets
c. Plans to delay or reduce expenditures
d. Plans to increase ownership equity
Note that mitigating factors must include not just intent but the ability to carry out the
planned procedures. Can the plans be effectively implemented?
4. Alleviation of Doubt
After considering management's plans, the auditor may decide that substantial doubt
(about the entity's ability to continue as a going concern for a reasonable period of
time) has been alleviated. In such cases, the auditor should still consider the need for
disclosure of the conditions and events that initially gave rise to the substantial doubt.
5. Modified Unqualified vs. Disclaimer
Although the general rule in going concern cases is to add an explanatory paragraph to
the unqualified opinion, the auditor is not precluded from choosing to disclaim an
opinion in cases involving uncertainties. The decision between an unqualified opinion
with an explanatory paragraph and a disclaimer of opinion is based on the auditor's
judgment.
6. Sample Report—Explanatory Paragraph after Opinion Paragraph
(Introduction, scope, and opinion paragraphs unchanged)
a. The wording of the explanatory paragraph must include the terms "substantial
doubt" and "going concern."
[Same Introduction]
[Same Scope Paragraph]
[Same Opinion Paragraph]
The accompanying financial statements have been prepared assuming that the Company will continue as a going concern.
As discussed in Note Z to the financial statements, the Company has suffered recurring losses from operations and has had
a net capital deficiency that raises
in regard to these matters are also described in Note Z. The financial statements do not include any adjustments that might
result from the outcome of this uncertainty.
substantial doubt about its ability to continue as a going concern. Management's plans
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7. Documentation Requirements
When the auditor believes there is substantial doubt about the ability of the entity to
continue as a going concern for a reasonable period of time, the following items should
be included in the audit documentation:
a. The conditions or events that gave rise to the substantial doubt,
b. Any mitigating factors that the auditor considers significant,
c. Audit work performed to evaluate management's plans,
d. The auditor's conclusion about whether substantial doubt remains or is
alleviated, and
e. The effect of the auditor's conclusion on the evaluation of the financial
statements and related disclosures, and on the resulting auditor's report.
8. Miscellaneous
a. If, in the auditor's judgment, the entity's disclosures are inadequate, a departure
from GAAP exists. This may result in either a qualified or adverse opinion.
b. If the auditor's doubts about the entity's ability to continue as a going concern are
removed in a subsequent period, the explanatory paragraph of the prior period
need not be repeated.
c. The auditor should communicate going concern issues with those charged with
governance.
PASS KEY
A commonly tested area is the concept of going concern. The chart below summarizes the effects of uncertainties and going
concern issues on the auditor's report.
Uncertainty Going Concern
GAAP & Evidence
Auditor
agrees with
management
No Evidence
Auditor unable
to obtain
evidence
Non-GAAP
Auditor
disagrees with
management
Adequate
GAAP
Disclosure
Inadequate
GAAP
Disclosure
Unqualified
Qualified
(GAAS)
or
Disclaimer
Qualified (GAAP)
or
Adverse
Modified
Unqualified
(Disclaimer not
prohibited)
Qualified
(GAAP)
or
Adverse
G. EMPHASIS OF A MATTER
The auditor may wish to emphasize a particular matter but still express an unqualified
opinion.
1. Items to Emphasize
a. A related-party transaction
b. A significant subsequent event
c. The entity is a component of a larger business enterprise
d. Accounting matters (other than changes in accounting principles) that affect the
comparability of the financial statements
Modified
Unqualified
Another CPA
Justified
Non-GAAP
Going Concern
Emphasis Matter
Consistency
Other
E
OF A
MPHASIS
M
ATTER
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L
ACK OF
C
ONSISTENCY
2. Explanatory Paragraph
Emphasis of a matter is not required, but the auditor may choose to emphasize a
matter by adding an explanatory paragraph to the report. When added, an explanatory
paragraph may
qualification of the report. A phrase such as "with the foregoing (following) explanation"
should not be used in the opinion paragraph if such an explanatory
paragraph is included in the auditor's report.
either precede or follow the opinion paragraph, and it does not result in
H. LACK OF CONSISTENCY (ACCEPTABLE/JUSTIFIED CHANGES IN
ACCOUNTING PRINCIPLE)
Consistency deals with the comparability of the financial statements from year to year. It is
implicit (implied) in the auditor's standard report that the comparability (consistency) of the
financial statements has not been materially affected by changes in accounting principles.
1. Acceptability of Accounting Changes
When evaluating the acceptability of an accounting change, the auditor should consider
whether:
a. The change is to an acceptable principle,
b. The method of accounting for the change is acceptable, and
c. Management is justified in the change.
The auditor satisfied with all three concerns may express an unqualified opinion with an
explanatory paragraph. If any of the three conditions is not met, the auditor would
generally express a qualified opinion (covered later).
2. Effect of an Acceptable Change on the Auditor's Report
If a change in GAAP has occurred between accounting periods and the effect is
material, the auditor should add an explanatory paragraph to the unqualified report.
The explanatory paragraph, which comes after the opinion paragraph, describes the
change and refers the reader to the appropriate note in the financial statements. This
does not constitute a qualified opinion.
a. If the effect of a change in GAAP is immaterial, no revision to the report is
necessary.
b. Changes in accounting estimates or corrections of errors (i.e., mathematical
mistakes, oversights, etc.) do not affect the consistency standard and would not
affect the auditor's report.
c. Corrections of an error in principle (e.g., from cash method to accrual method) do
affect consistency and would require a consistency modification.
d. If the year in which the change occurred is presented, the explanatory paragraph
is required in subsequent years' reports. If the change was treated as a
retroactive restatement, then the explanatory paragraph is not needed in
subsequent years.
e. Although a change in depreciation method is accounted for as a change in
estimate for financial reporting purposes, for purposes of the auditor's report,
changes in depreciation method do require the addition of an explanatory
paragraph.
Modified
Unqualified
Another CPA
Justified
Non-GAAP
Going Concern
Emphasis Matter
Consistency
Other
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VII. THE QUALIFIED OPINION—GAAP PROBLEMS
UNQUALIFIED OPINION
DISCLAIMER
GAAS
1. Uncertainty
2. Scope Limitation
3. Lack of Independence
4. Unaudited
WITHDRAW
False, Fraudulent, Deceptive or Misleading
ADVERSE
GAAP
1. Non-GAAP Change
2. Inadequate Disclosure
3. Departure from GAAP
4. Unreasonable Acctg. Estimate
QUALIFIED
"EXCEPT FOR"
GAAS
1. Uncertainty
2. Scope Limitation
QUALIFIED
"EXCEPT FOR"
GAAP
1. Non-GAAP Change
2. Inadequate Disclosure
3. Departure from GAAP
4. Unreasonable Acctg. Estimate
A. NON-GAAP CHANGE IN ACCOUNTING PRINCIPLE (GAAP ISSUE: QUALIFIED OR
ADVERSE)
As previously stated, a change from one generally accepted accounting principle to another
generally accepted accounting principle creates a consistency modification to the unqualified
opinion. The auditor can express an unqualified opinion as long as the auditor is satisfied
that:
1. The method of accounting for the change is acceptable;
2. The change is to an acceptable principle; and
3. Management is justified in the change.
If any
adverse opinion, depending on the materiality of the item. An explanatory paragraph(s)
should appear before the opinion paragraph to describe the non-GAAP accounting change
and the financial impact (if possible). The qualified or adverse opinion would be expressed
each year that the financial statements initially reflecting the change are presented.
one of these conditions is not met, the auditor would express either a qualified or
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