Louw12 Auditing

CHAPTER 12 Reports on Audited Financial Statements LEARNING O !
ECTI"ES
Review Checkpoints 1. Provide an overview of the types of reports that accompany the company s financial statements. "ist three #eneral functions of the auditor s report on the company s financial statements. Explain the si#nificance of each of the para#raphs in a standard un%ualified report on the company s financial statements. *rite an audit report with an un%ualified opinion on the company s financial statements, but containin# additional explanation for a #iven description of accountin# facts and audit circumstances. 0escribe the types of reports that may be written if the company s financial statements contain a departure from #enerally accepted accountin# principles. 0escribe the types of reports that may be written if the conduct of the audit of the company s financial statements involves a departure from #enerally accepted auditin# standards. 1, !
Exercises, Problems, and Simulations
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"ist other circumstances affectin# auditors reportin# responsibilities and explain how they affect audit reports on the company s financial statements.
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McGraw-Hill/Irwin 8uditin# and 8ssurance Services, "ouwers et al., !9e
1 2he 3c4raw56ill Companies, 7nc., !--) 1!51
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"ist the ma:or components of the auditor s report on internal control over financial reportin#. 0escribe situations in which the auditor s report on internal control over financial reportin# would be modified.
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1-. Summari;e important communications made by the auditor followin# completion of the audit and issuance of the auditor s reports.
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1 2he 3c4raw56ill Companies, 7nc., !--) 1!5!
SOL#TIONS FOR RE"IE$ CHEC%POINTS

1!.1 3ana#ement prepares a report on internal control over financial reportin#. 2he auditor prepares reports on .1/ the company s financial statement and other disclosures and .!/ the company s internal control over financial reportin#. 2hese can be presented as two separate reports or a combined report. 1!.! 3ana#ement s report on internal control over financial reportin# consists of the followin# ma:or components< 8 statement indicatin# that mana#ement is responsible for establishin# and maintainin# ade%uate internal control over financial reportin#. 8 statement identifyin# the framework used by mana#ement to assess the effectiveness of the company s internal control. 3ana#ement s opinion on the effectiveness of the company s internal control, includin# an explicit statement as to whether the internal control over financial reportin# is effective. 8 statement that the re#istered accountin# firm auditin# the financial statements .auditor/ has issued an attestation report on the company s internal control over financial reportin#.
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2he auditor s report serves to communicate to users three specific statements with respect to the financial statements, the conduct of the audit, and the company in #eneral. =irst, the auditor s report indicates whether the financial statements are presented in conformity with >.S. #enerally accepted accountin# principles .488P/. Second, auditors use their report to indicate any unusual aspects of the audit examination. 2hird, even if the financial statements are fairly presented and no problems were noted in the conduct of the audit, the auditor can use the report to communicate information useful to decision makers that may not appear on the face of the financial statements.
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5$
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Ei#ht important elements of the standard un%ualified audit report. 1. !. $. &. Title. 2he title should contain the word independent, as in ?independent re#istered public accountin# firm@ or ?independent auditors@. Address. 2he report shall be addressed to the client, which occasionally may be different from the auditee. Notice of Audit. 8 sentence should identify the financial statements and declare that they were audited. 2his appears in the introductory paragraph. Responsibilities. 2he report should state mana#ement s responsibility for the financial statements and the auditor s responsibility for the audit report. 2hese statements are also in the introductory paragraph. Description of the Audit. 2he second para#raph .scope paragraph/ should declare that the audit was conducted in accordance with #enerally accepted auditin# standards and describe the principal characteristics of an audit, includin# a statement of belief that the audit provided a reasonable basis for the opinion. Opinion. 2he report shall contain an opinion .opinion paragraph/ re#ardin# conformity with >.S. #enerally accepted accountin# principles. Signature. 2he auditor shall si#n the report, manually or otherwise. Date. 2he report shall be dated with the date when all si#nificant fieldwork was completed.
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Scope para#raph a. 2he ob:ects of the audit are the financial statements .balance sheet, income statement, statement of comprehensive income, statement of cash flows, and statement of stockholders e%uity/ and the related footnote disclosures, not the ?books and records.@ 2he description of the audit means< 1. !. $. &. '. (. ). the auditors were trained and proficient. the auditors were independent. due professional care was exercised. the work was planned and supervised. internal control was properly studied and evaluated. sufficient competent audit evidence was obtained. the 488S reportin# standards were followed.
b.
8lso, professional :ud#ment was exercised in performin# the tests and choosin# the procedures to perform in the circumstances. 1!.( 3a:or reasons for departure from the standard un%ualified report 1. !. $. &. 0epartures from 488P. "imitations on the scope of the audit .resultin# in a lack of evidence/. 2he auditor believes it important to brin# certain company information to financial statement users attention. 7f the company is sub:ect to auditin# and reportin# re%uirements of 8S ! and the auditor presents separate reports on the financial statements and internal control over financial reportin#.
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5&
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2he followin# situations cause auditors to reco#ni;e inconsistent applications of 488P< 1. !. $. &. '. (. ). Chan#e from 488P to 488P .with :ustification/ reported by restatin# prior financials. Chan#e from a principle not conformin# to 488P. Chan#e from 488P to 488P .with :ustification/ reported without restatin# prior financials, includin# chan#e in 488P inseparable from a chan#e in estimate. Chan#e from 488P to 488P without reasonable :ustification. .2he chan#e is also a departure from 488P./ Chan#e to a principle not conformin# to 488P. Chan#e in the reportin# entity .but not when creation, cessation, purchase or disposition of a subsidiary or other business unit is involved/. Chan#e of the definition of ?cash and cash e%uivalents@ for a statement of cash flows.
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2he followin# situations are not considered inconsistencies and do not re%uire references in the auditor s report< 1. !. $. &. '. (. ). Chan#es in accountin# estimates .8> &!-.1&/. Error corrections that do not involve a chan#e in accountin# principle .8> &!-.1'/. Chan#es in classification or a##re#ation of financial statement amounts .8> &!-.1(/. Chan#es in the format of the cash flow statement. Chan#es in the reportin# entity resultin# from a transaction or event. Chan#es in the consolidated reportin# entity as a result of creation, cessation, purchase or disposition of a subsidiary or other business unit .8> &!-.-)/. Chan#es with immaterial current effect but future material effect .8> &!-.1,/.
NOTE to Instructor ! good "uestion at this point is #$hat is the conse"uence of a company%s failure to disclose and e&plain material e'ents that are not considered inconsistencies(# !nswer )ac* of disclosure of them is a G!!+ departure, and the audit report would contain the missing information with an opinion "ualification.
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5'
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2he followin# circumstances may lead an auditor to have substantial doubts about an entity s ability to continue as a #oin# concern< =inancial difficulties .ne#ative trends in financial ratios/. "abor problems. "oss of key personnel. Si#nificant liti#ation. 0ividends in arreara#e. "oss of key customers or suppliers.
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Circumstances, events, or transactions that auditors may want to emphasi;e to financial statement users include< 8 description of the auditee as a subsidiary of a lar#er entity. 2he effects of business events on the comparability of financial statements. 2he interaction of the auditee with related parties. 2he effect of events that occur after the balance sheet date. 2he loss of a key customer.
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8n explanatory para#raph is added to the report which .1/ indicates that the auditor has audited the effectiveness of the company s internal control over financial reportin#, .!/ references the report on internal control over financial reportin#, and .$/ indicates the nature of opinions expressed on mana#ement s assessment of internal control over financial reportin# and the effectiveness of the company s internal control over financial reportin#. Rule !-$ has the effect of allowin# financial statements to contain a departure from a =8SA or 48SA .or their predecessors/ statement on accountin# standards, permittin# the auditors to explain why the departure was necessary, and then allowin# the departure to be ?in conformity with >.S. #enerally accepted accountin# principles,@ as indicated by the un%ualified opinion. 87CP8 Council has desi#nated bodies authori;ed to make official pronouncements of accountin# standards enforceable under Rule !-$. 2he =8SA was desi#nated, and the survivin# 8PA Bpinions and 8ccountin# Research Aulletins of predecessor committees were desi#nated retroactively. 7f there is a departure from accountin# principles and sufficient evidence shows the effect to be immaterial, then an un"ualified opinion may be rendered. 7f the effect of the departure is material .but not extremely material/ and isolated to a sin#le event, then a "ualified opinion may be #iven. 7f the effect is extremely material .fair presentation is precluded/, the auditor should render an ad'erse opinion.
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1 2he 3c4raw56ill Companies, 7nc., !--) 1!5(
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7n comparison to the standard un%ualified report, a report %ualified for a scope limitation has< a. 8n ?except for@ phrase in the scope para#raph directin# attention to the reason the audit was not in accordance with #enerally accepted auditin# standards or standards of the Public Company 8ccountin# Bversi#ht Aoard. 8n extra para#raph describin# the scope limitation, the accounts or disclosures affected, and the dollar amounts involved, if determinable. 8n ?except for ad:ustments that mi#ht have been determined to be necessary@ phrase precedin# the opinion sentence.
b. c. !.
7n comparison to the standard un%ualified report, a report in which the opinion is disclaimed because of a scope limitation has< a. 8 chan#e in the introductory para#raph indicatin# ?*e have been en#a#ed to audit@ instead of ?*e have audited,@ which indicates the nature of the en#a#ement and the attempt to audit, but implies the audit was not completed satisfactorily. 2he introductory para#raph omits the sentence in which the auditor takes responsibility for an opinion. 2he scope para#raph is omitted entirely. 8n extra para#raph describin# the scope limitation, the accounts or disclosures affected, and the dollar amounts involved, if determinable. 8n ?opinion@ sentence that refers to the extra para#raph and states that no opinion is #iven.
b. c. d. e. 1!.1'
=inancial statements are unaudited if the CP8 has not applied any audit procedures or has not applied procedures which produced sufficient evidence upon which to base an opinion on the financial statements as a whole. *ith respect to unaudited statements, in addition to a disclaimer of opinion .public companies/, the followin# #uides should be followed< 1. 7f the CP8 should learn that the statements are not in conformity with #enerally accepted accountin# principles .includin# ade%uate disclosures/, he should explain the departures in the disclaimer. 7f prior unaudited statements are present, the disclaimer should cover them as well as the current year statement. Each pa#e of the statements should be clearly labeled as ?unaudited@.
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*hen an auditor is not independent with respect to a public company client, a disclaimer of opinion must be rendered. 2he disclaimer must be issued because the statements cannot be audited in accordance with #enerally accepted auditin# standards or standards of the Public Company 8ccountin# Bversi#ht Aoard. .8n accountant, not an auditor, is the person associated with compiled and reviewed financial statements. 8n accountant can #ive a compilation disclaimer report on compiled unaudited financial statements./ 2he principal auditor s reference in his report to another auditor is not a scope limitation. 2he reference only shows the divided responsibility for the audit work.
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1 2he 3c4raw56ill Companies, 7nc., !--) 1!5)
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8 continuin# auditor can update a previously5issued report by obtainin# and evaluatin# information durin# the current en#a#ement. 2hus, an updated report is a previously5issued report that has been reevaluated in li#ht of current information and evidence. .2he updated report itself may be a compilation report, a review report, or an audit report./ 2he reevaluation may cause the updated version to be different from the report previously issued .for example, a new reason to write a %ualification may be found/. 8n updated report carries a current date, not the date of the previous report. 8 predecessor auditor usually does not have the current information necessary to update a report. Either a continuin# auditor or a predecessor auditor can reissue a previously5reissued report. 2he process does not contemplate consideration of information and evidence obtained durin# a current en#a#ement. 2hus, a reissued report is a current release of a previously5issued report without benefit of any additional examination or review of the sub:ect financial statements. 2he report date should be the date of the end of fieldwork for the ori#inal issue of the report.
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2he two types of disclosure problems related to ?other information@ are< a. 3aterial inconsistency of financial disclosures or discussions with numbers in the audited financial statements. 3ana#ers mi#ht intentionally or mistakenly use the wron# number or make improper comparisons of financial statement amounts. Essentially, these inconsistencies are obvious mistakes or misuse of audited financial statement fi#ures. 3aterial misstatements of fact may or may not relate to the audited financial statements. 2hese are not easy to describe and they are not always obvious in relation to financial statements. 8uditors need to think beyond the financial statement content itself.
b.
1!.!- 8uditors are prohibited from #ivin# a standard un%ualified audit report on condensed financial statements because the condensed statements are not a fair presentation of financial position, results of operations, and cash flows in conformity with 488P. 2he information is too condensed to meet the criteria expressed in S8S ', 8> &11.-&.d/< 2o be in conformity with 488P the information must be classified and summari;ed in a reasonable manner that is neither too detailed nor too condensed. 1!.!1 8n auditor must #ive a disclaimer of opinion on supplementary information in financial statements when< 3ana#ement s presentation of the information indicates the auditor performed review procedures without also sayin# the auditor does not express an opinion on it. 3ana#ement places the information close to, or within, the basic financial statements .e.#., in a financial statement footnote/ and does not label it unaudited.
2he audit report must be modified, but not disclaimed, when< Re%uired information is omitted. 2he information departs materially from 488P #uidelines. 2he review procedures auditors should perform cannot be completed
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5+
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2he ma:or components of the auditor s standard, un%ualified report on internal control over financial reportin# are< 8 title that includes the word ?independent@. Explicit identification of mana#ement s conclusion about the effectiveness of the company s internal control over financial reportin# as well as the title of mana#ement s report on internal control over financial reportin#. Statements re#ardin# the responsibility of the auditor and mana#ement with respect to the assessment and evaluation of internal control. 8 para#raph indicatin# that the en#a#ement was conducted in accordance with standards established by the Public Company 8ccountin# Bversi#ht Aoard, alon# with a brief description of the procedures performed in the en#a#ement. 2he definition of internal control over financial reportin#. 8n identification of the inherent limitations of internal control over financial reportin#. 2he auditor s opinion on .1/ whether mana#ement s assessment of the effectiveness of the company s internal control is fairly stated and .!/ whether the company maintained effective internal control over financial reportin#. 8 reference to the auditor s opinion on the financial statements, indicatin# the type of opinion expressed. 2he date of the report .dated usin# the last day of fieldwork/.
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3a:or reasons for departin# from the standard, un%ualified report on internal control over financial reportin# include< 1. !. $. &. '. (. ). 3aterial weaknesses in internal control over financial reportin#. 8 limitation in the scope of the en#a#ement. 7nade%uacies in mana#ement s assessment of internal control over financial reportin#. 3ana#ement s assessment of the effectiveness of its internal control over financial reportin# is inappropriate. Bther auditors have audited the financial statements and internal control over financial reportin# of one or more components of the entity. Chan#es in internal control have occurred that materially and adversely affect the effectiveness of the company s internal control over financial reportin#. 3ana#ement provides other information in its report on internal control over financial reportin#.
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5,
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2he auditor would issue an adverse opinion on the effectiveness of internal control over financial reportin# if a material weakness exists. 6owever, as lon# as mana#ement s report on internal control over financial reportin# provides the appropriate conclusion, the auditor would issue an un%ualified opinion on mana#ement s assessment of internal control over financial reportin#. 7f a material weakness in internal control is identified, the auditor s standard, un%ualified opinion on internal control over financial reportin# would be modified to< 3odify the introductory para#raph to note that mana#ement s assessment indicated the company has not maintained an effective internal control over financial reportin#. 7nclude a para#raph immediately followin# the inherent limitations para#raph that defines a material weakness and describes any material weakness.es/ identified durin# the audit. 3odify the opinion para#raph to indicate that because of the effect of the material weakness.es/ identified, the Company has not maintained an effective internal control over financial reportin#.
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7f a scope limitation exists, either a %ualified opinion or disclaimer of opinion would be issued, dependin# upon the si#nificance of the limitation. 1. 7f the auditor believes that the scope of mana#ement s assessment of internal control over financial reportin# is inade%uate, either a %ualified opinion or disclaimer of opinion would be issued on mana#ement s assessment. 2he auditor s opinion on the effectiveness of internal control over financial reportin# would not be affected, assumin# that no material weaknesses are identified or no scope limitations on the auditor s en#a#ement exist. 7f the auditor disa#rees with mana#ement s assessment of the effectiveness of its internal control over financial reportin#, the report would be modified to add an explanatory para#raph to discuss the nature of the disa#reement and to express an adverse opinion on mana#ement s assessment of internal control over financial reportin#. 2he auditor s opinion on the effectiveness of internal control over financial reportin# may need to be modified if material weaknesses exist, necessitatin# an adverse opinion.
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2he auditor s reports on the company s financial statements and on internal control over financial reportin# can be presented as separate reports or as a sin#le, combined report. 2he ma:or elements in a combined report on the company s financial statements and internal control over financial reportin# include< 2he responsibilities of the auditor and mana#ement for the financial statements and internal control over financial reportin# .introductory para#raph/. 2he scope of the auditor s en#a#ement related to both the financial statements and internal control over financial reportin# .scope para#raph/. 8 definition of internal control over financial reportin# .definition para#raph/. 8n identification of inherent limitations of internal control over financial reportin# .inherent limitations para#raph/. 2he auditor s opinion on the financial statements, mana#ement s assessment of the effectiveness of the company s internal control over financial reportin#, and the effectiveness of the company s internal control over financial reportin# .opinion para#raph/.
1 2he 3c4raw56ill Companies, 7nc., !--) 1!51-
SOL#TIONS FOR &#LTIPLE'CHOICE (#ESTIONS

1!.!, a. b. c. d. a. b. c. d. 1!.$1 a. b. c. d. 1!.$! a. b. c. d. 1!.$$ a. b. c. d. 1!.$& a. b. c. d. Correct 7ncorrect 7ncorrect 7ncorrect 7ncorrect 7ncorrect 7ncorrect Correct Correct 7ncorrect 7ncorrect 7ncorrect 7ncorrect 7ncorrect Correct 7ncorrect 7ncorrect 7ncorrect 7ncorrect Correct 7ncorrect Correct 7ncorrect 7ncorrect 2he 1st and &th are explicit, the !nd and $rd exception basis. Consistency is an exception basis matter. 2his choice has them all backwards. 2hese are all wron# except the consistency standard. 2he un%ualified is not a choice with a material 488P departure, and the disclaimer is inappropriate because the CP8 is aware of the 488P departure. 2he un%ualified is not a choice with a material 488P departure. 2he emphasis para#raph does not cure the 488P departure and the un%ualified is still inappropriate. Aecause this is a material departure from 488P, and the choices are to %ualify or #ive the adverse. 2he choice depends on the auditor s perception of the ma#nitude of the uncertainty. 2he standard un%ualified without an explanatory para#raph is not appropriate in the circumstances. Aecause the disclosures are ade%uate, a 488P departure for %ualification or adverse would be inappropriate. see b. and c. Cot the best answer because the auditor believes the statements would be misleadin#. Cannot disclaim when you have full knowled#e. Rule !-$ provides for explanation and un%ualified opinion. Cannot #ive the standard un%ualified when there is a departure from an official 488P. Chan#es in estimates do not re%uire a consistency para#raph. Error corrections not involvin# a chan#e in principle do not re%uire a consistency para#raph. Chan#es in the consolidated entity by reason of sale of a sub do not re%uire a consistency para#raph. 2his is a chan#e in accountin# principle. 2he prior audit must be described re#ardless of the type of opinion issued. 2he predecessor auditor should be named only if her report is included. 2he type of opinion must be stated. 2he predecessor should not be named unless that report is included.
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2he key word in the %uestion is ?can@ write an audit report. a. b. c. d. Correct Correct 7ncorrect 7ncorrect Correct 7ncorrect 7ncorrect 7ncorrect 0ivided responsibility and an un%ualified report is a possibility. 2he principal auditor takin# full responsibility by not mentionin# the other auditors is a possibility. 2he principal auditor must take some responsibility. *hen the other auditors are named, their reports must be presented. 2he ?emphasis@ para#raph is a modification, but otherwise does not chan#e an un%ualified opinion. See .a/ above. See .a/ above. See .a/ above. 1 2he 3c4raw56ill Companies, 7nc., !--) 1!511
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a. b. c. d. a. b. c. d.
7ncorrect 7ncorrect 7ncorrect Correct Correct 7ncorrect 7ncorrect 7ncorrect 7ncorrect 7ncorrect Correct 7ncorrect
8 disclaimer under uncertainty is permitted. 8 disclaimer based on scope restriction is permitted. 8n auditor must always disclaim when they are not independent. 8n auditor cannot disclaim when they are aware of a 488P departure. 2he auditor s responsibility declaration is e&plicitly stated in the introductory paragraph of the auditor s report. 2he auditor s responsibility is explicitly stated. 2he auditor s responsibility is described in the introductory, not the opinion para#raph. 2he auditor s responsibility is explicitly statedD in addition, it is stated in the introductory, not opinion, para#raph. 3e#abank is the user of the financial statements. Sampson E 0elila is the auditor. Company 8 hired the auditors .and will pay the fee/. Company A is the auditee.
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Note to Instructor -ince this "uestion as*s students to identify which statement is not included in the standard un"ualified report on the financial statements, the item la.eled /correct0 would not .e included and those la.eled /incorrect0 would .e included. a. b. c. d. 7ncorrect 7ncorrect 7ncorrect Correct 2he standard report identifies the financial statements. 2he standard report #ives a #eneral description of an audit. 2he standard report contains an opinion about conformity with 488P. 2he standard report does not call for economic analysis or commentary.
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Note to Instructor -ince this "uestion as*s students to identify which statement is not true, the item la.eled /correct0 would not .e true and those la.eled /incorrect0 would .e true.. a. b. c. d. Correct 7ncorrect 7ncorrect 7ncorrect 7ncorrect 7ncorrect 7ncorrect Correct 2he report would be dated as of the last day of fieldwork. 2he report does express an opinion on mana#ement s assessment of internal control over financial reportin# as well as the effectiveness of internal control over financial reportin#. 8n adverse opinion is issued if one or more material weakness.es/ exists. 2he report on internal control over financial reportin# can be presented alon# with the report on the company s financial statements or as a combined report. 2he reportin# options when a scope limitation exists are either a %ualified opinion or a disclaimer of opinion. *hile a %ualified opinion is one possible reportin# option, an adverse opinion would only be issued when one or more material weakness.es/ is identified. *hile a disclaimer of opinion is one possible reportin# option, it is not appropriate to issue an un%ualified opinion if a si#nificant scope limitation exists. 2he reportin# options when a si#nificant scope limitation exists are either a %ualified opinion or a disclaimer of opinion.
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a. b. c. d.
1 2he 3c4raw56ill Companies, 7nc., !--) 1!51!
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a.
7ncorrect
b. c. d.
7ncorrect Correct 7ncorrect
Reference to the audit of the company s financial statements would be included in the introductory para#raph of a combined report on the company s financial statements and internal control over financial reportin#, but not a separate report on internal control over financial reportin#. 7f a material weakness is identified, the auditor will add a para#raph to the report that defines a material weakness. 6owever, this information would not be included in the introductory para#raph. Statements identifyin# the responsibility of the auditor and mana#ement for internal control over financial reportin# would be included in the introductory para#raph. Reference to the auditor s report and opinion on the company s financial statements would be included in an explanatory para#raph followin# the opinion para#raph, not the introductory para#raph. 0isclaimers of opinion on internal control over financial reportin# are only issued when extremely si#nificant scope limitations exist. 2he existence of material weaknesses results in the issuance of an adverse opinion on internal control over financial reportin#. 7n addition, if the auditor disa#rees with mana#ement s conclusion with respect to its internal control, the report would express an adverse opinion on 2omlinson s assessment of internal control over financial reportin#, with an explanatory para#raph added to the report notin# the reasons for the disa#reement. 8n un%ualified opinion on internal control over financial reportin# would not be appropriate if one or more material weakness.es/ exist. 7t is not necessary for the auditor to withdraw from the en#a#ement in this situation. 2he report on internal control over financial reportin# would be modified to reference the report on the financial statementsD in addition, the report on the financial statements would be modified to reference the report on internal control over financial reportin#. 2he report on internal control over financial reportin# would be modified to reference the report on the company s financial statements. 2he report on the company s financial statements would be modified to reference the report on internal control over financial reportin#. Aoth the report on the financial statements and the report on internal control over financial reportin# would be modified to reference the other report.
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a. b.
7ncorrect Correct
c. d. 1!.&' a.
7ncorrect 7ncorrect Correct
b. c. d.
7ncorrect 7ncorrect 7ncorrect
1 2he 3c4raw56ill Companies, 7nc., !--) 1!51$
SOL#TIONS FOR E)ERCISES* PRO LE&S* AN+ SI&#LATIONS

1!.&( Audit Simulation: Reports on Financial Statements (Deficiencies and Omissions in an Audit Report) 1. !. 2itle. 2he report needs a title referrin# to Ross as the independent auditor or independent accountant. 2he auditor is reportin# to the body that has en#a#ed the auditin# services .the Continental Corporation Aoard of 0irectors/. *hile the report may be read and used by others who are indirect beneficiaries of the audit, current custom is not to address the report to the unknown class of users. Cotice of audit. 2he report does not #ive the proper declaration of an audit of the financial statements, especially the part about ?in accordance with your instructions,@ which su##est that Ross surrendered some audit independence. 2he reference to a ?complete audit@ is ill5advised because it su##ests a 1--F investi#ation, which is contradicted by the sentence about ?tests of the sales records.@ Responsibilities. 2he report says nothin# about the auditor s responsibility for the audit report. Scope< 2he report should explicitly mention that the audit was conducted in accordance with standards of the Public Company 8ccountin# Bversi#ht Aoard .>nited States/. Bpinion. 2he opinion sentence should not be modified with the phrase ?with the explanation #iven above.@ Bpinion. 2he opinion sentence should not mention ?minor errors we consider immaterial,@ but it should contain the phrase ?presents fairly in all material respects.@ Bpinion97dentification of =inancial Statements. 2he opinion should not include reference to cash flows because the introductory para#raph did not state that the cash flow statement was audited. 2his may be a deficiency in the identification of the financial statements that were actually audited. Bpinion. 2he opinion para#raph refers improperly to =8SA pronouncements. 7t should refer to ?>.S. #enerally accepted accountin# principles.@ Bpinion. 2he ?true and correct@ wordin# is similar to the typical Aritish audit report, and they seem to be able to live with it, but 8merican auditors believe that ?opinion@ connotes belief or :ud#ment stron#er than impression but less stron# than positive knowled#e. 8merican auditors do not wish to appear to have full, positive knowled#e about the statements on the #rounds that it s not feasible to know all there is to know about the financial statements. 2he standard report lan#ua#e leans heavily on 488P as the criteria for fair presentation. 0ate. 2he date accompanyin# Ross si#nature should be September !$ .the last day of fieldwork/ and not Continental Corporation s fiscal year5end date. Explanatory Para#raph< 2he date of the Ross report on internal control should be September !$ .the last day of fieldwork/ and not Continental Corporation s fiscal year5end date. Bther. 2he commentary on the economy and the strike are not #enerally appropriate for an audit report. Even if the auditor wanted to draw attention to these matters, their relevance for understandin# the financial statements and their manner of expression are both %uestionable. Bther. 2he ne#ative assurance .concernin# the recordin# of sales/ is not permitted in audit reports. 1 2he 3c4raw56ill Companies, 7nc., !--) 1!51&
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Reports on Financial Statements ( onsistenc!) Should 8uditor s Report Ae 3odifiedG Hes
7tem 1.
2ype of Chan#e 8n accountin# chan#e involvin# a chan#e from one #enerally accepted accountin# principle to another #enerally accepted accountin# principle. 8n accountin# chan#e involvin# a chan#e in an accountin# estimate. 8n error correction not involvin# an accountin# principle. 8n accountin# chan#e involvin# a correction of an error in principle which is accounted for as a correction of an error. 8n accountin# chan#e involvin# a chan#e in the reportin# entity which is a special type of chan#e in accountin# principle. 8n accountin# chan#e involvin# both a chan#e in accountin# principle and a chan#e in accountin# estimate. 8lthou#h the effect of the chan#e in each may be inseparable and the accountin# for such a chan#e is the same as that accorded a chan#e in estimate only, an accountin# principle is involved. Cot an accountin# chan#e but rather a chan#e in classification. 8n accountin# chan#e from one #enerally accepted accountin# principle to another #enerally accepted accountin# principle.
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1 2he 3c4raw56ill Companies, 7nc., !--) 1!51'
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Reports on Financial Statements ("rrors in an Ad#erse Report) 0eficiencies in the adverse report are< 1. !. $. &. '. 2he report is improperly addressed to the president instead of to the board of directors that en#a#ed the auditor. 2he scope para#raph does not identify the financial statements audited< balance sheet, statements of income, comprehensive income, retained earnin#s, and cash flows. 2he combined introductory and scope para#raph does not contain the re%uired sentence about mana#ements responsibility for the financial statements. 2he combined para#raph also does not contain the re%uired sentence about the auditor s responsibility to express an opinion based on the audit. Reference to ?Cote I@ in the scope para#raph relatin# to a subse%uent event disclosure is inappropriate. 7f the auditor wants to emphasi;e the disclosure, a separate emphasis para#raph should be used. 2he explanatory para#raph does not make reference to the re%uirements of 488P55property and e%uipment should be stated at an amount not exceedin# cost, and deferred income taxes should be provided. 2herefore, all the real reasons for the adverse opinion have not been stated in the report. 2he explanatory para#raph states neither the monetary effects of the departures from 488P .appraisal values and installment method/ nor that the effects are not reasonably determinable. 2he opinion para#raph does not contain a direct reference to the explanatory para#raph that tells the basis for the adverse opinion. 2he report is not properly dual dated for the fieldwork ended 3arch ) and the 3arch 1& subse%uent event. 2he date should be ?3arch ), except for Cote I, for which the date is 3arch 1&.@ 2he para#raph followin# the opinion para#raph inappropriately disclaims an opinion on Cook s internal control over financial reportin# .an un%ualified opinion should be expressed/.
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1 2he 3c4raw56ill Companies, 7nc., !--) 1!51(
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Reports on Financial Statements ("rrors in a omparati#e Report $ith hange from %rior &ear) 1. !. $. &. '. (. ). +. 2he audited financial statements are not identified by the proper names of the statements and the proper dates. 2he type of opinion .adverse/ previously #iven on the prior financial statements is not described, nor are the exact reasons for chan#in# the opinion stated well enou#h. 2he date of the previous audit report is wron#. 7t should be 3arch ' instead of the prior balance sheet date. 2he substantive reason for chan#in# the opinion is not #iven .chan#e from an unacceptable accountin# principle55C7=B55to an acceptable one55=7=B/. 2he phrase ?based upon the precedin#@ in the opinion introduction is not appropriate and may be misinterpreted as some sort of %ualification. 2he opinion refers only to the current5year financial statements, but should refer to both the current5year and the prior statements presented in comparative form. 2he consistency phrase is based on the lan#ua#e superseded in 1,++. 8 separate consistency para#raph should be inserted at the end of the report. 2he consistency matter should not be phrased in ?except for@ terms because this lan#ua#e is reserved for use to %ualify an opinion for a 488P departure or a scope limitation .488S departure/.
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Reports on Financial Statements ('sing the (or) and Report of Another Auditor) *hether or not 3ichaels, the principal auditor, decides to make reference to the examination of 2homas, 3ichaels should< 1. !. $. 3ake in%uiries concernin# the professional reputation and standin# of 2homas Bbtain a representation from 2homas that 2homas is independent under the re%uirements of the 87CP8 or the re%uirements of the Securities and Exchan#e Commission .SEC/, as appropriate 8dopt appropriate measures to assure the coordination of activities with those of 2homas in order to achieve a proper review of matters affectin# the consolidatin# or combinin# of accounts in the financial statements. 7n order to accomplish this, 3ichaels must ascertain that< 2homas is aware that the financial statements of the component 2homas has examined are to be included in the financial statements on which 3ichaels will report and that 2homas s report thereon will be relied upon .and, where applicable, referred to/ by 3ichaels. 2homas has knowled#e of the relevant financial reportin# re%uirements for statements and schedules to be filed with re#ulatory a#encies such as the SEC, if appropriate. 8 review will be made of matters affectin# elimination of intercompany transactions and accounts and, if appropriate in the circumstances, the uniformity of accountin# practices amon# the components included in the financial statements.
1 2he 3c4raw56ill Companies, 7nc., !--) 1!51)
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Reports on Financial Statements ('sing the (or) and Report of Another Auditor) ( ontinued) a. 7f 3ichaels decides to make reference to the examination of 2homas, 3ichaels s report should indicate clearly, in both the scope and opinion para#raphs, the division of responsibility between that portion of the financial statements covered by 3ichael s own examination and that covered by the examination of 2homas. 2he report should disclose the ma#nitude of the portion of the financial statements examined by 2homas by statin# the dollar amounts or percenta#es of one or more of the followin#< total assets, total revenues, or other appropriate criteria, whichever most clearly reveals the portion of the financial statements examined by 2homas. 2homas may be named but only with 2homas s express permission and provided 2homas s report is presented to#ether with that of 3ichaels. 7f 3ichaels can neither assume responsibility for 2homas work nor divide responsibility by referrin# to his work and report, 3ichaels .the principal auditor/ faces a scope limitation situation55a portion of the financial statements is unaudited insofar as 3ichaels is concerned. .8ssumin# that 3ichaels is not able to audit the portion./ So, 3ichaels scope para#raph will be %ualified to explain the unaudited portion .provided it is material/, and the opinion para#raph will be %ualified .?except for any ad:ustments that mi#ht have been determined had we been able to audit...@/ or disclaimed.
b.
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Reports on Financial Statements (Reference to Another Auditor in %rincipal Auditor*s Report and Other Operating +atters) 7C2RB0>C2BRH P8R84R8P6 1. !. $. &. 2he statement of cash flows is not identified, but the opinion para#raph references cash flows when expressin# an opinion. 2he mana#ement responsibility for financial statements sentence is omitted. 2he ma#nitude of the assets and revenues audited by the other auditors is not disclosed. 2he other auditor s name is written, but it can be used only if the other auditor s report is also included. 6ere we see no indication that the other auditor s report is printed alon# with the principal auditor s report.
SCBPE P8R84R8P6 '. (. ). 2he scope para#raph should not be is %ualified ?except for@ with reference to the other auditors. 2his phrase should be removed. 2he standard scope para#raph should not contain any mention of ?assessin# control risk.@ 2he concludin# sentence should refer both to ?our audit@ and to ?the report of other auditors.@ 2he latter reference is omitted.
1 2he 3c4raw56ill Companies, 7nc., !--) 1!51+
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Reports on Financial Statements (Reference to Another Auditor in %rincipal Auditor*s Report and Other Operating +atters) ( ontinued) BP7C7BC P8R84R8P6 +. 2he opinion should not appear to be %ualified by use of the phrase ?except for the report of the other auditor.@ 2he proper wordin# is ?7n our opinion, based on our audit and the report of other auditors, the financial statements...@ 2he opinion covers the statement of cash flows, but this financial statement was not identified in the introductory para#raph as bein# audited. 2he opinion omits the re%uired reference to >.S. #enerally accepted accountin# principles. 2he audit report is not dated with the date of the end of fieldwork.
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Reports on Financial Statements (,arious Report Situations) 1. a. b. !. a. b. $. a. b. &. a. b. '. a. b. (. a. b. Either an opinion %ualified for lack of evidence .?except for@ ad:ustments that mi#ht have been determined/ or a disclaimer, dependin# upon the de#ree of materiality. Jualify the scope para#raph and insert a para#raph explainin# the lack of evidence, and %ualify the opinion para#raph. Either an opinion %ualified for a 488P departure or an adverse opinion, dependin# upon de#ree of materiality. Explain the departure from 488P in an extra para#raph before the opinion para#raph and %ualify the opinion. Bpinion %ualified for a departure from 488P .S=8S '/. Aefore the opinion para#raph, insert a para#raph explainin# the amount of probable loss and the failure to report it in the balance sheet and income statement. Either an opinion %ualified for lack of evidence .?except for@ ad:ustments that mi#ht have been determined/ or a disclaimer, dependin# upon the de#ree of materiality. Jualify the scope para#raph and insert a para#raph explainin# the lack of evidence, and %ualify the opinion para#raph. >n%ualified opinion. 0escribe the omitted information is a separate para#raph followin# the standard report, but do not modify any of the standard report para#raphs. >n%ualified opinion. 0escribe the other auditors work in the introductory para#raphD include in the scope para#raph concludin# sentence ?*e believe that our audit and the reports of other auditors provide a reasonable basis for our opinionD@ include in the opinion sentence ?7n our opinion, based upon our audit and the reports of other auditors, the financial statements...@ 0o not add a separate explanatory para#raph.
1 2he 3c4raw56ill Companies, 7nc., !--) 1!51,
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Reports on Financial Statements (,arious Report Situations) ( ontinued) ). a. b. >n%ualified opinion. *ithout chan#in# the three para#raphs of the standard report, add a para#raph .sentence/ followin# the opinion para#raph pointin# out the chan#e in accountin# principle and referrin# to the financial statement note. >n%ualified opinion. 0o not chan#e the three basic standard report para#raphs. 8dd followin# the opinion para#raph another para#raph pointin# out the #oin# concern doubt and referrin# to the note in the financial statements.
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a. b.
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"-plain Deficiencies in an Opinion Disclaimer 0eficiency 1. 2he first sentence of the report states that the examination was made in accordance with #enerally accepted auditin# standards. Reason 2he examination has not been made in accordance with standards of the Public Company 8ccountin# Bversi#ht Aoard because the second #eneral standard re%uires that the audit be independent. 2his sentence is also inconsistent with the financial sentence of the report which states that the financial statements were not audited. 2his disclosure mi#ht confuse the readerD i.e., the reader may not believe that this investment prevents the auditor from bein# independent and cause him to place undue reliance on the auditor s report and the financial statements. Since independence is a matter of professional :ud#ment, the reader should not be called upon to make this :ud#ment. Correction 0elete the first sentence.
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2he auditor disclosed the reason for his lack of independence55his wife owns 'F of the stock of the company.
0elete the reason for lack of independence.
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5!-
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Reports on Financial Statements ("#idence Re.uired for ,arious Audit Reports) a. "ist the reports that re%uire fully sufficient competent evidence. b. Standard un%ualified audit report Rule !-$ report :ustifyin# departures from official pronouncements Standard un%ualified report on a comprehensive basis of accountin# other than 488P >pdatin# the opinion on prior period comparative statements Expandin# the report citin# reliance on the work of other auditors adverse opinion Jualified opinion for departures from #enerally accepted accountin# principles Reference para#raph for chan#es in accountin# principles. Expansion para#raph for problems with ?other information,@ interim financial statements, and re%uired supplementary information
"ist the reports that result from pervasive and massive evidence deficiencies. 0isclaimer on unaudited financial statements of public companies 0isclaimer resultin# from super material scope limitation 0isclaimer resultin# from lack of independence 0isclaimer resultin# from massive uncertainty over #oin# concern problems
c.
"ist the reports that result from isolated evidence deficiencies. Jualified opinion resultin# from material scope limitation .but not massive and pervasive/ Expansion with a #oin# concern problem uncertainty explanation para#raph
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Audit Simulation: Reports on Financial Statements ('n.ualified Report/ Accounting hange/ and 'ncertaint!) =irst .introductory/ para#raph< 2he statement of retained earnin#s is not identified. 2he auditors responsibility to express an opinion is omitted.
Second .scope/ para#raph< 2he auditor obtains reasonable assurance about whether the financial statements are ?free of material misstatement,@ not ?fairly presented.@ 8n audit provides a ?reasonable basis for an opinion,@ not a ?basis for determinin# whether any material modifications should be made.@
2hird .first explanatory/ para#raph< 8n explanatory para#raph added to the report to describe a chan#e in accountin# principle .lack of consistency/ should follow the opinion para#raph, not precede it.
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5!1
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Audit Simulation: Reports on Financial Statements ('n.ualified Report/ Accounting hange/ and 'ncertaint!) ( ontinued) =ourth .opinion/ para#raph< 2he phrase ?except for@ should not be used. 2he auditors concurrence with the chan#e in accountin# principles is implicit and should not be mentioned. Reference to the prior .!--'/ financial statements is omitted.
=ifth .second explanatory/ para#raph< 8n explanatory para#raph for this kind of uncertainty is no lon#er re%uired by auditin# standards. 8s written here, it is an ?emphasis of a matter@ para#raph. 7n terms of bein# an emphasis para#raph< .a/ .b/ 2he fact that the outcome of the lawsuit cannot presently be estimated is omitted. 7t is inappropriate to state that ?provision for any liability is sub:ect to ad:udication@ because the report is ambi#uous as to whether a liability has been recorded.
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5!!
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Reports on Financial Statements (Reports and the "ffect of +aterialit!) 7f the amounts involved are immaterial, the report can be un%ualified, otherwise materiality affects the report choice as follows< +aterialit! "esser 4reater 8mounts are material but not pervasive or overwhelmin# a. Scope limitation on accounts receivable audit. 0eparture from 488P .failure to accrue revenue/, but not a departure from a pronouncement 0eparture from an =8SA pronounce5 ment that re%uires capitali;ation of leases. >ncertainty related to the amount of dama#e that mi#ht eventually be confirmed by an appeals court rulin#. ?Except for@ lan#ua#e used to express no opinion on the accounts receivable. Reference to ?ad:ustments, if any.@ ?Except for@ lan#ua#e used to %ualify the opinion for the 488P departure. 8mounts are very lar#e, pervasive, and overwhelm the presentation 0isclaimer, with separate para#raph describin# the restricted scope. 8dverse opinion.
b.
c.
?Except for@ lan#ua#e used to %ualify the opinion for the 488P departure.
8dverse opinion.
d.
?Except for@ lan#ua#e for a 488P departure. =ailure to record an amount as re%uired by =8SA '.
0isclaimer, if auditor thinks the amount that mi#ht be awarded seriously threatens the #oin#5 concern status of the company. 8dverse opinion, if unrecorded loss and related disclosures are seriously deficient.
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Reports on Financial Statements (0nternet "-ercise) 2he students answers will be dependent on the companies that they choose to examine. Bne thin# that we do is to collect and summari;e the students information to #et an idea of the relative fre%uencies of the different types of opinions9modifications.
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Reports on 0nternal ontrol O#er Financial Reporting (0nternet "-ercise) 2he students answers will be dependent on the companies that they choose to examine. Bne thin# that we do is to collect and summari;e the students information to #et an idea of the relative fre%uencies of the different types of opinions9modifications.
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5!$
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Reports on 0nternal ontrol O#er Financial Reporting (Report +odifications) a. 2his situation would result in an adverse opinion bein# issued on the effectiveness of the company s internal control over financial reportin#. 8ssumin# that mana#ement s appropriately concludes that it has not maintained an effective internal control over financial reportin#, the auditor would express an un%ualified opinion on mana#ement s assessment of internal control over financial reportin#. 2he standard report would be modified as follows< 3odify the introductory para#raph to note that mana#ement s assessment indicated the company has not maintained an effective internal control over financial reportin#. 7nclude a para#raph immediately followin# the inherent limitations para#raph that defines a material weakness and describes any material weakness identified durin# the audit. 3odify the opinion para#raph to indicate that because of the effect of the material weakness identified, the Company has not maintained an effective internal control over financial reportin#.
b.
2his situation represents a scope limitationD dependin# upon the si#nificance of the scope limitation, the auditor could issue either a %ualified opinion or disclaimer of opinion. 7f a %ualified opinion is issued, the standard report would be modified as follows< 3odify the scope para#raph to refer to scope limitation .?except for@/. Provide an explanatory para#raph describin# the scope limitation. 7f the scope limitation is related to the inability to #ather sufficient evidence with respect to a potential material weakness, this para#raph should also include the definition of a material weakness. 3odify the opinion para#raph to reflect a %ualified opinion .?except for the effect of matters we mi#ht have discoveredK@/.
7f a disclaimer of opinion is issued, the standard report would be modified as follows< 0elete the sentence describin# the auditor s responsibility for internal control over financial reportin# in the introductory para#raph. 0elete the scope para#raph. Provide an explanatory para#raph describin# the scope limitation. 7f the scope limitation is related to the inability to #ather sufficient evidence with respect to a potential material weakness, this para#raph should also include the definition of a material weakness. 3odify the opinion para#raph to either disclaim an opinion .?the scope of our work was not sufficient to enable us to express, and we do not express, an opinion@/.
7t is important to note that the scope limitation will normally affect the auditor s ability to issue an opinion on both management%s assessment of internal control o'er financial reporting and the effecti'eness of internal control o'er financial reporting.
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5!&
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Reports on 0nternal ontrol O#er Financial Reporting (Report +odifications) ( ontinued) c. 7n this situation, an un%ualified opinion would still be appropriate, assumin# that the work of other auditors can be relied upon and does not indicate the existence of one or more material weakness.es/. 2he introductory, scope, and opinion para#raphs would be modified to indicate the division of responsibility. 7f mana#ement has not ade%uately assessed its internal control over financial reportin#, the auditor would issue either a %ualified opinion or disclaimer of opinion on mana#ement s assessmentD essentially, this would be treated in a manner similar to a scope limitation. 2he report modifications noted in .b/ would be appropriate. 6owever, assumin# no scope limitations on the auditor s own evaluation of internal control over financial reportin#, an opinion on the effectiveness of internal control over financial reportin# could still be issued. 7n this case, the auditor would express an adverse opinion on mana#ement s assessment of internal control over financial reportin# and the effectiveness of internal control over financial reportin#D as a result, the modifications noted in .a/ would be appropriate. 7n addition, because of the disa#reement with mana#ement s conclusion, an explanatory para#raph should be added to the report.
d.
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Audit Simulation: Reports on 0nternal ontrol O#er Financial Reporting (0dentif! Report Deficiencies) 0ntroductor! %aragraph: 1. 2he introductory para#raph does not discuss Lan 0yke s responsibility with respect to maintainin# an effective internal control over financial reportin# M8S !.1().e/N
0nherent 1imitations %aragraph: !. 2his para#raph is omitted. M8S !.1().k/N
+aterial (ea)ness %aragraphs: $. &. '. 2he para#raph definin# a material weakness was omitted. M8S !.1)(N 2he para#raph identifyin# the material weaknesses in internal control noted by Sorrell should provide some brief information on the nature of the material weaknesses. M8S !.1)(N 2he para#raph discussin# the effect of material weaknesses on the nature, timin#, and extent of audit tests should explicitly indicate that the report on internal control over financial reportin# does not affect Sorrell s report on the financial statements. M8S !.1,&N 2he para#raph identifyin# deficiencies in internal control over financial reportin# less severe than material weaknesses is inappropriate. Mno applicable referenceN
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Opinion %aragraph: ). Sorrell s disclaimer of opinion on Lan 0yke s assessment of internal control over financial reportin# is inappropriate. Aecause Sorrell is able to #ather sufficient evidence, an un%ualified opinion on Lan 0yke s assessment that is has not maintained effective internal control over financial reportin# is appropriate. M8S !.1)), Example 85! in 8S !N
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5!'
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Audit Simulation: Reports on 0nternal ontrol O#er Financial Reporting (0dentif! Report Deficiencies) ( ontinued) "-planator! %aragraph (Financial Statement Report): +. Date: ,. 2he date on the report should be the last day of fieldwork, not the balance sheet date. M8S!.1)1N 2he final explanatory para#raph should reference Sorrell s report on the financial statements, as well as the date and type of opinion rendered on those financial statements. M8S !.1)-N
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Audit Simulation: Reports on 0nternal ontrol O#er Financial Reporting (Drafting Reports) a. Report of 7ndependent Re#istered Public 8ccountin# =irm 2o the Aoard of 0irectors and Shareholders 4ammons, 7nc. *e have audited the accompanyin# balance sheets of 4ammons, 7nc. as of 0ecember $1, !--( and !--' and the related statements of income, comprehensive income, shareholders e%uity, and cash flows for each of the three years in the period ended 0ecember $1, !--(. *e have also audited mana#ement s assessment, included in the accompanyin# 3ana#ement s Report on 7nternal Control Bver =inancial Reportin#, that 4ammons, 7nc., maintained effective internal control over financial reportin# as of 0ecember $1, !--(, based on criteria established in 7nternal Control O 7nte#rated =ramework issued by the Committee of Sponsorin# Br#ani;ations of the 2readway Commission .CBSB criteria/. 4ammons, 7nc. s mana#ement is responsible for these financial statements, for maintainin# effective internal control over financial reportin#, and for its assessment of internal control over financial reportin#. Bur responsibility is to express an opinion on these financial statements, an opinion on mana#ement s assessment, and an opinion on the effectiveness of the company s internal control over financial reportin# based on our audits. *e conducted our audits in accordance with the standards of the Public Company 8ccountin# Bversi#ht Aoard .>nited States/. 2hose standards re%uire that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reportin# was maintained in all material respects. Bur audit of the financial statements includin# examinin#, on a test basis, evidence supportin# the amounts and disclosures in the financial statements, assessin# the accountin# principles used and si#nificant estimates made by mana#ement, and evaluatin# the overall financial statement presentation. Bur audit of internal control over financial reportin# included obtainin# an understandin# of internal control over financial reportin#, evaluatin# mana#ement s assessment, testin# and evaluatin# the desi#n and operatin# effectiveness of internal control, and performin# such other procedures as we considered necessary in the circumstances. *e believe that our audits provide a reasonable basis for our opinions.
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5!(
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Audit Simulation: Reports on 0nternal ontrol O#er Financial Reporting (Drafting Reports) (part a/ ontinued) 8 company s internal control over financial reportin# is a process desi#ned to provide reasonable assurance re#ardin# the reliability of financial reportin# and the preparation of financial statements for external purposes in accordance with #enerally accepted accountin# principles. 8 company s internal control over financial reportin# includes those policies and procedures that .1/ pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the companyD .!/ provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with #enerally accepted accountin# principles, and that receipts and expenditures of the company are bein# made only in accordance with authori;ations of mana#ement and directors of the companyD and .$/ provide reasonable assurance re#ardin# prevention or timely detection of unauthori;ed ac%uisition, use, or disposition of the company s assets that could have a material effect on the financial statements. Aecause of its inherent limitations, internal control over financial reportin# may not prevent or detect misstatements. 8lso, pro:ections of any evaluation of effectiveness to future periods are sub:ect to the risk that controls may become inade%uate because of chan#es in conditions, or that the de#ree of compliance with the policies or procedures may deteriorate. 7n our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of 4ammons, 7nc. as of 0ecember $1, !--( and !--' and the results of its operations and cash flows for each of the three years in the period ended 0ecember $1, !--( in conformity with >.S. #enerally accepted accountin# principles. 8lso in our opinion, mana#ement s assessment that 4ammons, 7nc. maintained effective internal control over financial reportin# as of 0ecember $1, !--(, is fairly stated, in all material respects, based on the CBSB criteria. =urthermore, in our opinion, 4ammons, 7nc.. maintained, in all material respects, effective internal control over financial reportin# as of 0ecember $1, !--(, based on the CBSB criteria.
Reynolds, CPA
=ebruary 1&, !--)
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5!)
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Audit Simulation: Reports on 0nternal ontrol O#er Financial Reporting (Drafting Reports) ( ontinued) b. Report of 7ndependent Re#istered Public 8ccountin# =irm 2o the Aoard of 0irectors and Shareholders 4ammons, 7nc. *e have audited mana#ement s assessment, included in the accompanyin# 3ana#ement s Report on 7nternal Control Bver =inancial Reportin#, that 4ammons, 7nc. maintained effective internal control over financial reportin# as of 0ecember $1, !--(, based on criteria established in 7nternal Control O 7nte#rated =ramework issued by the Committee of Sponsorin# Br#ani;ations of the 2readway Commission .CBSB criteria/. 4ammons 7nc. s mana#ement is responsible for maintainin# effective internal control over financial reportin# and for its assessment of the effectiveness of internal control over financial reportin#. Bur responsibility is to express an opinion on mana#ement s assessment and an opinion on the effectiveness of the company s internal control over financial reportin# based on our audit. *e conducted our audit in accordance with the standards of the Public Company 8ccountin# Bversi#ht Aoard .>nited States/. 2hose standards re%uire that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reportin# was maintained in all material respects. Bur audit included obtainin# an understandin# of internal control over financial reportin#, evaluatin# mana#ement s assessment, testin# and evaluatin# the desi#n and operatin# effectiveness of internal control, and performin# such other procedures as we considered necessary in the circumstances. *e believe that our audit provides a reasonable basis for our opinion. 8 company s internal control over financial reportin# is a process desi#ned to provide reasonable assurance re#ardin# the reliability of financial reportin# and the preparation of financial statements for external purposes in accordance with #enerally accepted accountin# principles. 8 company s internal control over financial reportin# includes those policies and procedures that .1/ pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the companyD .!/ provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with #enerally accepted accountin# principles, and that receipts and expenditures of the company are bein# made only in accordance with authori;ations of mana#ement and directors of the companyD and .$/ provide reasonable assurance re#ardin# prevention or timely detection of unauthori;ed ac%uisition, use, or disposition of the company s assets that could have a material effect on the financial statements. Aecause of its inherent limitations, internal control over financial reportin# may not prevent or detect misstatements. 8lso, pro:ections of any evaluation of effectiveness to future periods are sub:ect to the risk that controls may become inade%uate because of chan#es in conditions, or that the de#ree of compliance with the policies or procedures may deteriorate.
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5!+
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Audit Simulation: Reports on 0nternal ontrol O#er Financial Reporting (Drafting Reports) (part b/ ontinued) 7n our opinion, mana#ement s assessment that 4ammons, 7nc. maintained effective internal control over financial reportin# as of 0ecember $1, !--(, is fairly stated, in all material respects, based on the CBSB criteria. 8lso in our opinion, 4ammons, 7nc. maintained, in all material respects, effective internal control over financial reportin# as of 0ecember $1, !--(, based on the CBSB criteria. *e have also audited, in accordance with the standards of the Public Company 8ccountin# Bversi#ht Aoard .>nited States/, the balance sheets of 4ammons, 7nc. as of 0ecember $1, !--( and !--' and related statements of income, comprehensive income, shareholders e%uity, and cash flows for each of the three years in the period ended 0ecember $1, !--( and our report dated =ebruary 1&, !--) expressed an un%ualified opinion thereon.
Reynolds, CPA
=ebruary 1&, !--) c. 1. Opinion %aragraph: 7n our opinion, mana#ement s assessment that 4ammons, 7nc. did not maintain effective internal control over financial reportin# as of 0ecember $1, !--(, is fairly stated, in all material respects, based on the CBSB criteria. 8lso in our opinion, because of the effect of the material weakness described above on the achievement of the ob:ectives of the control criteria, 4ammons, 7nc. has not maintained, in all material respects, effective internal control over financial reportin# as of 0ecember $1, !--(, based on the CBSB criteria. M8S !.1)' O 8S !. 1))N Other +odifications: 3odify the introductory para#raph to note that 4ammons assessment indicated the company has not maintained an effective internal control over financial reportin#. M8S !.1)(N 7nclude a para#raph immediately followin# the inherent limitations para#raph that defines a material weakness and describes any material weakness.es/ identified durin# the audit. M8S !.1)(N
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5!,
1!.(1
Audit Simulation: Reports on 0nternal ontrol O#er Financial Reporting (Drafting Reports) (part c/ ontinued) !. Opinion %aragraph: 7n our opinion, because of the effect of the material weakness described above on the achievement of the ob:ectives of the control criteria, mana#ement s assessment that 4ammons, 7nc. maintained an effective internal control over financial reportin# as of 0ecember $1, !--(, is not fairly stated, in all material respects, based on the CBSB criteria. 8lso in our opinion, because of the effect of the material weakness described above on the achievement of the ob:ectives of the control criteria, 4ammons, 7nc. has not maintained, in all material respects, effective internal control over financial reportin# as of 0ecember $1, !--(, based on the CBSB criteria. . M8S !.1)' O 8S !.1))D Example 85 (N Other +odifications: 7nclude a para#raph immediately followin# the inherent limitations para#raph that defines a material weakness and describes any material weakness.es/ identified durin# the audit. M8!.1)(N 8dd an explanatory para#raph mentionin# Reynolds disa#reement with 4ammons assessment. M8!.1)&N
$.
Opinion %aragraph: 7n our opinion, except for the effect of matters we mi#ht have discovered had we been able to examine evidence about the effectiveness of the remediated controls over cash receipts, mana#ement s assessment that 4ammons, 7nc. maintained an effective internal control over financial reportin# as of 0ecember $1, !--(, is fairly stated, in all material respects, based on the CBSB criteria. 8lso in our opinion, except for the effect of matters we mi#ht have discovered had we been able to examine evidence about the effectiveness of the remediated controls over cash receipts, 4ammons, 7nc. maintained, in all material respects, effective internal control over financial reportin# as of 0ecember $1, !--(, based on the CBSB criteria. MExample 85$N Other +odifications: 3odify the scope para#raph to discuss the scope limitation with respect to the remediated control. MExample 85$N 8dd an explanatory para#raph to describe the scope limitation in detail. MExample 85$N
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5$-
1!.(1
Audit Simulation: Reports on 0nternal ontrol O#er Financial Reporting (Drafting Reports) (part c/ ontinued) &. Opinion %aragraph: 7n our opinion, based on our audit and the report of other auditors, mana#ement s assessment that 4ammons, 7nc. maintained effective internal control over financial reportin# as of 0ecember $1, !--(, is fairly stated, in all material respects, based on the CBSB criteria. 8lso in our opinion, based on our audit and the report of other auditors, 4ammons, 7nc. maintained, in all material respects, effective internal control over financial reportin# as of 0ecember $1, !--(, based on the CBSB criteria. M8S !.1+', Example 85'N Other +odifications: '. 3odify the introductory para#raph to reference the report of other auditors. M8S !.1+', Example 85'N 3odify the scope para#raph to reference the report of other auditors. M8S !.1+', Example 85'N
Opinion %aragraph: 7n our opinion, except for the effect of matters that it mi#ht have discovered had a more complete assessment of internal control been made, mana#ement s assessment that 4ammons, 7nc. maintained effective internal control over financial reportin# as of 0ecember $1, !--(, is fairly stated, in all material respects, based on the CBSB criteria. 8lso in our opinion, 4ammons, 7nc. maintained, in all material respects, effective internal control over financial reportin# as of 0ecember $1, !--(, based on the CBSB criteria. MCo applicable professional referenceD however, lan#ua#e such as the followin# would be appropriate to acknowled#e the limitation on mana#ement s assessment.N Other +odifications: 3odify the scope para#raph to discuss the scope limitation with respect to mana#ement s assessment. M8S !.1)&N 8dd an explanatory para#raph to describe the scope limitation with respect to mana#ement s assessment in detail. M8S !.1)&N
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5$1
SOL#TIONS TO REPORT $RITING CASES

1!.(! Financial Difficult!2The 34oing oncern5 %roblem a. Reportin# on financial difficulty with an additional explanatory para#raph in place of the ?sub:ect to@ opinion. Report of 0ndependent Auditors 2o the Aoard of 0irectors and Stockholders Pitts Company MStandard introductory para#raphN MStandard scope para#raphN 7n our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Pitts Company as of 0ecember $1, !--(, and the results of its operations and its cash flows for the year then ended, in conformity with >.S. #enerally accepted accountin# principles. 8s shown in the financial statements, Pitts Company has current liabilities that exceed current assets by P1 million. Cash balances have been drawn down to P1-,---, and the interest on the lon# term debt has not been paid. 8s explained in Cote $ to the financial statements, a customer has sued for P'--,--- on a product liability claim. 2hese factors, alon# with other matters discussed in Cote $, indicate substantial doubt that Pitts Company may be able to continue in existence as a #oin# concern. 2he financial statements do not include any ad:ustments relatin# to these uncertainties. 8nderson, Blds E *atershed =ebruary 1-, !--) b. Reportin# on financial difficulty with a disclaimer of opinion. Report of 0ndependent Auditors 2o the Aoard of 0irectors and Stockholders Pitts Company MStandard introductory para#raphN MStandard scope para#raphN 8s shown in the financial statements, Pitts Company has current liabilities that exceed current assets by P1 million. Cash balances have been drawn down to P1-,---, and the interest on the lon# term debt has not been paid. 8s explained in Cote $ to the financial statements, a customer has sued for P'--,--- on a product liability claim. 2hese factors, alon# with other matters discussed in Cote $ indicate substantial doubt that Pitts Company may be able to continue in existence. 2he financial statements do not include any ad:ustments relatin# to these uncertainties. Aecause of the possible material effect on the financial statements of the matters discussed in the precedin# para#raph, we cannot and do not express an opinion on the financial statements referred to above. 8nderson, Blds E *atershed =ebruary 1-, !--) McGraw-Hill/Irwin 8uditin# and 8ssurance Services, "ouwers et al., !9e 1 2he 3c4raw56ill Companies, 7nc., !--) 1!5$!
1!.($
Disagreement $ith Auditors Accountants* Report 2o the Aoard of 0irectors and Stockholders Richnow Company *e are not independent with respect to Richnow Company, and the accompanyin# balance sheet as of 0ecember $1, !--(, and the related statements of income, comprehensive income, retained earnin#s, and cash flows for the year then ended were not audited by us and, accordin#ly, we do not express an opinion on them. 8nderson, Blds E *atershed =ebruary 1-, !--)
1!.(&
1ate Appointment of Auditor NOTE $here in'entory "uantities are determined solely .y means of physical count, as in this case, an auditor ordinarily cannot o.tain sufficient competent e'idence .y means of alternati'e procedures that do not include ma*ing or o.ser'ing some physical counts of the in'entory. 1epending upon the degree of materiality of the amounts in'ol'ed, the 2+! should descri.e the limitation on the e&amination in the scope paragraph 3or a middle paragraph4 and either "ualify the opinion or disclaim an opinion. Report of 0ndependent Auditors 2o the Aoard of 0irectors and Stockholders 3us#rave Company MStandard introductory para#raphN Except as discussed in the followin# para#raph, we conducted our audits in accordance with auditin# standards #enerally accepted in the >nited States of 8merica. 2hose standards re%uire that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. 8n audit includes examinin#, on a test basis, evidence supportin# the amounts and disclosures in the financial statements. 8n audit also includes assessin# the accountin# principles used and si#nificant estimates made by mana#ement, as well as evaluatin# the overall financial statement presentation. *e believe that our audit provides a reasonable basis for our opinion. *e were unable to perform a physical observation of the inventory carried in the accounts in the amount of P 1,,&-,---, which is approximately $,F of total assets and approximately (,F of current assets. 2he inventory enters into the determination of cost of #oods sold and net income to a si#nificant extent. 3us#rave Company determines inventory %uantities and, hence, inventory valuations, solely by means of physical count. Aecause we were unable to audit the physical inventory, we are unable to express, and do not express, an opinion on the aforementioned financial statements. 8nderson, Blds E *atershed =ebruary 1-, !--)
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5$$
1!.('
'sing (or) of Other 0ndependent Auditors Report of 0ndependent Auditors 2o the Aoard of 0irectors and Stockholders =er#uson Company *e have audited the accompanyin# balance sheets of =er#uson Company and subsidiaries as of 0ecember $1, !--( and !--' and the related statements of income, comprehensive income, retained earnin#s, and cash flows for each of the two years in the period ended 0ecember $1, !--(. 2hese financial statements are the responsibility of =er#uson Company s mana#ement. Bur responsibility is to express an opinion on these financial statements based on our audits. *e did not examine the financial statements of certain consolidated subsidiaries, which statements reflect total assets and revenues constitutin# !, percent and $( percent in !--( and $1 percent and &1 percent in !--', respectively, of the related consolidated totals. 2hese statements were examined by other independent accountants whose reports thereon have been furnished to us, and our opinion expressed herein, insofar as it relates to the amounts included for these subsidiaries, is based solely on the reports of the other independent accountants. *e conducted our audits in accordance with auditin# standards #enerally accepted in the >nited States of 8merica. 2hose standards re%uire that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. 8n audit includes examinin#, on a test basis, evidence supportin# the amounts and disclosures in the financial statements. 8n audit also includes assessin# the accountin# principles used and si#nificant estimates made by mana#ement, as well as evaluatin# the overall financial statement presentation. *e believe that our audits and the reports of other independent accountants provide a reasonable basis for our opinion. 7n our opinion, based upon our audits and the reports of the other independent accountants, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Iin#ston Company and subsidiaries at 0ecember $1, !--( and !--', and the consolidated results of their operations and their cash flows for each of the two years in the period ended 0ecember $1, !--( in conformity with >.S. #enerally accepted accountin# principles. 8nderson, Blds E *atershed =ebruary 1-, !--)
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5$&
1!.((
Other 0nformation in a Financial Re#ie$ Section of an Annual Report a. 2he financial review section contains statements inconsistent with the audited financial statements. .*hether the inconsistency is material is not explored here./ Calculations< Current Hear Bperatin# income Extraordinary #ain reali;ation of tax benefits 7nterest expense 7ncome taxes Cet income P &--,--Prior Hear P $(-,--7ncremental Aasis P &-,---
1--,--. +1,!'-/ .1!),'--/ P !,1,!'. (-,---/ .1!-,---/ P 1+-,---
1--,--. !1,!'-/ . ),'--/ P 111,!'-
Ratio of operatin# income to interest expense< P&--,--- 9 P+1,!'Ratio Ratio includin# Extraordinary #ain in Cumerator &.,!<1 P$(-,--- 9 P(-,--(<1 P&-,--- 9 P!1,!'1.++<1
(.1'<1
(<1
(.',<1
Cotice that the officers have mana#ed to find the combination of numbers that produces the hi#hest ratio, doin# some violence to the idea of ?consistency with the audited financial statements.@ b. Explanatory para#raph in audit report< 2he financial review on pa#e xx contains a statement to the effect that, on an incremental basis, operatin# income covera#e of interest expense increased to a ratio of (.', to 1. *e believe this relationship is inconsistent with the audited financial statements. Bperatin# income .before extraordinary #ains, interest expense and income taxes/ covera#e of interest expense was in the ratio of (<1 in the prior year and &.,!<1 in the current year. Bn an incremental basis, operatin# income increased P&-,---, and interest expense increased P!1,!'-, a ratio of 1.++<1. *hen the extraordinary #ain is included for the current year, interest covera#e for the year is in the ratio of (.1'<1, and on an incremental basis is (.'++<1.
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5$'
1!.()
Departures from 4AA% a. Report %ualified for 488P exception. Report of 0ndependent Auditors 2o the Aoard of 0irectors and Stockholders 4raham Company MStandard introductory para#raphN MStandard scope para#raphN 8s explained in Cote 1 to the financial statements, 4raham Company reports its investment in land on which its buildin#s stand at appraisal value, and reports the amount in excess of cost in a stockholder e%uity account entitled ?Current value increment.@ 7n our opinion, #enerally accepted accountin# principles do not permit reportin# appraisal values in financial statements that purport to show financial position and results of operations in conformity with #enerally accepted accountin# principles. 7f the cost of the land were reported in the financial statements, total assets would be P&--,--- .+F/ lower, and stockholder e%uity would also be P&--,--- lower .11F/. 7n our opinion, except for the effects of reportin# land at appraisal value as described in the precedin# para#raph, the financial statements referred to above present fairly, in all material respects, the financial position of 4raham Company as of 0ecember $1, !--(, and the results of its operations and its cash flows for the year then ended, in conformity with >.S. #enerally accepted accountin# principles. 8s described in Cote 1 to the financial statements, 4raham Company chan#ed its accountin# principles re#ardin# recordin# and reportin# the appraised value of land for the year ended 0ecember $1, !--(. 8nderson, Blds E *atershed =ebruary 1-, !--)
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5$(
1!.()
Departures from 4AA% ( ontinued) b. 8dverse report based on same facts. Report of 0ndependent Auditors 2o the Aoard of 0irectors and Stockholders 4raham Company MStandard introductory para#raphN MStandard scope para#raphN MExplanatory para#raph is the same as in the %ualified reportN 7n our opinion, because of the effects of the appraisal value reportin# described in the precedin# para#raph, the balance sheet referred to above does not present fairly the financial position of 4raham Company as of 0ecember $1, !--( , in conformity with >.S. #enerally accepted accountin# principles,. 6owever, because the reported land appraisal values do not affect the statements of operations and cash flows, in our opinion these financial statements referred to above present fairly the results of operations and cash flows 4raham Company for the year ended 0ecember $1, !--(, in conformity with >.S. #enerally accepted accountin# principles. 8s described in Cote 1 to the financial statements, 4raham Company chan#ed its accountin# principles re#ardin# recordin# and reportin# the appraised value of land for the year ended 0ecember $1, !--(. 8nderson, Blds E *atershed =ebruary 1-, !--)
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5$)
1!.()
Departures from 4AA% ( ontinued) c. 2here are two possibilities. Bn one hand, if one takes the view that fixed assets .includin# land/ should not reflect appraisal values, the case could be made that the reportin# options in .a/ or .b/ are appropriate, dependin# upon materiality. Bn the other hand, a report conformin# to Rule !-$ could be prepared, assumin# that the auditor felt that presentation in conformity with 488P would create misleadin# financial statements. Brdinarily, because of the strict prohibitions of reflectin# appraisal values for fixed assets under 488P, most students would ar#ue that a report conformin# to Rule !-$ would not be appropriate in this situation. *hen discussin# this with students, it is interestin# to ask students to identify the pros and cons of the different types of presentations. 8fter all, an individual readin# the reports shown in .a/, .b/, and .c/ would have access to exactly the same information with respect to the valuation of the landD only the auditor s opinion .and accompanyin# lan#ua#e/ differs. 7f prepared, a report conformin# to Rule !-$ that could be prepared is shown below. Report of 0ndependent Auditors 2o the Aoard of 0irectors and Stockholders 4raham Company MStandard introductory para#raphN MStandard scope para#raphN 8s explained in Cote 1 to the financial statements, 4raham Company reports its investment in land on which its buildin#s stand at appraisal value, and reports the amount in excess of cost in a stockholder e%uity account entitled ?Current value increment.@ 2he asset total of P',$,&,--- and the stockholders e%uity of P$,',&,---, each reflect the P(--,--- appraisal increment reduced by implicit disposal taxes at the rate of $$ percent. *hile 8ccountin# Principles Aoard Bpinion Co. ( provides that property shall not be written up to reflect appraisal values in excess of cost, we believe nonreco#nition of the si#nificant increase in land value would omit relevant information from the financial statements and cause the report of total asset and stockholder e%uity values to be materially misleadin#. 7n our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of 4raham Company as of 0ecember $1, !--(, and the results of its operations and its cash flows for the year then ended, in conformity with >.S. #enerally accepted accountin# principles. 8s described in Cote 1 to the financial statements, 4raham Company chan#ed its accountin# principles re#ardin# recordin# and reportin# the appraised value of land for the year ended 0ecember $1, !--(. 8nderson, Blds E *atershed =ebruary 1-, !--)
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5$+
1!.(+
Reporting on an Accounting hange a. Reportin# on an accountin# chan#e with which the auditors concur. Report of 0ndependent Auditors 2o the Aoard of 0irectors and Stockholders *illiams Company MStandard introductory para#raphN MStandard scope para#raphN 7n our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of *illiams Company as of 0ecember $1, !--(, and the results of its operations and its cash flows for the year then ended, in conformity with >.S. #enerally accepted accountin# principles. 8s described in Cote ! to the financial statements, *illiams Company chan#ed its accountin# principles from the last5in first5out method to the first5in first5out method for the year ended 0ecember $1, !--(. 8nderson, Blds E *atershed =ebruary 1-, !--) b. Reportin# on an accountin# chan#e the auditors think is not :ustified in accordance with S=8S 1'&. 2he explanatory consistency para#raph is not #iven because the middle para#raph explains the chan#e. Report of 0ndependent Auditors 2o the Aoard of 0irectors and Stockholders *illiams Company MStandard introductory para#raphN MStandard scope para#raphN 8s disclosed in Cote ! to the financial statements, *illiams Company has adopted the =7=B method of accountin# for the cost of inventory and #oods sold, whereas it previously used the "7=B method. 8lthou#h the =7=B method is in conformity with #enerally accepted accountin# principles, in our opinion *illiams Company has not provided reasonable :ustification, in this period of risin# prices, for makin# a chan#e as re%uired by 8ccountin# Principles Aoard Bpinion Co. !-. 7nventories that would have been reported at P1.' million ."7=B/ are reported at P1., million .=7=B/D operatin# income before tax that would have been P1$-,--- is reported at P'$-,---D current assets are revised upward 1) percent and total assets nine percentD stockholder e%uity is 1& percent #reater. 7n our opinion, except for the chan#e in accountin# principle as stated above, the aforementioned financial statements present fairly, in all material respects, the financial position of *illiams Company as of 0ecember $1, !--(, and the results of its operations and its cash flows for the year then ended, in conformity with >.S. #enerally accepted accountin# principles. 8nderson, Blds E *atershed =ebruary 1-, !--)
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5$,
1!.(,
6aplan %A "-am Simulation: Reports on Financial Statements (4eneral Audit Reports) A F Specifies that the financial statements are the responsibility of the company s mana#ement. .2his is included in the first, or introductory, para#raph./ Specifies that the financial statements present accurately in all material respects the financial position, operations, and cash flows. .Replace the word ?accurately@ with ?fairly@ and the statement is correctly included in the third, or opinion, para#raph. 2his is a subtle but important point to remember. ?8ccurately@ su##ests absolute precision, which is #enerally not ascertainable in an audit for many reasonsQfor instance, cost5benefit./ Specifies that there is a #oin#5concern problem .not disclaimin# an opinion/. .8n explanatory fourth para#raph is added after the opinion para#raph if substantial doubt exists as to the company s ability to stay in business for 1! months from the date of the balance sheet./ Specifies that the financial statements contain a si#nificant number of related5party transactions. .8n explanatory fourth para#raph is added to draw attention to a matter of particular importance that the auditor would like to emphasi;e to the readers of the financial statements./ Specifies that an assessment was made of accountin# principles, si#nificant estimations, and statement presentation. .2his is included in the second, or scope, para#raph./ Specifies that evidence supportin# amounts and disclosures has been examined, but only on a test basis. .2his is included in the second, or scope, para#raph./
"
"
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5&-
1!.)-
6aplan %A "-am Simulation: Reports on Financial Statements (Opinions and Report +odifications) A 8 consolidated subsidiary of the =erreira Company was audited by another CP8 firm. Riley E 8ssociates has carried out the necessary procedures and has decided not to indicate the division of responsibility in its audit report. .7f the CP8 chooses not to divide the responsibility with the other auditor, a standard un%ualified opinion can be #iven./ Riley E 8ssociates was not able to observe the physical inventory count because of the date on which the firm was hired. 2he inventory is a material amount, but the firm is not able to #ain sufficient, satisfactory evidence by other means. .2he CP8 firm was not able to follow #enerally accepted auditin# standards so that the assurance level must be reduced or eliminated. 8 scope %ualification or a disclaimer should be #iven. 2hose reports necessitate chan#es in the scope para#raph and opinion para#raph alon# with an added explanatory para#raph prior to the opinion para#raph./ Riley E 8ssociates believes that there is substantial doubt that =erreira Company can remain a #oin# concern for a period of 1! months from the company s balance sheet date. =erreira Company has made appropriate disclosure of this uncertainty in its financial statements. .2he CP8 firm needs to draw attention to this problem althou#h it has no impact on the audit opinion. 8n explanatory para#raph is added at the end of the report without any chan#e in the wordin# of the other para#raphs. 7n extreme cases, the CP8 does have the ri#ht to issue a disclaimer of opinion./ =erreira Company wants to present the current year financial statements audited by Riley E Company alon# with the financial statements from the prior year that were audited by a different firm. =erreira does not want to include the previous audit report althou#h it was un%ualified. .7f the previous report is not presented, the current CP8 must provide information about that earlier opinion. 2his information is included at the end of the introductory para#raph./ 7n the current year, =erreira Company switched from double5declinin# balance depreciation to strai#ht5line depreciation. Riley E 8ssociates concurs with this chan#e althou#h it is viewed to be of a material amount. .2he CP8 should draw attention to this chan#e althou#h it does not affect the audit opinion. 8n explanatory para#raph is added at the end of the report without chan#in# the wordin# of the other para#raphs./ Riley E 8ssociates discovers that =erreira Company has not provided ade%uate disclosure of re%uired information of a material nature about its employee pension plan and refuses to do so because of employee confidentiality. .2he financial statements contain a material misstatement so that either a %ualified opinion or an adverse opinion should be rendered. 7n both cases, an explanatory para#raph is added and the opinion para#raph is modified./ 8 consolidated subsidiary of the =erreira Company was audited by another CP8 firm. Riley E 8ssociates has carried out the necessary procedures and has decided to indicate the division of responsibility in its audit report. .*hen the CP8 chooses to divide the responsibility for the opinion with another CP8, all three para#raphs must be modified. 6owever, no para#raph need be added./ 8 letter from the president of =erreira Company that is attached to the financial statements contains information that Riley E 8ssociates believes to be misleadin#. .2his information is outside of the financial statements, but it is still misleadin# to the user of the financial statements. 2hus the CP8 needs to draw attention to the problem by addin# an extra para#raph at the end of the audit report althou#h none of first three para#raphs are modified./
"
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5&1
1!.)1
6aplan %A "-am Simulation: Di#ision of Responsibilit! Re.uired if %re#ious Opinion is 0ncluded (8) Re.uired if %re#ious Opinion is Omitted Re.uired in 7oth Situations
Not Re.uired
2he predecessor auditor must a#ree to the inclusion of its report with the current report. 2he date of the previous report must be included. 2he predecessor auditor should review the earlier financial statements to make certain that nothin# has been chan#ed since the ori#inal examination. 8n explanation, if the report varied from a standard un%ualified opinion, should be included in the introductory para#raph of the report. 2he current auditors must issue a representation letter statin# that nothin# has been found to indicate that the previous statements re%uire ad:ustment. 2he current auditor must refer to the earlier report. 2he predecessor auditor must obtain an updated representation letter from mana#ement similar to the one that is re%uired at the end of an audit. 2he predecessor auditor must perform analytical procedures sufficient to ensure that the previous statements do not re%uire ad:ustment. 2he predecessor auditor must make certain that the ori#inal opinion is still appropriate. 2he statements bein# presented that were audited by the predecessor auditor must be identified in the introductory para#raph of the audit report.
(8) (8)
(8)
(8)
(8) (8)
(8)
(8) (8)
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5&!
1!.)!
6aplan %A "-am Simulation: Reports on Financial Statements ( omparati#e Financial Statements) =or comparative purposes, both reports .the successor auditor and the predecessor auditor/ must be included with the financial statements bein# released in year two. False. Aoth reports could be presented, but this is not a re%uirement. 7f the previous report is omitted, the current auditor must refer to the previous report in the first para#raph of the current report.
2he predecessor auditor must #ive permission to the successor auditor for the previous audit opinion to be included in year two. 7f in year two, an audit is bein# performed and only a review was performed in year one, then additional audit work will have to be performed on year one to ensure that the year two financial statements are comparable.
True
False. Aecause Ierklaan Enterprises is not a publicly5traded company, a review would be permissible in the previous year. 2he current audit report would contain a separate para#raph to indicate the level of assurance provided on the year one financial statements. False. 7f the opinion is chan#ed from that issued in a prior year, an explanatory para#raph is added prior to the opinion para#raph. 2here is no need to seek permission from the predecessor auditor prior to doin# so. False. 2he predecessor auditor is re%uired to obtain mana#ement representations from the current auditor indicatin# that nothin# has been found to indicate that the year one statements re%uire ad:ustment.
2he successor auditor is not allowed to chan#e the opinion #iven by the predecessor auditor on the year one financial statements unless permission is #iven from the predecessor auditor.
*hen a previous opinion is included alon# with the year two audit report .and the predecessor auditor has #ranted permission for its inclusion/, the predecessor auditor should, but is not re%uired to, obtain a representation letter from the successor auditor statin# that nothin# has been found to indicate that the year one statements re%uire ad:ustment.
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5&$
INTENTIONALL, LEFT
LAN%
1 2he 3c4raw56ill Companies, 7nc., !--) 1!5&&

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CHAPTER 12 Reports on Audited Financial Statements LEARNING O !

Exercises, Problems, and Simulations

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SOL#TIONS FOR E)ERCISES* PRO LE&S* AN+ SI&#LATIONS

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