Chapter 17

First Pages
Chapter
Auditors’ Reports
Expressing an independent and expert opinion on the fairness of financial statements
17
Learning objectives
is the most frequently performed attestation service rendered by the public accounting
profession. This opinion, which is expressed in the auditors’ report, provides users After studying this chapter,
you should be able to:
of financial statements with reasonable assurance that the statements are in confor-
mity with the appropriate financial reporting framework, most frequently generally LO1 Describe the standard
accepted accounting principles. audit report for non-
In Chapter 2 we saw that the auditors’ standard report states that the audit was per- public entity (nonis-
formed in conformity with generally accepted auditing standards and expresses an opin- suer) audits.
ion that the client’s financial statements are presented fairly in conformity with generally LO2 Describe the standard
accepted accounting principles. However, auditors cannot issue the standard report if: audit report for public
entity (issuer) audits.
• There are conditions, although not departures from GAAP, about which the readers
of the financial statements should be informed (e.g., a lack of consistent application LO3 Identify the circum-
of GAAP). stances that result
in audit reports with
• There are material departures from GAAP in the client’s financial statements.
emphasis of matter
• The auditors are unable to obtain sufficient appropriate audit evidence (e.g., due to paragraphs added to
client not retaining certain important records). reports with unmodi-
fied opinions.
Instead, they must modify their report to communicate those matters.
In this chapter we describe the different types of audit reports that auditors issue in LO4 Identify the circum-
various circumstances. Their goal in reporting is to present clearly the nature of the stances that result
in modified audit
audit and their opinion on the financial statements.
opinions.
LO5 Describe the audi-

Financial Statements and Standard Unmodified tors’ responsibilities
for reporting on
Audit Reports comparative financial
statements.
Because we are discussing audit reports on financial statements, we first briefly pro-
vide an overview of financial statements, including disclosures. Next, we discuss in
detail the standard unmodified audit reports included in AICPA Auditing Standards
Board and Public Company Accounting Oversight Board professional standards.
Financial Auditors most frequently report upon a complete set of finan-

Statements cial statements: that is, the balance sheet, the income state-
ment, the statement of retained earnings, and the statement
of cash flows and related notes.1 In some cases, the statement of retained earnings is
either expanded to a statement of stockholders’ equity or combined with the income
1
As is discussed in further detail in Chapter 19, an auditor may report on less than the complete
set of financial statements. Thus, for example, an auditor could issue an audit report with an
opinion on a balance sheet alone. One issue that complicates matters is a GAAP requirement
that when a company presents a balance sheet and an income statement, it must also present
a statement of cash flows; if a statement of cash flows is omitted in this situation, a departure
from GAAP exists.
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662 Chapter Seventeen
statement. Financial statements generally are presented in comparative form for the current
year and one or more preceding years. The financial statements for a parent corporation
usually are consolidated with those of the subsidiaries. In the United States, these financial
statements are most frequently prepared following the general-purpose framework
referred to as accounting principles generally accepted in the United States of America.2
Financial The purpose of notes to financial statements is to achieve adequate disclosure of informa-
Statement tion required by generally accepted accounting principles (or any other financial report-
Disclosures ing framework followed [e.g., International Financial Reporting Standards]) that cannot
be adequately conveyed on the face of the financial statements. Adequate disclosure in
the notes to the financial statements is necessary for the auditors to issue an unmodified
opinion on the financial statements.
The Financial Accounting Standards Board (FASB), the Government Accounting
Standards Board (GASB), the Federal Accounting Standards Advisory Board (FASAB),
and the Securities and Exchange Commission (SEC) have issued numerous pronounce-
ments that have added extensive disclosure requirements. Examples of these require-
ments include the disclosure of significant accounting policies, accounting changes, loss
contingencies, and lease and post-retirement benefit information.
In evaluating financial reporting disclosures, the auditors should keep in mind that dis-
closures are meant to supplement the information on the face of the financial statements—
not correct improper financial statement presentation. Thus, a note or supplementary
schedule, no matter how skillfully drafted, does not compensate for the erroneous presen-
tation of an item in the financial statements.
Comparative Comparative financial statements are financial statements for one or more prior
Financial periods, included for comparison with the financial statements of the current period. Com-
Statements parative financial statements allow users to identify changes and trends in the financial
position and operating results of a company over an extended period, and thus are more
useful to investors and creditors than are financial statements for a single period. Publicly
owned companies are required to include in their annual reports the balance sheets for
each of the last two years and the related statements of income, retained earnings, and
cash flows for each of the last three years. The auditors’ report covers all financial state-
ments that are presented. Later in this chapter we will describe in detail the auditors’
reporting responsibilities when management presents comparative financial statements.
The Auditors’ Chapter 2 includes a standard audit report on the audit of a nonpublic company’s finan-
Standard Report— cial statements for two years. The following is a nonpublic company standard unmodified
Nonpublic Clients report on financial statements for one year (AICPA AU 700):
LO1
Describe the standard audit report Independent Auditors’ Report
for nonpublic entity (nonissuer)
To the Board of Directors and Stockholders of ABC Company:
audits.
We have audited the accompanying consolidated financial statements of ABC Company and
its subsidiaries, which comprise the consolidated balance sheet as of December 31, 20X1, and the
related consolidated statements of income, changes in stockholders’ equity and cash flows for
the year then ended, and the related notes to the financial statements.
Management’s Responsibility for the Financial Statement
Management is responsible for the preparation and fair presentation of these consolidated
financial statements in accordance with accounting principles generally accepted in the United
2
While financial statements may be prepared using a number of financial reporting frame-
works other than GAAP (e.g., International Financial Reporting Standards, Cash Basis, Tax Basis),
throughout this chapter we will ordinarily just refer to GAAP unless a distinction relating to
another framework is being made.
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Auditors’ Reports 663
States of America; this includes the design, implementation, and maintenance of internal
control relevant to the preparation and fair presentation of consolidated financial statements
that are free from material misstatement, whether due to fraud or error.
Auditors’ Responsibility
Our responsibility is to express an opinion on these consolidated financial statements based on
our audit. We conducted our audit in accordance with auditing standards generally accepted in
the United States of America. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the consolidated financial statements are free of
material misstatement.
An audit involves performing procedures to obtain audit evidence about the amounts and dis-
closures in the consolidated financial statement. The procedures selected depend on the auditors’
judgment, including the assessment of the risks of material misstatement of the consolidated finan-
cial statements, whether due to fraud or error. In making those risk assessments, the auditor consid-
ers internal control relevant to the entity’s preparation and fair presentation of the consolidated
financial statements in order to design audit procedures that are appropriate in the circumstances,
but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control.
Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of
accounting policies used and the reasonableness of significant accounting estimates made by man-
agement, as well as evaluating the overall presentation of the consolidated financial statements.
We believe that the audit evidence we have obtained is sufficient and appropriate to provide
a basis for our audit opinion.
Opinion
In our opinion, the consolidated financial statements referred to above present fairly, in all mate-
rial respects, the financial position of ABC Company and its subsidiaries as of December 31, 20X1,
and the results of their operations and their cash flows for the year then ended in accordance
with accounting principles generally accepted in the United States of America.
February 5, 20X2 Phoenix Arizona

Williams & Co., LLP
Before continuing, notice several details about this report. It has a title that includes
the word independent. It is addressed to those for whom it is prepared, generally the
audited company itself or to those charged with governance. After the introductory para-
graph, the report is divided into sections with headings.
The introductory paragraph of the auditors’ report indicates that the financial state-
ments have been audited. The section heading of Management’s Responsibility for the
Financial Statement indicates that management is responsible for the preparation and fair
presentation of the financial statements, in accordance with generally accepted account-
ing principles (or another financial reporting framework such as cash basis, if
appropriate) and its responsibility for internal control. The Auditors’ Responsibility sec-
tion includes three paragraphs that indicate that it is the auditors’ responsibility to express
an opinion on the financial statements based on audits conducted in accordance with gen-
erally accepted auditing standards, outline the nature of an audit, and conclude that the
auditors believe that sufficient appropriate audit evidence has been obtained to provide a
basis for the audit opinion. Finally, the Opinion Section presents the auditors’ opinion
on whether the financial statements are in conformity with accounting principles gener-
ally accepted in the United States.3
3
Auditors sometimes have reporting responsibilities related to other legal and regulatory require-
ments. For example, for audits performed under Government Auditing Standards the auditor may
be required to report on internal control over financial reporting and on compliance with laws,
regulations, and other matters. It is when the relevant law or regulation requires or permits the
auditors to report within the auditors’ report on the financial statements that this becomes rel-
evant. In such a situation the overall report is divided by:
• Report on Financial Statements. This heading is added following the opinion paragraph.
• Report on Other Legal and Regulatory Requirements. This heading and the related report follow
the opinion paragraph on the financial statements.
Note that this treatment is not applicable for emphasis of matter or other matter paragraphs
added to an audit report and is not required by the PCAOB.
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Historically, audit reports referred simply to generally accepted auditing standards and
generally accepted accounting principles. Today, however, a number of nations have their
own generally accepted standards (principles), and those standards usually differ from one
another. To reduce confusion, audit reports issued in the United States now use terms such as
“generally accepted auditing standards (United States of America)” or “auditing standards
generally accepted in the United States of America.” A similar modification is made relat-
ing to generally accepted accounting principles. For simplicity’s sake, in our text discussion
we will use the simpler historical terms or their abbreviations “GAAP” and “GAAS.”
Notice that the audit report is signed with the name of the CPA firm, not the name of
an individual partner in the firm. This signature stresses that it is the firm, not the individ-
ual, that takes responsibility for the audit report. If the CPA is practicing under his or her
own name as a sole practitioner, the report is signed with the CPA’s personal signature.
In addition, a sole practitioner should use I instead of we in the audit report.4
Also notice the date under the signature. The auditors’ report should not be dated
earlier than the date on which the auditors have obtained sufficient appropriate audit evi-
dence to support their opinion on the financial statements. Sufficient appropriate audit
evidence has been obtained when all audit documentation has been reviewed, the finan-
cial statements (including notes) are prepared, and management has asserted that they
have taken responsibility for these financial statements (ordinarily through a represen-
tation letter). The date of the audit report is quite significant because the auditors have
a responsibility to perform procedures through that date to search for any subsequent
events that may affect the fairness of the client’s financial statements (see Chapter 16),
and due to requirements relating to changes in documentation that arise after that date
(see Chapter 5). It is important to note that under PCAOB standards, the report is dated as
of the last day of field work, which is the day in which the auditors conclude their inves-
tigative procedures at the client’s offices.
An auditors’ report with an unmodified opinion may be issued only when the auditors
have obtained sufficient appropriate audit evidence to conclude that the financial state-
ments, as a whole, are not materially misstated.
The Auditors’ Standard Nos. 1 and 5 of the Public Company Accounting Oversight Board5 modify the
Standard Report— wording of the standard audit report for audits of public companies. The resulting report
Public Clients is follows.
LO2
Describe the standard audit report Report of Independent Registered Public Accounting Firm
for public entity (issuer) audits. To the Board of Directors and Stockholders of Southwest Airlines Co.:
We have audited the accompanying consolidated balance sheets of Southwest Airlines Co. as
We made this line of December 31, 2009 and 2008, and the related consolidated statement of income, stockholders’
equity, and cash flows for each of the three years in the period ended December 31, 2009. These
roman for financial statements are the responsibility of the Company’s management. Our responsibility is
consistency to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of material mis-
statement. An audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis for our opinion.
4
Section ISA 700 of the International Standards on Auditing allows the signature to be that of the
audit firm, the personal name of the auditor who directed the audit, or both, as appropriate for
the particular jurisdiction.
5
The titles of Nos. 1 and 5 are References in Auditors’ Reports to the Standards of the Public Com-
pany Accounting Oversight Board and An Audit of Internal Control over Financial Reporting Per-
formed in Conjunction with an Audit of Financial Statements, respectively.
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In our opinion, the financial statements referred to above present fairly, in all material
respects, the consolidated financial position of Southwest Airlines Co. at December 31, 2009 and
2008, and the consolidated results of its operations and its cash flows for each of the three years
in the period ended December 31, 2009, in conformity with U.S. generally accepted accounting
principles.
We also have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), Southwest Airlines Co.’s internal control over financial reporting
as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our
report dated January 29, 2010, expressed an unmodified opinion thereon.
Ernst & Young LLP

Dallas, Texas
January 29, 2010
There are a number of differences between this PCAOB audit report and the report used
for audits of nonpublic companies. The primary differences are that the PCAOB report:
• Includes the words “Registered” in the title.
• References standards of the PCAOB rather than generally accepted auditing standards.
• Includes less detailed discussions of management and auditor responsibilities.
• Includes an additional paragraph indicating that the auditors have also issued a report
on the client’s internal control over financial reporting. (For a description of audits of
internal control over reporting, see Chapters 7 and 18.)
• Does not include section headings.
We will now turn our attention to modifications of auditors’ standard reports. Although
our illustrations using audit reports are for nonpublic companies, they require few or no
changes to be used with the PCAOB audit report.
Expression of an Opinion
The options when expressing an opinion on financial statements may be summarized as
being either unmodified or modified as follows:
Unmodified Opinions
• Unmodified opinion—standard report. This report expresses a “clean opinion” and
may be issued only when the auditors have obtained sufficient appropriate audit evi-
dence to conclude that the financial statements, taken as a whole, are not materially
misstated and there is no need to modify the report for an emphasis of matter
paragraph, an other matter paragraph or to indicate a group audit situation.6
• Unmodified opinion with an emphasis of matter paragraph. An emphasis of matter
paragraph in an audit report follows the opinion paragraph and is included to refer to
a matter that is appropriately presented or disclosed in the financial statements but is
being emphasized through the audit report. In certain circumstances an emphasis of
matter paragraph is required (e.g., when there is substantial doubt about a company’s
ability to continue as a going concern and when the company changes accounting
principles). In others it is included at the auditors’ discretion (e.g., an uncertainty relat-
ing to future exceptional litigation, significant transactions with related parties, and
unusually important subsequent events).
6
PCAOB standards use the term “unqualified” rather than “unmodified.” In 2010, the AICPA
Auditing Standards Board switched from using “unqualified” to align its terminology with Interna-
tional Standards on Auditing.
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• Unmodified opinion with an other matter paragraph. An other matter paragraph

in an audit report follows the opinion paragraph (and any emphasis of matter
paragraph) and refers to a matter other than those presented or disclosed in the
audited financial statements. The matter is, in the auditors’ judgment, relevant to
users’ understanding of the audit, the auditors’ responsibilities, or the auditors’
report. These may arise in a variety of circumstances, including those presented in
Chapter 16, relating to other information in documents containing audited financial
statements and required supplementary information. Also, as discussed in Chapter
19, an other matter paragraph is added when auditing financial statements prepared
in accordance with special-purpose frameworks. In this chapter we discuss other
matter paragraphs relating to reporting on comparative statements when there are
predecessor auditors and to alert readers about the intended use of an audit report
when it is not for general use.
• Unmodified opinion on group financial statements. This circumstance involves a situ-
ation in which two or more CPA firms are involved in the audit of components of
group financial statements (e.g., the component auditors may audit one subsidiary
of an organization structured as a parent company with five subsidiaries). When the
audit firm that does the remainder of the audit does not wish to take responsibil-
ity for the work of the component auditors, the audit report is modified throughout
to divide responsibility between the CPA firms. This situation is unique in that the
report modifications do not involve inclusion of an emphasis of matter or an other
matter paragraph.
Modified Opinions
• Qualified opinion. A qualified opinion states that the financial statements are pre-
sented fairly in conformity with generally accepted accounting principles “except for”
the effects of some matter. Qualified opinions are issued when the financial state-
ments are materially misstated (“a departure from GAAP”) or when the auditors are
unable to obtain sufficient appropriate audit evidence on which to base the opinion (“a
scope limitation”). In both cases, the likely effects, while material, are not considered
pervasive. All significant reasons for the issuance of a qualified opinion should be
set forth in a basis for modification paragraph (expanatory paragraph under
PCAOB standards) that precedes the opinion paragraph.
• Adverse opinion. An adverse opinion states that the financial statements are not
presented fairly in conformity with generally accepted accounting principles. Audi-
tors issue an adverse opinion when the deficiencies in the financial statements are
both material and pervasive. All significant reasons for the issuance of an adverse
opinion should be set forth in a basis for modification paragraph that precedes the
opinion paragraph.
• Disclaimer of opinion. A disclaimer of opinion most frequently is the result of a
scope limitation that creates a situation in which the auditors are unable to obtain
sufficient appropriate audit evidence on which to base the opinion, and they conclude
that the possible effects on the financial statements of undetected misstatements, if
any, could be both material and pervasive. A disclaimer is not an opinion; it simply
states that the auditors do not express an opinion on the financial statements. All sig-
nificant reasons for the issuance of a the disclaimer of opinion should be set forth in a
basis for modification paragraph that precedes the opinion paragraph. As we discuss
later in this chapter, disclaimers may also result from substantial doubt about a cli-
ent’s ability to continue as a going concern and multiple uncertainties relating to the
financial statements.
We structure our discussion of audit reports around the above two basic types of opinions—
unmodified and modified opinions. Since several circumstances may result in either an
unmodified or a modified opinion (e.g., substantial doubt about going-concern status and
uncertainties), we emphasize that circumstance in the category in which the report is
most frequently issued.
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Reports with an Unmodified Opinion and

an Emphasis of Matter Paragraph
LO3 Auditors express an unmodified opinion when they are able to obtain sufficient appropri-
ate audit evidence to conclude that the financial statements as a whole are free from mate-
Identify the circumstances that
result in audit reports with empha-
rial misstatement. As indicated in the preceding section, under certain circumstances
sis of matter paragraphs added to auditors add an additional paragraph, referred to as an emphasis of matter paragraph, to
reports with unmodified opinions. the report, emphasizing a matter relating to the financial statements or the audit (AICPA
AU 706). This paragraph always follows the opinion paragraph and states that the audi-
tors’ opinion is not modified with respect to this matter.7
Substantial The professional standards require that auditors evaluate whether there is substantial
Doubt about a doubt about the client’s ability to continue as a going concern for a reasonable period
Company’s Going- of time, which is defined as not to exceed one year beyond the date of the financial
statements being audited. Going-concern status is a significant issue for users of finan-
Concern Status
cial statements, because assets and liabilities are normally recorded and classified on the
assumption that the company will continue to operate. Assets, for example, may be pre-
sented at amounts that are significantly greater than their liquidation values.
The professional standards state that although the auditors are not required to per-
form procedures specifically designed to test the going-concern assumption, they must
evaluate the assumption in relation to the results of the normal audit procedures. When
performing risk assessment procedures, the auditors should consider whether there are
events or conditions that indicate that there could be substantial doubt about the entity’s
ability to continue as a going concern. Also, throughout the audit the auditors should
remain alert for audit evidence indicating such substantial doubt.
Conditions that may cause the auditors to question the going-concern assumption include
negative cash flows from operations, defaults on loan agreements, adverse financial ratios,
work stoppages, and legal proceedings. When such conditions or events are identified, the
auditors should gather additional information and consider whether management’s plans
for dealing with the conditions are likely to mitigate the problem. If, after evaluating the
information and management’s plans, the auditors conclude that the substantial doubt is
resolved, they may issue a standard unmodified report. If, on the other hand, substantial
doubt still exists about the company’s ability to continue as a going concern for a period of
one year from the balance sheet date, the auditors should add an emphasis of matter para-
graph to their unmodified opinion or issue a disclaimer of opinion.8 Including an emphasis
of matter paragraph with an unmodified opinion is the most frequent resolution.
The following is an example of an emphasis of matter paragraph relating to substantial
doubt about a company’s ability to continue as a going concern (emphasis added):
Emphasis of Matter
The accompanying consolidated financial statements have been prepared assuming that the
Company will continue as a going concern. As discussed in Note 1 to the consolidated financial
statements, the Company has suffered negative cash flows from operations and has an accumu-
lated deficit, [conditions] that raise substantial doubt about the Company’s ability to continue
as a going concern. Management’s plans in regard to these matters are also described in Note 1.
The consolidated financial statements do not include any adjustments that might result from the
outcome of this uncertainty. Our opinion is not modified with respect to this matter.
7
PCAOB standards require that consistency and going-concern emphasis of matter paragraphs fol-
low the opinion paragraph of the audit report; other emphasis of matter paragraphs may either
precede or follow the opinion paragraph. PCAOB standards also do not require a statement con-
cerning the opinion not being modified. (International Standards of Auditing (ISA) are consistent
with GAAS in this area.)
8
The International Standards on Auditing (ISA 570) state that in rare cases involving multiple mate-
rial uncertainties that are significant to the financial statements the auditor may consider it appro-
priate to issue a disclaimer of opinion. This is consistent with GAAS and PCAOB standards.
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Regardless of whether the auditors decide to add an emphasis of matter paragraph to a

report with an unmodified opinion or to issue a disclaimer of opinion, the auditors should
consider the adequacy of financial statement disclosures that relate to the firm’s going-
concern status. Financial statement disclosures include:
• Pertinent conditions and events giving rise to the substantial doubt and their possible effects.
• Management’s evaluation of the significance of the conditions and effect and manage-
ment’s plans for dealing with them.
• Possible discontinuance of operations.
• Information about the recoverability or classification of recorded asset amounts and
the amounts and classification of liabilities.
When conditions and events indicate that there could be substantial doubt about the
entity’s ability to continue as a going concern, the auditors should document in the work-
ing papers the conditions and events and significant management plans. In addition, they
should document the auditing procedures performed to evaluate management’s plans,
the conclusion about whether substantial doubt exists, and their consideration of the ade-
quacy of financial statement disclosures. If those financial statement disclosures are inad-
equate, a qualified or adverse opinion is appropriate due to the departure from generally
accepted accounting principles.
Recall that this section is entirely based on the client’s “substantial doubt” about the
client’s ability to continue as a going concern. What about the situation in which liquida-
tion of the company is imminent (that is, the company definitely is not a going concern)?
In such a case, using the liquidation basis of accounting is considered following generally
accepted accounting principles. The auditors’ report ordinarily should use an emphasis
of matter paragraph that states that the company has changed the basis of accounting
from the going-concern basis to a liquidation basis. Consequentially, to follow a going-
concern basis of accounting when liquidation is imminent is a departure from GAAP,
which results in an adverse opinion due to its materiality and pervasiveness.
Generally United States auditing standards for both public (PCAOB AS 1) and nonpublic companies
Accepted (ASB AU 708) require that auditors evaluate the client’s current period financial statements
Accounting for consistency of application of accounting principles with the past.9 Which periods should
be considered in this evaluation? Both Auditing Standards Board and PCAOB standards
Principles Not
base that decision on the periods covered by the auditors’ report on the financial statements.
Consistently
Applied • When the auditors are reporting only on the current period, they should evaluate
whether the current-period financial statements are consistent with those of the pre-
ceding period, regardless of whether the preceding period is presented.
• When the auditors are reporting on two or more periods, they should evaluate consis-
tency between such periods and the consistency of such periods with the period prior
thereto if that prior period is presented with the financial statements being reported upon.
When the client makes a change in accounting principles, the nature of, justifica-
tion for, and effect of the change are reported in a note to the financial statements for the
period in which the change is made. The auditors should evaluate the change by deter-
mining whether it meets the following four requirements:
1. The newly adopted principle is generally accepted.
2. The method of accounting for the effect of the change is in conformity with GAAP.
3. The disclosures related to the change are adequate.
4. Management has justified that the new accounting principle is preferable.
9
International Standards on Auditing (ISA 706) allow, but do not require, an emphasis of matter
situation relating to a properly accounted for change in accounting principles.
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When the auditors believe that the new principle meets the above requirements, an
emphasis of matter paragraph is added to the audit report to highlight the lack of con-
sistent application of acceptable accounting principles; but the opinion remains unmodi-
fied. Following is an example of an emphasis of matter paragraph that would follow the
opinion paragraph:
Emphasis of Matter
As discussed in Note 5 to the consolidated financial statements, the Company adopted Statement
of Financial Accounting Standards Update No. XXX, Provide Title, as of December 31, 20X8. Our
opinion is not modified with respect to this matter.
When the auditors believe that the new principle does not meet one or more of the
above requirements, a departure from generally accepted accounting principles exists. In
such a circumstance, the auditors should issue either a qualified or an adverse opinion.
A client’s correction of a material misstatement in previously issued financial state-
ments also results in addition of an emphasis of matter paragraph to the audit report. The
paragraph is only included in the year of correction and includes a statement that the previ-
ously issued financial statements have been restated for correction of a material misstate-
ment and a reference to the entity’s disclosure of the correction in the financial statements.
Among situations that ordinarily do not result in an emphasis of matter paragraph on
consistency are changes in accounting estimates (e.g., changing the life of a fixed asset)
and changes in principles with an immaterial effect (even if the effects are expected to be
material in the future); absent other circumstances, a standard unmodified opinion may
be issued in the year of the change. Finally, because consistency is a between-periods
concept, a consistency modification is not appropriate for a company in the first year of
its existence.
Auditor While the professional standards require auditors to include an emphasis of matter para-
Discretionary graph in the circumstances presented previously, in the following circumstances the audi-
Circumstances tors may elect to include an emphasis of matter paragraph.
That Result in Uncertainties
an Emphasis of Uncertainties are situations in which conclusive audit evidence concerning the ultimate
Matter Paragraph outcome cannot be expected to exist at the time of the audit, since that outcome will occur
in the future. While all financial statements are affected to some extent by uncertainties,
it is only for an uncertainty whose outcome is unusually important that auditors consider
adding an emphasis of matter paragraph: for example, unusually important ongoing liti-
gation or regulatory action in process against the client. The following shows the nature
of an emphasis of matter paragraph describing an uncertainty:
Emphasis of Matter
As discussed in Note X to the financial statements, the company is a defendant in a lawsuit
[briefly describe the nature of the litigation consistently with the Company’s description in the
note to the financial statements]. Our opinion is not modified with respect to this matter.
Adding an emphasis of matter paragraph for matters such as the above is at the discre-
tion of the auditors. The major assumption underlying the inclusion of an emphasis of
matter paragraph is that the matter is adequately disclosed in the notes to the financial
statements. The auditors simply choose to emphasize it. As is the case with other emphasis
of matter paragraphs, a discretionary emphasis paragraph follows the opinion paragraph.
While an unmodified opinion with an emphasis of matter paragraph is the most fre-
quent resolution regarding a particularly important uncertainty, there are situations in
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which a disclaimer may be issued. When multiple uncertainties cause the auditors to
conclude that it is not possible to form an opinion on the financial statements as a whole
due to the interaction and cumulative possible effects of the uncertainties, a disclaimer
may be appropriate.
If a matter such as described above is not adequately disclosed in the financial state-
ments, a departure from GAAP exists; as described later in the chapter, either a qualified
or an adverse opinion is then appropriate.
Additional Circumstances That May Result in an Emphasis of Matter Paragraph.
Auditors also may at their own discretion choose to add an emphasis of matter paragraph
to a report with an unmodified opinion for other circumstances relating to the financial
statements. Examples of such matters include:
• Significant related party transactions described in a note to the financial statements.
• The company is a component of a larger business enterprise.
• Unusually important significant events.
Note that the matter should relate to the financial statements, not to the audit itself
(e.g., adding an emphasis of matter paragraph relating to an audit procedure performed
would not be appropriate).
Group Financial Group financial statements include financial information of a company that is composed
Statements of more than one component. For example, group financial statements may include finan-
cial information of a parent and one or more subsidiaries, or joint ventures. When one
CPA firm audits the entire group, no particular audit reporting complications arise. It
is when one or more components are audited by component auditors other than the
group auditors10 that issues arise about the component auditors’ and group auditors’
responsibility for planning and performing the audit and reporting. Note that this situa-
tion involves two or more CPA firms auditing one year—not different CPA firms audit-
ing each year of comparative financial statements. The most common group audit is one
in which auditors of one firm rely upon the work of auditors who audited a component of
a consolidated entity; for example, the component auditors may have audited one of the
company’s five subsidiaries while the group auditors audited the other four as well as the
consolidation of the client’s financial statements. The issue here is auditor responsibility
relating to the overall consolidated entity—the group financial statements.
When the component auditors are involved in an audit, the group auditors should
determine whether sufficient appropriate audit evidence can reasonably be expected to be
obtained regarding the overall group controls, the consolidation process, and the financial
information of the components. In addition, the group engagement team should obtain an
understanding of:
• Whether the component auditors are competent and understand and will comply with
all ethical requirements, particularly independence.
• The extent to which the group engagement team will be involved with the component
auditors.
• Whether the group engagement team will be able to obtain necessary information on
the consolidation process from the component auditors.
• Whether the component auditors operate in a regulatory environment that actively
oversees auditors.
10
GAAS (ASB AU 600) and International Standards of Auditing (ISA 600) use the terms “group
engagement partner” and “group engagement team”—for simplicity sake, in parts of the discussion,
we will also use the term “group auditors.” Also, previously, the group auditors were referred to as
the “principal auditors” and the component auditors as the “other auditors.” The terms “principal
auditors” and “other auditors” are still used in PCAOB auditing standards (PCAOB AU 543).
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The group auditors should communicate with the component auditors. Specifically,
the group auditors should (1) inform the component auditors of how their work will be
used, (2) communicate ethical requirements, (3) provide a list of related parties, and (4)
identify significant risk of misstatements of the group financial statements. Subsequently,
the component auditors should communicate matters relevant to the group auditors’ con-
clusions on the group audit.
If the group auditors encounter problems in performing the above procedures, they
should obtain sufficient appropriate audit evidence without using the work of the compo-
nent auditors. In addition, the group auditors will not use work of the component auditors
when the component auditors’ work is unlikely to be completed in time to meet group
auditors’ requirements, or when differences exist in auditing standards applied by the
component auditors.
The group auditors should establish an overall group audit strategy and develop a group
audit plan. In developing the group audit plan, the group auditors should determine whether
the work of the component auditors will be referred to in the group audit report. Under
GAAS and PCAOB standards, the group auditors have two basic reporting alternatives:11
1. Make reference to the component auditors. When the group auditors make reference
to the work performed by the component auditors, they communicate that the source
of the group auditors’ audit evidence on the component is obtained through the com-
ponent auditors. In essence it divides the responsibility for the engagement among
the participating CPA firms. Historically, this type of report has often been called a
shared responsibility opinion, even though it is signed only by the group audi-
tors. When the group auditors decide to make reference to the component auditors,
they should perform the procedures described previously relating to the availability
of sufficient appropriate audit evidence and characteristics of the component auditors.
In addition, the group auditors should read the component’s financial statements and
the component auditors’ report on those statements to identify significant findings and
issues. If considered necessary, the group auditors should communicate with the com-
ponent auditors. Also, the group auditors may only make reference to the component
auditors (a) when the component’s financial statements are prepared using the same
financial reporting framework (e.g., GAAP) as the group, and (b) the component audi-
tors have performed an audit and issued an audit report that is not restricted as to use.
A shared responsibility opinion indicates the portion of the engagement performed
by the component auditors in terms of dollars or percentages in the Auditors’ Respon-
sibility section and refers to the component auditors in the Opinion section. The actual
report modifications are as presented below.
our audits. We did not audit the financial statements of B Company, a wholly owned subsid-
iary, which statements reflect total assets and revenues constituting 20 percent and 22 percent,
respectively, of the related consolidated totals. Those statements were audited by other auditors
whose report has been furnished to us, and our opinion, insofar as it relates to the amounts
included for B Company, is based solely on the report of the other auditors. We conducted our
audits in accordance with auditing standards generally accepted in the United States of America.
Those standards require that we plan and perform the audit to obtain reasonable assurance
about whether the consolidated financial statements are free of material misstatement.
An audit involves performing procedures to obtain audit evidence about the amounts and
disclosures in the consolidated financial statements. The procedures selected depend on the
auditors’ judgment, including the assessment of the risks of material misstatement of the con-
solidated financial statements, whether due to fraud or error. In making those risk assessments,
the auditors consider internal control relevant to the entity’s preparation and fair presentation
11
International Standards on Auditing (ISA 600) do not permit the audit report to make reference
to a component auditors unless required by law or regulation.
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of the consolidated financial statements in order to design audit procedures that are appro-
priate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness
of the entity’s internal control. An audit also includes evaluating the appropriateness of account-
ing policies used and the reasonableness of significant accounting estimates made by manage-
ment, as well as evaluating the overall presentation of the consolidated financial statements.
Opinion
In our opinion, based on our audit and the report of the other auditors, the consolidated finan-
cial statements referred to above present fairly, in all material respects, the financial position of
ABC Company and its subsidiaries as of December 31, 20X1 and 20X0, and the results of their
operations and their cash flows for the years then ended in accordance with accounting prin-
ciples generally accepted in the United States of America.
The additional wording in the illustration is not a qualification, but rather an indication
of the divided responsibility between the auditors who conducted the audits of the vari-
ous portions of the overall financial statements.12
What if the component auditors modify the opinion of their report on the component?
Are the group auditors required to qualify the report on the consolidated financial state-
ments? The answer to this question depends on the materiality of the matter. The consoli-
dated financial statements ordinarily will have much larger amounts and totals than those
of the component. Matters that were material to the component’s financial statements
may be quite insignificant to the consolidated entity. To determine whether a qualifica-
tion is in order, the group auditors must evaluate the materiality of the matter in relation
to the consolidated financial statements.
2. Make no reference to the component auditors. If the group auditors make no reference
in their report to the portions of the engagement performed by the component audi-
tors, they assume responsibility for the entire audit. This approach is usually followed
when the component auditors are well known or when the group auditors are respon-
sible for hiring the component auditors. Also, when difficulties arise relating to the
component auditors’ competence or work, the group auditors may decide to audit the
component and not refer to the component auditors. If the group auditors elect to make
no reference, they will issue the standard auditors’ report with no additional wording.
When the group auditors decide not to make reference to the work of the component
auditors, they must perform certain additional audit procedures. First, the group auditors
should evaluate the appropriateness of performance materiality at the component level.
The additional required procedures relating to the component depend upon whether that
component is considered to be a significant component; a significant component is one
identified by the group engagement team as having financial significance to the group
or, due to its nature, is likely to include significant risks of material misstatement of the
group financial statements. Figure 17.1 summarizes the audit work that ordinarily must
be performed for components.
Group auditors are never forced to rely on the work of other auditors. Instead, they
may insist upon personally auditing any aspect of the client’s operations. If the client
refuses to permit them to do so, the auditors may regard this as a scope limitation
and, depending upon materiality, issue a qualified report or a disclaimer of opinion. As a
practical matter, opinions are seldom modified for this reason. Satisfactory arrangements
about who will audit the various aspects of a client’s business normally will be worked
out before the audit begins.
12
Another acceptable, although less frequently used, option allows the group auditor to obtain
the permission of the component auditors to explicitly use that auditors’ name in the audit report.
In such circumstances the component auditors’ report must also be presented with the report of
the group auditors.
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FIGURE 17.1 Component Nature Audit Procedures

Additional Procedures
When Not Making Not significant The group engagement team should perform analytical
Reference to the procedures at the group level. Audit additional components
Component Auditors if sufficient appropriate audit evidence has not been obtained.
Significant due to its 1. The group auditors or component auditors should perform
individual financial an audit of the component, adapted as necessary to the
significance to the needs of the group engagement team, using the materiality
group of the component.
2. The group engagement team should be involved in the risk
assessment and should:
• Discuss with the component auditors or component
management the component’s business activities of
significance to the group.
• Discuss with the component auditors the susceptibility of
the component to material misstatement.
• Review the component auditors’ documentation of
identified significant risks of material misstatement of
the group financial statements.
Significant because it 1. The group auditors or the component auditors:

is likely to include • Should perform an audit of the component, adapted as
significant risks of necessary to the needs of the group engagement team,
material misstate- using the materiality of the component.
ment of the group • Should audit one or more component account balances,
financial statements classes of transactions, or disclosures that relate to the
significant risks.
• Should perform specified audit procedures relating to
the likely significant risks of material misstatement of
the group financial statements.
2. Requirement 2 above.
Figure 17.2 summarizes important points related to emphasis of matter paragraphs and
group audits.
FIGURE 17.2 Summary of Emphasis of Matter Paragraphs and Group Audits

Matter Giving Risk to Emphasis Effect on Audit Report If Matter Effect on Audit Report If the
of Matter Paragraph Is Properly Presented Matter Is Improperly Presented
in Financial Statements
Going Concern—Substantial doubt Emphasis of matter paragraph A departure from GAAP is involved
about ability to remain a going added after the opinion and the auditors modify the
concern paragraph. (Going concern opinion paragraph to either a
Consistency—GAAP not consistently and uncertainties may also qualified or adverse opinion
applied lead to disclaimers of opinion.) and add a basis for modification
Auditor Discretionary—Circumstances paragraph preceding the opin-
in which the auditors may add an ion paragraph.
emphasis of matter paragraph
(e.g., significant related party
transactions, significant events,
or uncertainty)
Group Audits The component auditors are Not applicable because it is an
referred to when the group auditor reporting concern.
auditors do not take responsibility
for the component auditors’
work. If the group auditors take
responsibility, no modification
of the audit report is necessary.
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Modified Opinions
LO4 Modified opinions are required in two circumstances:
Identify the circumstances that • Materially misstated financial statements (i.e., a “departure from GAAP”)—The
result in modified audit report auditors conclude that the financial statements as a whole are materially misstated.
opinions.
• Inability to obtain sufficient appropriate audit evidence (i.e., a “scope limitation”)—
The auditors are unable to obtain sufficient appropriate audit evidence to conclude that
the financial statements as a whole are free from material misstatements (ASB AU
705; PCAOB AU 508).
Recall from earlier in the chapter that there are three types of modified opinions: quali-
fied opinions, adverse opinions, and disclaimers of opinion. Figure 17.3 describes the
situations in which each type of modified opinion is issued.
As indicated in Figure 17.3, materially misstated financial statements result in either a
qualified opinion or an adverse opinion. Similarly, an inability to obtain sufficient appro-
priate audit evidence leads to either a qualified opinion or a disclaimer opinion based on
the possible effects on the financial statements of undetected misstatements. In both situ-
ations the decision is based on whether misstatements are both material and pervasive.
In the context of misstatements, pervasive is the term used to describe the effects on the
financial statements of misstatements (departures from GAAP) or the possible effects on
the financial statements of misstatements (scope limitations). Effects of misstatements become
pervasive when, in the auditors’ judgment, they meet one or more of the following three criteria:
• They are not confined to specific elements, accounts, or items of the financial statements.
• If confined, they represent or could represent a substantial proportion of the financial
statements.
• In relation to disclosures, they are fundamental to users’ understanding of the financial
statements.
When a modified opinion is issued, the report includes a basis for modification para-
graph prior to the opinion paragraph. The following sections discuss modified opinions
(1) for misstated financial statements and (2) for the inability to obtain sufficient appro-
priate audit evidence.
Materially The auditors sometimes do not agree with the accounting principles used in preparing
Misstated Financial the financial statements—that is, they believe that the financial statements depart from
Statements GAAP. As indicated in Figure 17.3, they must consider the materiality of the effects
of any departure from GAAP to determine the appropriate type of audit report to issue.
(“Departures from
When the effects of the departures are immaterial, an unmodified opinion may be issued:
GAAP”) when the effects are material, the auditors must issue either a qualified opinion or an
adverse opinion based on the pervasiveness of the misstatement.
FIGURE 17.3 Auditors’ Judgment about the Pervasiveness of the

Modified Audit Opinions
Effects or Possible Effects on the Financial Statements
Not Material
Nature of Matter Giving (accordingly, Material but Material
Rise to the Modification also not pervasive) not Pervasive and Pervasive
Materially Misstated Unmodified Qualified Adverse
Financial Statements
(Departure from GAAP)
Inability to Obtain Unmodified Qualified Disclaimer
Sufficient Appropriate
Audit Evidence
(Scope Limitation)
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The distinction between the effects of departures from generally accepted account-
ing principles that are material but not pervasive and those that are material and
pervasive is a matter of professional judgment. In the discussions that follow, it will
not be practical to present sufficient detail for readers to make these judgments. There-
fore, we will either (1) use the terms material, but not pervasive and material and
pervasive, or (2) use terms from the criteria for when a misstatement is pervasive,
such as “a substantial proportion of the financial statements” or “fundamental to users’
understanding.”
When the report is qualified for a departure from GAAP, the modification involves
adding a basis for modification paragraph immediately above the opinion paragraph and
qualifying the opinion paragraph. The opinion section should have a heading indicating
the nature of the opinion and including the phrase except for the effects of the matter(s)
described in the Basis for Qualified Opinion paragraph.13 The following is an example
of basis for modification and opinion paragraphs of an audit report qualified for a depar-
ture from generally accepted accounting principles. The report’s other paragraphs would
contain standard wording.
Basis for Qualified Opinion

The company has excluded from property and debt in the accompanying balance sheets certain
lease obligations that, in our opinion, should be capitalized in order to conform with account-
ing principles generally accepted in the United States of America. If these lease obligations
were capitalized, property would be increased by $15,000,000, long-term debt by $14,500,000,
and retained earnings by $500,000 as of December 31, 20X8. Additionally, net income would
be increased by $500,000 and earnings per share would be increased by $1.22 for the year
then ended.
Qualified Opinion
In our opinion, except for the effects of not capitalizing certain lease obligations as discussed in
the Basis for Qualified Opinion paragraph, the financial statements referred to above present
fairly, in all material respects, the financial position of Wend Company as of December 31,20X8,
and the results of its operations and its cash flows for the year then ended in conformity with
accounting principles generally accepted in the United States of America.
If the material misstatement is considered pervasive, an adverse opinion is appro-

priate. An adverse opinion is the opposite of an unmodified opinion; it states that the
financial statements do not present fairly the financial position, results of operations, and
cash flows. When the auditors express an adverse opinion, they should disclose in a sepa-
rate basis for modification paragraph similar to that of a report with a qualified opinion
as illustrated above (although a pervasiveness of misstatement may require a longer para-
graph). An illustration of an adverse opinion paragraph follows:
Adverse Opinion
In our opinion, because of the significance of the matter discussed in the Basis for Adverse Opin-
ion paragraph, the consolidated financial statements referred to above do not express fairly the
financial position of Wend Company as of December 31, 20X8, and the results of its operations
and its cash flows for the year then ended.
A material misstatement may exist due to the omission of information; that is,
disclosures required by GAAP for a fair presentation may have been omitted. In such
a circumstance, if, after communicating with those charged with governance, the
13
International Standards on Auditing (ISA 705) follow the same approach. PCAOB standards are
similar, but rather than “Basis for Modification Opinion paragraph” the phrase used is “preceding
paragraph.” The PCAOB also follows this approach for adverse opinions and disclaimers of opinion.
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information is still considered necessary and omitted, the auditors will issue a qualified or
adverse opinion based upon the pervasiveness of the resulting misstatement.14
The professional standards require the auditors to describe in the basis for modification
paragraph the nature of the omitted information and include the omitted information if it
is practicable to do so. Practicable, as used here, means that the information is reasonably
obtainable from the accounts and records and that in providing the information in the
report the auditors do not assume the position of a preparer of the financial statements.
For example, the auditors would not be expected to prepare a basic financial statement
or segment information and include it in the auditors’ report when management omits
such information. Also, disclosing the information in the basis of modification paragraph
would not be practicable if the information:
• Has not been prepared by management.
• Is otherwise not readily available.
• In the auditors’ judgment would be unduly voluminous in relation to the auditors’ report.
Ordinarily, a client that is reluctant to make a particular disclosure would rather dis-
close the information in a note than have it highlighted in the auditors’ report. There-
fore, very few auditors’ reports actually are qualified because of inadequate disclosure.
Instead, the requirements of the professional standards usually convince the client to
include the necessary disclosure among the notes to the financial statements.15
Inability to Limitations on the scope of an audit may create a situation in which the auditors are
Obtain Sufficient unable to obtain sufficient appropriate audit evidence. Such limitations may occur due to:
Appropriate Audit • Circumstances beyond the control of the client (e.g., important accounting records
Evidence (Scope were destroyed),
Limitation) • Circumstances relating to the nature and timing of the auditors’ work (e.g., the audi-
tors are hired too late to observe the client’s beginning inventory16).
• The client (e.g., the client’s refusal to allow the auditors to send confirmations to
customers).
Client-imposed limitations are very significant since they may have other implications
for the audit, such as for the auditors’ assessment of fraud risks and consideration of
whether to continue the engagement or to withdraw. If a management imposes a imita-
tion, the auditors should communicate the limitation to those charged with governance.
When a scope limitation is encountered, the auditors attempt to obtain sufficient appro-
priate audit evidence by performing alternative procedures. If those procedures provide
14
As indicated in footnote 1, GAAP require that when a balance sheet and an income statement
are presented, a statement of cash flows should also be presented and its omission is a departure
from GAAP. Historically this has led to a qualified opinion, although the current GAAS standards
are silent on whether a qualified opinion or an adverse opinion standard should be issued. PCAOB
standards, in this case the superseded GAAS standards that were adopted by the PCAOB as interim
standards, still recommend a qualified opinion. International Auditing Standards do not explicitly
address omission of the statement of cash flows.
15
Rule 203 of the AICPA Code of Professional Conduct recognizes that in unusual circumstances a
departure from accounting principles may be justified. However, the FASB does not allow such a
departure from authoritative body pronouncements and this type of report is not generally issued.
Under a financial reporting framework that allows such a departure, when the auditors agree with
such departure, the auditors may issue a report with an unmodified opinion, but must disclose the
departure in an emphasis of matter paragraph after the opinion paragraph. When the auditors do
not agree that the departure is justified, a qualified or an adverse opinion is appropriate. Note that
it is very seldom that the auditors would consider such a departure as justified under any financial
reporting framework.
16
Note that, even though this may be the “fault” of the client, it is not considered a limitation
imposed by management because the client is not refusing to allow the auditors to perform a
procedure that is possible to perform.
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the required evidence, no report modification is necessary. If they do not, a decision

needs to be made about whether a qualified opinion is necessary or whether the possible
effects on the financial statements are so pervasive as to require a disclaimer of opinion.
If the auditors decide that the possible effects on the financial statements of undetected
misstatements, if any, could be material but not pervasive, a qualified opinion is appro-
priate. The report will include a Basis for Modification Paragraph and a modification of
the opinion paragraph as follows (the remainder of the report uses the standard wording):
Basis for Qualified Opinion

We were unable to obtain audited financial statements supporting the Company’s investment in
a foreign affiliate stated at $20,500,000, or its equity in earnings of that affiliate of $6,250,450,
which is included in net income, as described in Note 8 to the financial statements; nor were we
able to satisfy ourselves as to the carrying value of the investment in the foreign affiliate or the
equity in earnings by other auditing procedures.
Qualified Opinion
In our opinion, except for the effects of such adjustments, if any, as might have been determined
to be necessary had we been able to examine evidence regarding the foreign affiliate investment
and earnings, the financial statements referred to above present fairly, in all material respects,
the financial position of XYZ Company as of December 31, 20XX, and the results of its operations
and its cash flows for the year then ended in conformity with accounting principles generally
accepted in the United States of America.
Notice in the opinion paragraph that the qualification is worded as being due to the possi-
ble effects of the matter(s) on the financial statements, and not to the scope limitation itself.
When the auditors conclude that the possible effects on the financial statements could
be both material and pervasive, a disclaimer of opinion is appropriate. A disclaimer of
opinion is no opinion. Auditors issue a disclaimer whenever they are unable to form an
opinion or have not formed an opinion about the fairness of presentation of the financial
statements. The following is an example of the opinion paragraph when a disclaimer of
opinion is issued (the basis for modification paragraph is similar to that presented for a
qualified opinion):
Disclaimer of Opinion
Because of the significance of the matter described in the Basis for Disclaimer of Opinion para-
graph, we have not been able to obtain sufficient appropriate audit evidence to provide a basis
for an audit opinion. Accordingly, we do not express an opinion on these financial statements.
Scope Limitations versus Uncertainties

It is important to be able to distinguish between inability to obtain sufficient appropriate
audit evidence (a scope limitation) and an uncertainty. This is because a scope limitation
results in either a qualified opinion or disclaimer of opinion, while an uncertainty ordi-
narily results in a report with an unmodified opinion and an emphasis of matter paragraph
(or, less frequently, a disclaimer of opinion).
An inability to obtain sufficient appropriate audit evidence (a scope limitation) occurs
in situations in which audit evidence should be available and is not—due to circum-
stances beyond the control of the organization, circumstances dealing with the timing of
the auditors’ work, or limitations imposed by management. Alternatively, an uncertainty
involves a situation that is expected to be resolved at a future date, at which time conclu-
sive audit evidence concerning its outcome would be expected to become available.
Complicating the matter is the fact that a situation involving an uncertainty may also
involve a scope limitation. As an example, assume that an uncertainty exists relating
to the future outcome of a lawsuit against the company. Also assume that the lawyer
engaged by the client who has devoted substantive attention to the matter refuses to
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provide appropriate information on the uncertainty. Here the lawyer’s refusal to reply
may result in a lack of sufficient appropriate audit evidence (a scope limitation) relating
to the litigation (an uncertainty). The appropriate audit opinion would be either qualified
or a disclaimer of opinion.
A Disclaimers Is Not an Alternative to an Adverse Opinion
A disclaimer cannot be issued when the auditors have formed an opinion on the financial
statements. For example, if the auditors have already formed an opinion that the financial
statements are materially and pervasively misstated, an adverse opinion is appropriate.
A disclaimer of opinion cannot be used as a way to avoid expressing an adverse opin-
ion. In fact, even when auditors issue a disclaimer of opinion, they should express in the
basis for modification paragraphs of their report any and all material reservations they
have concerning the financial statements. These reservations would include any material
departures from generally accepted accounting principles, including inadequate disclo-
sure. In short, the issuance of a disclaimer can never be used to avoid warning financial
statement users about problems that the auditors know to exist in the financial statements.
Summary of Figure 17.4 summarizes the types of auditors’ reports that should be issued under differ-
Auditors’ Reports ent conditions.
Additional Reporting Issues

Two or An audit report may be qualified for two or more matters. For example, an audit report
More Report may include a modification for a scope limitation and for a departure from generally
Modifications accepted accounting principles. The wording of such a report would include the appropri-
ate qualifying language and basis for modification for both types of qualifications.
When there are several matters requiring the qualification of an opinion, the auditors
should consider the cumulative effects of those matters. If the effect involves material
FIGURE 17.4 Summary of Auditors’ Reports

Unmodified or
Modified Opinion?
Unmodified Opinion Modified Opinion
Going GAAP not Auditor Discretionary Group GAAP Scope

Concern* Consistent Circumstances** Audit Departure Limitation
Material Qualified Qualified

“Except for” “Except for”
Unmodified with Emphasis

of Matter Paragraph
Material and
Pervasive Adverse Disclaimer
*
The auditors may decide to issue a disclaimer in this situation.
**
Examples include an uncertainty relating to the outcome of an unusually important event, a major catastrophe, related party transactions, unusually
important subsequent events. Also, note that in circumstances involving multiple uncertainties the auditors may issue a disclaimer of opinion.
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and pervasive known misstatements, an adverse opinion would be appropriate, not a

qualified opinion.
When several matters requiring modification of the audit report exist, a separate
emphasis of matter and basis for modification paragraphs will ordinarily refer to each
matter. As an example, consider the audit report for a company in extremely weak finan-
cial condition and with financial statements that include a material departure from gener-
ally accepted accounting principles. The audit report would likely include a emphasis of
matter paragraph describing substantial doubt about the ability of the company to con-
tinue as a going concern, and a basis for modification paragraph and opinion modification
relating to the departure from generally accepted accounting principles.
Reporting on As indicated previously, many companies present with the current year’s financial state-
Comparative ments’ comparative financial statements for one or more prior years. When compara-
Financial tive financial statements are presented by the client company, the auditors’ report should
cover the current year’s financial statements as well as those for prior periods that were
Statements
audited by their firm.
The auditors may express different opinions on the financial statements of different
LO5 years. In addition, auditors should update their reports for all prior periods presented for
Describe the auditors’ responsibil- comparative purposes. Updating the report means either reexpressing the opinion origi-
ities for reporting on comparative nally issued or, depending upon the circumstances, revising the opinion from that origi-
nally issued. A different opinion on the prior-period financial statements may be warranted
because new information may have come to light that causes the auditors to alter their
original opinion. For example, the client may revise previously issued financial state-
ments to correct a departure from GAAP, resulting in a situation in which a qualified
opinion is no longer warranted.
In some situations, the current auditors have not audited the prior period financial state-
ments, because those financial statements are either unaudited or audited by predecessor
auditors. If the financial statements of prior comparative periods are unaudited, this fact
should be indicated on the applicable financial statements and the auditors’ report should
include a disclaimer of opinion on those statements. If the prior-period financial statements
were audited by predecessor auditors, the current (successor) auditors’ opinion will cover
only the period or periods that they have audited. For the financial statements audited by
the predecessor auditors, there are two reporting options. First, the report of the predeces-
sor auditors may be reissued by them bearing its original date. Before reissuing the report,
the predecessor auditors should read the subsequent period financial statements, compare
them with the prior-period financial statements, and obtain representation letters from both
management and the successor auditors in essence indicating that they are not aware of
information that would indicate that the financial statements are incorrect or improper.
The second reporting option is to have the successor auditors refer to the report of the
other auditors by indicating in an other matter section of the current auditors’ report: (1)
that the prior-period statements were audited by predecessor auditors, (2) the type of opin-
ion expressed by the predecessor and, if the opinion was modified, the reasons therefore,
(3) the nature of any emphasis of matter paragraph or other matter paragraph included in
the predecessor auditors’ report and (4) the date of the predecessor auditors’ report.
An example of an other matter paragraph of a report in which the predecessor audi-
tors’ report on the prior year was qualified but not presented in the current year is illus-
trated below, with the explanatory language emphasized.
Other Matter
The financial statements of XYZ Company for the year ended December 31, 20X7, were audited
by a predecessor auditing firm whose opinion, dated March 1, 20X8, on those statements was
qualified as being presented fairly except for the effects on the 20X7 statements of the adjust-
ments pertaining to the valuation of inventory, as discussed in Note X to the financial statements.
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Different Opinions The professional standards provide an illustration of a situation in which auditors may
on Different provide differing opinions on the respective financial statements. The situation involves
Statements auditors being retained after the client has taken its beginning inventory count and the
auditors being unable to obtain sufficient appropriate audit evidence relating to that begin-
ning inventory. Here the auditors satisfy themselves as to the amounts in the year-end
balance sheet, but they are unable to satisfy themselves as to the statements of income,
retained earnings, and cash flows due to the effects on these statements of the beginning
inventory. Thus, the auditors may issue an unmodified opinion on the balance sheet and a
disclaimer of opinion on the other financial statements.
Alerting Readers Audit reports on a complete set of general-purpose financial statements (e.g., those pre-
about the pared following GAAP) ordinarily are not restricted as to use or users. Indeed, for public
Intended Use companies the SEC requires this to be the case. However, nothing in GAAS precludes an
auditor from “restricting use,” that is indicating that the report is only for use by speci-
of the Auditors’
fied users. As an example, the auditors might indicate that an audit report of a nonpublic
Report company is restricted to use by management, the board of directors, and shareholders.
This, however, is seldom done and must be a part of the understanding with the client.
When a restriction on use is included in an audit report, it is included in an other matter
paragraph that:
• Indicates that the report is intended solely for the information and use of the specified
parties indicated in the audit report.
• Identifies the specified parties.
• Indicates that the report is not intended to be used by anyone other than the specified
parties.17
Reports to the SEC Most publicly owned corporations are subject to the financial reporting requirements
of the federal securities laws, administered by the Securities and Exchange Commis-
sion (SEC). Many of the reports, or forms, filed with the SEC include audited financial
statements for one or more years. Among the most important of these forms are the
following:
• Forms S-l through S-11. These are the “registration statements” for companies plan-
ning to issue securities to the public.
• Forms SB-1 and SB-2. These are more simplified registration forms for small businesses.
• Form 8-K. This is a “current report” filed for any time in which significant events
occur for a company subject to the Securities Exchange Act of 1934. If the significant
event is a business combination, audited financial statements of the acquired company
often are required in the current report. An 8-K report is also used to notify the SEC of
a change in auditors.
• Form 10-Q. This form is filed quarterly with the SEC by publicly owned companies. It
contains unaudited financial information. The company’s auditors perform reviews of
this information, but their work is substantially less in scope than an audit.
• Form I0-K. This report is filed annually with the SEC by publicly owned companies.
The report includes audited financial statements and other detailed financial informa-
tion. It also includes management and the auditors’ reports on internal controls over
financial reporting.
17
In some circumstances restriction of particular auditor reports is required. As we discussed in
Chapter 7, two reports arising from an audit, communicating internal control related matters and
the auditor’s communication with those charged with governance, result in reports alerting readers
as to intended use. Also, as discussed in Chapter 19, special purpose financial statements prepared
in accordance with a contractual or regulatory basis of accounting must be restricted.
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Auditors dealing with these reports should be well versed on the requirements of each
form, as well as in the provisions of the SEC’s Regulation S-X, which governs the form
and content of financial statements filed with the various forms.
The SEC, in conjunction with the Public Company Accounting Oversight Board
(PCAOB), has the power to enforce a high quality of audit work on financial statements
of public companies. The federal securities laws provide both civil and criminal penalties
for any person, including auditors, responsible for misrepresentations of fact in audited
statements filed with the SEC. The auditors’ legal liability under the federal securities
acts is discussed in Chapter 4.
Chapter This chapter explained the different types of reports that auditors issue to indicate the
Summary character of their audit and the degree of responsibility they are taking. To summarize:
1. Audit reports included in this chapter include those with unmodified opinions and
those with modified opinions. A report with an unmodified opinion may be “standard
in form,” or include emphasis of matter or other matter paragraph. The three types of
modified opinions are qualified, adverse, and disclaimer of opinion.
2. A report with an unmodified opinion and standard in form includes an introductory para-
graph, sections describing management and auditor responsibilities, and an opinion sec-
tion. The report has a title that includes the word independent, is addressed to the company
whose financial statements are being audited or to its board of directors or stockholders,
and is signed with the name of the CPA firm. The public company audit report includes
similar but less detailed information on management and auditor responsibilities.
3. An emphasis of matter paragraph is included following an unmodified opinion para-
graph to emphasize matters described in the audited financial statements. Circum-
stances in which emphasis of matter paragraphs are required include substantial
doubt about a client’s ability to remain a going concern and inconsistency in the
application of GAAP. Auditors may choose to add an emphasis of matter paragraph
in a variety of circumstances involving matters properly described in the financial
statements that they believe merit emphasis (e.g., related party transactions, unusu-
ally important significant events, and uncertainties).
4. An other matter paragraph is included following an unmodified opinion paragraph to
emphasize something other than information described in the audited financial state-
ments. Other matter paragraphs are included when required supplementary informa-
tion is present and sometimes regarding information included in a document with
audited financial statements; other matter paragraphs are also used when an audit
report’s use is to be restricted to certain parties. Group financial statements describe
the situation when multiple audit firms are involved in an audit and the group audi-
tors do not wish to take responsibility for a component auditors’ work.
5. Modified opinions are issued when material departures from GAAP exist and when
a scope limitation is involved. Figure 17.2 provides details on the appropriate modi-
fications required for each of these types of reports.
6. When a client presents comparative financial statements for one or more prior peri-
ods with the current-period financial statements, the auditors should make certain
that all periods are covered by an audit report. Audit reports on prior periods should
be updated based on any new information that might affect the auditors’ opinion.
When predecessor auditors have audited the prior-period financial statements, the
current (successor) auditors may summarize the predecessor auditors’ opinion in the
current-year audit report, or the client may arrange to have the predecessor auditors
reissue their audit report.
7. Auditors of publicly held corporations must understand the various reporting require-
ments of the SEC. The reports filed with the SEC must be in accordance with Regula-
tion S-X, which governs the form and content of the corporation’s financial statements.
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Insert pg nos. in
682 Chapter Seventeen pg proof
Key Terms Adverse opinion (xxx) An opinion that the financial statements do not fairly present financial position,
results of operations, and cash flows in conformity with generally accepted accounting principles. This
Introduced or situation occurs when the auditors believe that departures from GAAP are both material and pervasive.
Emphasized in Auditors’ Responsibility section (xxx) The section of the audit report that sets forth the auditors’
Chapter 17 responsibilities and the scope of the audit.
Basis for modification paragraph (XXX) A paragraph added to a report with a modified opinion
(qualified, adverse, or disclaimer) that provides a description of the matter giving rise to the modification.
The paragraph should be placed immediately before the opinion paragraph in the auditors’ report and
use the heading “Basis for Qualified Opinion,” “Basis for Averse Opinion,” or “Basis for Disclaimer of
Opinion,” as appropriate.
Change in accounting principle (xxx) Changes in accounting principles and reporting entities result
in an emphasis of matter paragraph being added to the auditors’ report.
Comparative financial statements (xxx) A complete set of financial statements for one or more prior
periods included for comparison with the financial statements of the current period.
Component auditors (xxx) Auditors that audit one or more components of a group of entities that
provide consolidated financial statements.
Disclaimer of opinion (xxx) A form of report in which the auditors state that they do not express an
opinion on the financial statements.
Emphasis of matter paragraph (xxx) A paragraph included in the auditors’ report that is required
by GAAS or is included at the auditors’ discretion, and that refers to a matter appropriately presented
or disclosed in the financial statements that, in the auditors’ judgment, is of such importance that it is
fundamental to users’ understanding of the financial statements (e.g., a lack of consistent application of
GAAP, substantial doubt about an entity’s ability to continue as a going concern).
Explanatory language (xxx) A paragraph inserted in an auditors’ report to explain a matter or
to describe the reasons for giving an opinion that is other than unmodified. This term is still used in
PCAOB standards, but has been replaced in AICPA standards by emphasis of matter paragraph and
other matter paragraph.
Financial reporting framework (xxx) A set of criteria used to determine measurement, recognition,
presentation, and disclosure of all material items appearing in the financial statements: for example,
accounting principles generally accepted in the United States of America, International Financial
Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB), or a
special purpose framework (discussed in Chapter 19). An “applicable financial reporting framework” is
the framework adopted by management of the company being audited in a particular situation.
General-purpose framework (xxx) A financial reporting framework designed to meet the common
financial information needs of a wide range of users (e.g., GAAP, International Financial Reporting
Standards).
Group auditors (xxx) Auditors that are responsible for issuing the audit report on the audit of a group
of components (subsidiaries). date as equivalent to that used for audits of nonpublic companies (the date
on which sufficient appropriate audit evidence has been gathered and evaluated).
Material (xxx) Being of substantial importance. Significant enough to affect evaluations or decisions by
users of financial statements. Information that should be disclosed in order for the financial statements to
constitute a fair presentation. Determining what is material involves both quantitative and qualitative criteria.
Opinion Section (xxx) The paragraph of an auditors’ report that communicates the degree of
responsibility that the auditors are taking for the financial statements.
Other matter paragraph (XXX) A paragraph included in the auditors’ report that is required by
GAAS or is included at the auditors’ discretion, and that refers to a matter other than those presented or
disclosed in the financial statements that, in the auditors’ judgment, is relevant to users’ understanding
of the audit, the auditors’ responsibilities, or the auditors’ report.
Pervasive (xxx) A term used, in the context of misstatements, to describe the effects on the financial
statements of misstatements or the possible effects on the financial statements of misstatements, if any,
that are undetected due to an inability to obtain sufficient appropriate audit evidence. Pervasive effects
on the financial statements are those that, in the auditors’ judgment:
• Are not confined to specific elements, accounts, or items of the financial statements.
• If confined, represent or could represent a substantial proportion of the financial statements.
• In relation to disclosures, are fundamental to users’ understanding of the financial statements.
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Principal auditors (xxx) The term previously used by the AICPA to describe the group auditors. This
term is still used in PCAOB standards.
Qualified opinion (xxx) A modification of the auditors’ standard report, employing a clause such as
except for to limit the auditors’ opinion on the financial statements. A qualified opinion indicates that,
except for the effects of some limitation on the scope of the audit or some departure from generally
accepted accounting principles, the financial statements are fairly presented.
Scope limitation (xxx) A restriction that prevents the auditors from being able to apply all of the audit
procedures that they consider necessary in the circumstances. Scope limitations may be client imposed
or may be imposed by other circumstances.
Shared responsibility opinion (xxx) An auditors’ report in which the principal auditors decide to
share responsibility with other auditors who have audited some segment of the client’s business. The
sharing of responsibility is done by making reference to the other auditors. Making reference is not, in
itself, a qualification of the auditors’ report.
Standard report (xxx) The “standard wording” of an unmodified auditors’ report, not including
such modifications as emphasis of matter, substantial doubt about going-concern status, a change in
accounting principle, departures from official GAAP, or a group audit (shared responsibility opinion).
Unmodified opinion (xxx) The opinion expressed by the auditors when they conclude that the
financial statements are prepared, in all material respects, in accordance with the applicable financial
reporting framework (e.g., GAAP).
Review 17–1. Identify the sections of the standard audit report for a nonpublic company.
17–2. What is the function of notes to financial statements?
Questions
17–3. List three primary differences between the audit report for nonpublic entities and the one for
public entities.
17–4. Comment on whether you agree with the following and why: GAAP and GAAS represent two
frequently used financial reporting frameworks.
17–5. Provide a list of the types of unmodified and modified audit opinions.
17–6. Howard Green, a partner with Cary, Loeb, & Co., and his audit team have completed the audit
of Baker Manufacturing. Determine the proper date of the audit report.
• December 31, 20X0: Baker’s year-end.
• February 15, 20X1: Green completed audit procedures performed at Baker’s location.
• February 19, 20X1: The financial statements were completed.
• February 20, 20X1: All audit procedures were completed, including the review of all audit
documentation.
• February 25, 20X1: Green signed the audit report.
• February 26, 20X1: Green delivered the audit report to Baker.
17–7. When the current auditors make reference to the work of the component auditors, does this
result in expression of a qualified opinion? Explain.
17–8. Explain three situations in which the wording of a report with an unmodified opinion might
depart from the auditors’ standard report.
17–9. Wade Corporation has been your audit client for several years. At the beginning of the current
year, the company changed its method of inventory valuation from average cost to last in, first
out (LIFO). The change, which had been under consideration for some time, was in your opin-
ion a logical and proper step for the company to take. What effect, if any, will this situation
have on your audit report for the current year?
17–10. What are the two circumstances that result in modified opinions?
17–11. Comment on the following: “If the financial statements contain an immaterial departure from
generally accepted accounting principles, the auditors issue a qualified opinion; if the financial
statements contain a material departure from GAAP, the auditors issue an adverse opinion.”
17–12. What factors determine whether a misstatement is considered pervasive?
17–13. Can the client change a set of financial statements to receive an unmodified opinion instead of
an opinion qualified as to the adequacy of disclosure? Explain.
17–14. Describe the alterations from the standard form audit report when a scope limitation has
occurred and the auditors have issued a qualified opinion.
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17–15. The auditors know that the client’s accounting for deferred income taxes is not in accordance
with generally accepted accounting principles, but because of a very significant scope limita-
tion they have not been able to determine the amount of the misstatement involved and have
not been able to form an opinion on the financial statements taken as a whole. What type of
report should they issue?
17–16. Why are adverse opinions rare?
17–17. Comment on whether you agree with the following: A basis for modified opinion paragraph is
the same as a basis for qualified opinion paragraph.
17–18. Assume that CPAs are attesting to comparative financial statements. Can the CPAs express
differing opinions on the sets of financial statements of two successive years?
17–19. Assume that CPAs are attesting to comparative financial statements. Can the CPAs change
their report on the prior year’s statements?
17–20. Describe the reports containing audited financial statements that are customarily filed by a
company subject to the reporting requirements of the SEC.
Questions LO 1, 2 17–21. An accountant of an audit client made the following statement: It is important to read the
notes to financial statements, even though they are presented in technical language and are
Requiring incomprehensible. Auditors may reduce their exposure to third-party liability by stating some-
Analysis thing in the notes that contradicts completely what the client has presented in the balance
sheet or income statement.
Evaluate the above statement and indicate:
a. Areas of agreement, if any.
b. Areas of misconception, incompleteness, or fallacious reasoning included in the statement.
LO 3 17–22. Rowe & Myers audits the financial statements of Dunbar Electronics. During the audit, Ross
& Myers engaged Jones & Abbot, a Canadian public accounting firm, as a component auditor
to audit Dunbar’s wholly owned Canadian subsidiary.
Required a. Must Rowe & Myers make reference to the component auditor in its audit report? Explain.
b. Assume that Jones & Abbott issued a qualified report on the Canadian subsidiary. Must
Rowe & Myers include the same qualification in its report on Dunbar Electronics?
LO 3 17–23. Lando Corporation is a domestic company with two wholly owned domestic subsidiaries.
Michaels, CPA, has been engaged to audit the financial statements of the parent company and
one of the subsidiaries and to act as the group auditors. Thomas, CPA, has audited financial
statements of the other subsidiary. Michaels has not yet decided whether to make reference to
the audit of Thomas.
Required a. What audit procedures should Michaels perform with respect to the component auditor,
regardless of whether Michaels decides to make reference to Thomas in the report?
b. What modifications are made to the audit report if Michaels decides to make reference to
the audit of Thomas?
LO 3 17–24. While performing your audit of Williams Paper Company, you discover evidence that indi-
cates that Williams may not have the ability to continue as a going concern.
a. Discuss types of information that may indicate substantial doubt about a client’s ability to
remain a going concern.
b. Explain the auditors’ obligation in such situations.
Objective All applicable questions are available with McGraw-Hill’s ConnectTM Accounting.
Questions 17–25. Multiple Choice Questions

LO 4 a. A material departure from generally accepted accounting principles will result in auditor
consideration of:
(1) Whether to issue an adverse opinion rather than a disclaimer of opinion.
(2) Whether to issue a disclaimer of opinion rather than a qualified opinion.
(3) Whether to issue an adverse opinion rather than a qualified opinion.
(4) Nothing, because none of these opinions is applicable to this type of exception.
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LO 1, 2 b. The auditors’ report should be dated as of the date the:

(1) Report is delivered to the client.
(2) Auditors have accumulated sufficient evidence.
(3) Fiscal period under audit ends.
(4) Peer review of the working papers is completed.
LO 3 c. In an audit report on combined financial statements, reference to the fact that a portion of
the audit was performed by a component auditor is:
(1) Not to be construed as a qualification, but rather as a division of responsibility between
the two CPA firms.
(2) Not in accordance with generally accepted auditing standards.
(3) A qualification that lessens the collective responsibility of both CPA firms.
(4) An example of a dual opinion requiring the signatures of both auditors.
LO 1, 2 d. Assume that the opinion paragraph of an auditors’ report begins as follows: “With the
explanation given in Note 6., . . .” the financial statements referred to above present
fairly. . . .)” This is:
Text unclear,
(1) An unmodified opinion.
(2) A disclaimer of opinion.
Please check
(3) An “except for” opinion.
and confirm.
(4) An improper type of reporting.
LO 3 e. The auditors who wish to draw reader attention to a financial statement note disclosure on
significant transactions with related parties should disclose this fact in:
(1) An emphasis of matter paragraph to the auditors’ report.
(2) A footnote to the financial statements.
(3) The body of the financial statements.
(4) The “summary of significant accounting policies” section of the financial statements.
LO 4 f. What type or types of audit opinion are appropriate when financial statements are materi-
ally and pervasively misstated?
Qualified Adverse
(1) Yes Yes
(2) Yes No
(3) No Yes
(4) No No
LO 3 g. Which of the following ordinarily involves the addition of an emphasis of matter para-
graph to an audit report?
(1) A consistency modification.
(2) An adverse opinion.
(3) A qualified opinion.
(4) Part of the audit has been performed by component auditors.
LO 2 h. An audit report for a public client indicates that the audit was performed in accordance
with:
(1) Generally accepted auditing standards (United States).
(2) Standards of the Public Company Accounting Oversight Board (United States).
(3) Generally accepted accounting principles (United States).
(4) Generally accepted accounting principles (Public Company Accounting Oversight
Board).
LO 2 i. An audit report for a public client indicates that the financial statements were prepared in
conformity with:
(1) Generally accepted auditing standards (United States).
(2) Standards of the Public Company Accounting Oversight Board (United States)
(3) Generally accepted accounting principles (United States)
(4) Generally accepted accounting principles (Public Company Accounting Oversight Board).
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LO 3 j. When the matter is properly disclosed in the financial statements, the likely result of sub-
stantial doubt about the ability of the client to continue as a going concern is the issuance
of which of the following audit opinions?
Unmodified with
Qualified Emphasis of Matter
(1) Yes Yes
(2) Yes No
(3) No Yes
(4) No No
LO 4 k. A change in accounting principles that the auditors believe is not justified is likely to result
in which of the following types of audit opinions?
Unmodified with
Qualified Emphasis of Matter
(1) Yes Yes
(2) Yes No
(3) No Yes
(4) No No
LO 3 l. Which of the following is least likely to result in inclusion of an emphasis of matter para-
graph in an audit report?
(1) The company is a component of a larger business enterprise.
(2) An unusually important significant event.
(3) A decision not to confirm accounts receivable.
(4) A risk or uncertainty.
LO 3, 4 17–26. For each of the following brief scenarios, assume that you are reporting on a client’s financial
statements. Reply as to the type(s) of opinion possible for the scenario. In addition:
• Unless stated otherwise, assume the matter involved is material.
• If the problem does not state that a misstatement (or possible misstatement) is pervasive,
assume that it may or may not be pervasive (thus, the appropriate reply may include two
possible reports).
• Do not read more into the circumstance than what is presented.
Do not consider an auditor discretionary circumstance for modification of the audit report
unless the situation explicitly suggests that the auditors wish to emphasize a particular matter.
Report Types may be used once, more than once, or not at all.
Situation Report Types

a. Bowles Company is engaged in a hazardous trade and has obtained insurance coverage related to 1. Standard
the hazard. Although the likelihood is remote, a material portion of the company’s assets could be unmodified
destroyed by a serious accident. 2. Unmodified
b. Draves Company owns substantial properties that have appreciated significantly in value since with an
the date of purchase. The properties were appraised and are reported in the balance sheet at the emphasis
appraised values (which materially exceed costs) with related disclosures. The CPAs believe that the of matter
appraised values reported in the balance sheet reasonably estimate the assets’ current values. paragraph
c. During the audit of Eagle Company, the CPA firm has encountered a significant scope limitation 3. Qualified
relating to inventory record availability and is unable to obtain sufficient appropriate audit evidence 4. Adverse
in that area. 5. Disclaimer
d. London Company has material investments in stocks of subsidiary companies. Stocks of the sub- 6. Either qualified
sidiary companies are not actively traded in the market, and the CPA firm’s engagement does not or adverse
extend to any subsidiary company. The CPA firm is able to determine that all investments are carried 7. Either
at original cost, but has no real idea of market value. Although the difference between cost and qualified or
market could be material, it could not have a pervasive effect on the overall financial statements. disclaimer
e. Slade Company has material investments in stocks of subsidiary companies. Stocks of the subsidiary com- 8. Either adverse
panies are actively traded in the market. Management insists that all investments be carried at original or disclaimer
costs, and the CPA firm is satisfied that the original costs are accurate. The CPA firm believes that the
client will never ultimately realize a substantial portion of the investments because the market value is
much lower than the cost; the client has fully disclosed the facts in notes to the financial statements.
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LO 3, 4 17–27. Use the following to provide the type of audit report the auditors generally should issue in the
situations presented below:
1. Unmodified—standard.
2. Unmodified—with an emphasis of matter paragraph.
3. Qualified.
4. Adverse.
5. Disclaimer
Situation: a. Client-imposed restrictions significantly limit the scope of the auditors’ procedures, and
they are unable to obtain sufficient appropriate audit evidence. The possible effects on
the financial statements of undetected misstatements, if any, could be both material and
pervasive.
b. The auditors decide not to make reference to the report of a component auditor that audited
a portion of group financial statements.
c. The auditors believe that the financial statements have been presented in conformity with
generally accepted accounting principles in all respects, except that a loss contingency
that should be disclosed through a note to the financial statements is not included. While
they consider this a material omission, they do not believe that it pervasively affects the
d. The client has changed from LIFO to FIFO for inventory valuation purposes; the audi-
tors concur with this change. The effect is considered material to the financial statements,
although inventory is not a large part of total assets.
e. The client has changed from LIFO to FIFO for inventory valuation purposes; the auditors
do not concur with this change. The effect is considered material and pervasive.
LO 3 17–28. Auditors report on the consistency of application of accounting principles. Assume that the
following list describes changes that have a material effect on a client’s financial statements
for the current year.
(1) A change from the completed-contract method to the percentage-of-completion method of
accounting for long-term construction contracts.
(2) A change in the estimated service lives of previously recorded plant assets based on newly
acquired information.
(3) Correction of a mathematical error in inventory pricing made in a prior period.
(4) A change from direct costing to full absorption costing for inventory valuation.
(5) A change from deferring and amortizing preproduction costs to recording such costs as an
expense when incurred because future benefits of the costs have become doubtful. The new
accounting method was adopted in recognition of the change in estimated future benefits.
(6) A change to including the employer’s share of FICA taxes as “Retirement benefits” on the
income statement. This information was previously included with “Other taxes.”
(7) A change from the FIFO method of inventory pricing to the LIFO method of inventory
pricing.
Required For each of the above situations, state whether the audit report should include an emphasis of
matter paragraph on consistency.
LO 3, 4 17–29. Simulation
Items 1 through 5 present various independent factual situations an auditor might encounter in
conducting an audit. For each situation assume:
• The auditor is independent.
• The auditor previously expressed an unmodified opinion on the prior year’s financial
statements.
• Only single-year (not comparative) statements are presented for the current year.
• The conditions for an unmodified opinion exist unless contradicted in the factual situations.
• The conditions stated in the factual situations are material.
• No report modifications are to be made except in response to the factual situation.
1. In auditing the long-term investments account, an auditor is unable to obtain audited finan-
cial statements for an investee located in a foreign country. The auditor concludes that
sufficient appropriate audit evidence regarding this investment cannot be obtained.
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2. Due to recurring operating losses and working capital deficiencies, an auditor has sub-
stantial doubt about an entity’s ability to continue as a going concern for a reasonable
period of time. However, the financial statement disclosures concerning these matters are
adequate. The auditor has decided not to issue a disclaimer of opinion.
3. A group auditor decides to take responsibility for the work of a component CPA who
audited a wholly owned subsidiary of the entity and issued an unmodified opinion. The
total assets and revenues of the subsidiary represent 17 percent and 18 percent, respec-
tively, of the total assets and revenues of the entity being audited.
4. An entity changes its depreciation method for production equipment from straight-line
to a units-of-production method based on hours of utilization. The auditor concurs with
the change, although it has a material effect on the comparability of the entity’s financial
statements.
5. An entity discloses certain lease obligations in the notes to the financial statements. The
auditor believes that the failure to capitalize these leases is a departure from generally
accepted accounting principles and, although the possible effects on the financial state-
ments of the misstatements is material, they could not be pervasive.
Required List A represents the types of opinions the auditor ordinarily would issue and List B repre-
sents the report modifications (if any) that would be necessary. Select as the best answer for
each situation (items 1 through 6) the type of opinion and alterations, if any, the auditor would
normally select. Replies may be selected once, more than once, or not at all.
(AICPA, adapted)
List A: Types of Opinions List B: Report Alteration

A. Unmodified H. Add an emphasis of matter paragraph—prior to opinion
B. Qualified paragraph.
C. Adverse I. Add an emphasis of matter paragraph—after opinion paragraph.
D. Disclaimer J. Add a basis for modification paragraph—prior to opinion
E. Qualified or adverse paragraph.
F. Qualified or disclaimer K. Add a basis for modification paragraph—after opinion paragraph.
G. Disclaimer or adverse L. Modifications other than addition of a paragraph.
M. Issue standard auditors’ report without alteration.
LO 3, 4, 5 17–30. Simulation*
For each of the following brief scenarios, assume that you are reporting on a client’s finan-
cial statements. Reply as to the type(s) of opinion (per below) possible for the scenario. In
addition:
• Unless stated otherwise, assume the matter involved is material. If the problem doesn’t tell
you whether a misstatement pervasively misstates the financial statements or doesn’t list a
characteristic that indicates pervasiveness, two reports may be possible (i.e., replies 6 to 9).
• Do not read more into the circumstances than what is presented.
• Do not consider an auditor discretionary circumstance for modification of the audit report
unless the situation explicitly suggests that the auditor wishes to emphasize a particular matter.
Types of Opinion
1. Standard unmodified.
2. Unmodified with an emphasis of matter paragraph.
3. Qualified.
4. Adverse.
5. Disclaimer.
6. Unmodified with an emphasis of matter paragraph or disclaimer.
7. Qualified or adverse.
8. Qualified or disclaimer.
9. Adverse or disclaimer.
10. Other.
*
Note that this simulation has more parts than one would expect in a particular CPA exam simula-
tion. We present it to provide examples of many types of reporting situations in one problem.
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Situation Report
1. A company has not followed generally accepted accounting principles in the recording of its leases.
2. A company has not followed generally accepted accounting principles in the recording of its leases. The
amounts involved are immaterial.
3. A company valued its inventory at current replacement cost. Although the auditor believes that the inventory
costs do approximate replacement costs, these costs do not approximate any GAAP inventory valuation method.
4. A client changed its depreciation method for production equipment from the straight-line method to the units-
of-production method based on hours of utilization. The auditor concurs with the change.
5. A client changed its depreciation method for production equipment from the straight-line to a units-of-produc-
tion method based on hours of utilization. The auditor does not concur with the change.
6. A client changed the depreciable life of certain assets from 10 years to 12 years. The auditor concurs with the change.
7. A client changed the depreciable life of certain assets from 10 years to 12 years. The auditor does not concur with
the change. Confined to fixed assets and accumulated depreciation, the misstatement is not considered pervasive.
8. A client changed from the method it uses to calculate postemployment benefits from one acceptable method
to another. The effect of the change is immaterial this year, but expected to be material in the future.
9. A client changed the salvage value of certain assets from 5 percent to 10 percent of original cost. The auditor
concurs with the change.
10. A client uses the specific identification method of accounting for valuable items in inventory, and LIFO for less
valuable items. The auditor concurs that this is a reasonable practice.
11. Due to recurring operating losses and working capital deficiencies, an auditor has substantial doubt about an
entity’s ability to continue as a going concern for a reasonable period of time. The notes to the financial state-
ments adequately disclose the situation.
12. Due to recurring operating losses and working capital deficiencies, an auditor has substantial doubt about an
entity’s ability to continue as a going concern for a reasonable period of time. The notes to the financial state-
ments do not adequately disclose the substantial doubt situation, and the auditor believes the omission funda-
mentally affects the users’ understanding of the financial statements.
13. An auditor reporting on group financial statements decides to take responsibility for the work of a component audi-
tor who audited a 70 percent owned subsidiary and issued an unmodified opinion. The total assets and revenues of
the subsidiary are 5 percent and 8 percent, respectively, of the total assets and revenues of the entity being audited.
14. An auditor reporting on group financial statements decides not to take responsibility for the work of a com-
ponent auditor who audited a 70 percent owned subsidiary and issued an unqualified opinion. The total assets
and revenues of the subsidiary are 5 percent and 8 percent, respectively, of the total assets and revenues of the
entity being audited.
15. An auditor was hired after year-end and was unable to observe the counting of the year-end inventory. She is unable
to apply other procedures to determine whether ending inventory and related information are properly stated.
16. An auditor was hired after year-end and was unable to observe the counting of the year-end inventory. How-
ever, she was able to apply other procedures and determined that ending inventory and related information
are properly stated.
17. An auditor discovered that a client made illegal political payoffs to a candidate for president of the United
States. The auditor was unable to determine the amounts associated with the payoffs because of the client’s
inadequate record-retention policies. The client has added a note to the financial statements to describe the
illegal payments and has stated that the amounts of the payments are not determinable.
18. An auditor discovered that a client made illegal political payoffs to a candidate for president of the United
States. The auditor was unable to determine the amounts associated with the payoffs because of the client’s
inadequate record-retention policies. Although there is no likelihood that the financial statements are perva-
sively misstated, they may be materially misstated. The client refuses to disclose the payoffs in a note to the
19. In auditing the long-term investments account of a new client, an auditor finds that a large contingent liability
exists that is material to the consolidated company. It is probable that this contingent liability will be resolved
with a material loss in the future, but the amount is not estimable. Although no adjusting entry has been
made, the client has provided a note to the financial statements that describes the matter in detail.
20. In auditing the long-term investments account of a new client, an auditor finds that a large contingent liability
exists that is material to the consolidated company. It is probable that this contingent liability will be resolved
with a material loss in the future, and this amount is reasonably estimable as $2,000,000. Although no adjust-
ing entry has been made, the client has provided a note to the financial statements that describes the matter in
detail and includes the $2,000,000 estimate in that note.
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Situation Report
21. A client is issuing two years of comparative financial statements. The first year was audited by another auditor
who is not being asked to reissue her audit report. (Reply as to the successor auditors’ report.)
22. A client is issuing two years of comparative financial statements. The first year was audited by another auditor
who is being asked to reissue her audit report. (Reply as to the successor auditors’ report.)
23. A client’s financial statements follow GAAP, but the auditor wishes to emphasize in his audit report a signifi-
cant related party transaction that is adequately described in the notes to the financial statements.
24. A client’s financial statements follow GAAP except that they do not include a note on a significant related
party transaction.
LO 3, 4 17–31. Simulation
Last year, Johnson & Barkley, CPAs, audited the consolidated financial statements of Jordan
Company (a nonpublic company) for the year ended December 31, 20X0, and expressed a
standard unmodified report.
Johnson & Barkley also audited Jordan’s this year’s financial statements—for the year
ended December 31, 20X1. These consolidated financial statements are being presented on a
comparative basis with those of the prior year, and an unmodified opinion is being expressed.
Smith, the engagement supervisor, instructed Abler, an assistant on the engagement, to draft
the auditors’ report. In drafting the report below, Abler considered the following:
• Jordan changed its method of accounting for inventory from LIFO to FIFO in 20X1.
• Larkin & Lake, CPAs, audited the financial statements of BX, Inc., a consolidated subsid-
iary of Jordan, for the year ended December 31, 20X1. The subsidiary’s financial state-
ments reflected total assets and revenues of 2 percent and 3 percent, respectively, of the
consolidated totals. Larkin & Lake expressed an unmodified opinion and furnished John-
son & Barkley with a copy of the auditors’ report. Johnson & Barkley has decided to
assume responsibility for the work of Larkin & Lake insofar as it relates to the expression
of an opinion on the consolidated financial statements taken as a whole and has applied the
necessary audit procedures.
• Jordan is a defendant in a lawsuit alleging patent infringement. This is adequately dis-
closed in the notes to Jordan’s financial statements, but no provision for liability has been
recorded because the ultimate outcome of the litigation cannot presently be determined.
Abler drafted the following audit report:
Auditors’ report
We have audited the accompanying consolidated financial statements of Jordan Company and
its subsidiaries, which comprise the consolidated balance sheets as of December 31, 20X1 and
20X0, and the related consolidated statements of income, changes in stockholders’ equity, and
cash flows for the years then ended, and the related notes to the financial statements.
our audits. We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the consolidated financial statements are free of
material misstatement.
the auditors considers internal control relevant to the entity’s preparation and fair presentation
of the consolidated financial statements in order to design audit procedures that are appropri-
ate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness
of the entity’s internal control. Accordingly, we express no such opinion. An audit also includes
evaluating the appropriateness of accounting policies used and the reasonableness of significant
accounting estimates made by management, as well as evaluating the overall presentation of the
consolidated financial statements.
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Emphasis of Matter
As discussed in Note 2 to the consolidated financial statements, the Company adopted the first-
in-first- out method of inventory valuation in 20X1. Our opinion is not modified with respect to
this matter.
Opinion
In our opinion, the consolidated financial statements referred to above present fairly, in all mate-
rial respects, the financial position of Jordan Company and its subsidiaries as of December 31,
20X1 and 20X0, and the results of their operations and their cash flows for the years then ended
in accordance with accounting principles generally accepted in the United States of America.
Johnson & Barkley, CPAs

Phoenix, Arizona
December 31, 20X1
Required Smith reviewed Abler’s draft and stated in the Supervisor’s Review Notes below that there
were deficiencies in Abler’s draft. Items 1 through 10 represent the deficiencies noted by
Smith. For each deficiency, indicate whether Smith is correct or incorrect in the criticism of
Abler’s draft.
1. The report’s title is incorrect as it should include the word “independent.”
2. The report should have an addressee such as the board of directors.
3. There should be a section entitled Management’s Responsibility for the Financial Statements.
4. The first sentence of the Auditors’ Responsibility section should state that “Our responsi-
bility is to provide assurance . . .,” not “Our responsibility is to express an opinion . . .”
5. The Auditors’ Responsibility and the Opinion sections should both refer to the component
auditors.
6. The third paragraph under the Auditors’ Responsibility section is not required—let’s omit it.
7. The emphasis of matter paragraph should follow the opinion paragraph.
8. The Opinion section should indicate that the principles were consistently applied except
for the change in method of inventory valuation.
9. The report should be dated as of the date sufficient appropriate audit evidence has been
gathered, not as of year-end.
10. The names of the individual financial statements should be included in the Opinion section.
Problems All applicable problems are available with McGraw-Hill’s ConnectTM Accounting.
LO 1, 3 17–32. The auditors’ report that follows was drafted by a staff accountant of Williams & Co., CPAs,
at the completion of the audit of the financial statements of Lenz Corporation (nonpublic com-
pany) for the year ended December 31, 20X1. Assume that there is substantial doubt about the
entity’s ability to continue as a going concern, and that this doubt is properly disclosed in the
Independent Auditors’ Report

To the Board of Directors and Stockholders of Lenz Corporation:
We have audited the accompanying consolidated financial statements of Lenz Corporation
and its subsidiaries, and the related notes to the financial statements.
Management’s Responsibility for the Financial Statements

Management is responsible for the preparation and fair presentation of these consolidated
financial statements in accordance with accounting principles generally accepted in the United
States of America; this includes the design, implementation, and maintenance of internal control
relevant to the preparation and fair presentation of consolidated financial statements that are
free from material misstatement, whether due to fraud or error.
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our audit. Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the consolidated financial statements are in conformity with account-
ing principles generally accepted in the United States of America.
the auditors considers internal control relevant to the entity’s preparation and fair presentation
of the consolidated financial statements in order to design audit procedures that are appropri-
ate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness
of the entity’s internal control. Accordingly, we express no such opinion. An audit also includes
evaluating the appropriateness of accounting policies used and the reasonableness of significant
accounting estimates made by management, as well as evaluating the overall presentation of the
consolidated financial statements.
Emphasis of Matter
The accompanying consolidated financial statements have been prepared assuming that the Com-
pany will continue as a going concern. As discussed in Note 1 to the consolidated financial state-
ments, the Company has suffered negative cash flows from operations and has an accumulated
deficit that raises substantial doubt about the Company’s ability to continue as a going concern
beyond a reasonable time. Management’s plans in regard to these matters are also described in
Note 1. The consolidated financial statements do not include any adjustments that might result
from the outcome of this uncertainty. Our opinion is modified with respect to this matter.
Opinion
In our opinion, except for the effects of the matter described in the preceding paragraph, the con-
solidated financial statements referred to above present fairly, in all material respects, the finan-
cial position of Lenz Corporation and its subsidiaries and the results of their operations and their
cash flows for the year then ended in accordance with accounting principles generally accepted in
the United States of America applied on a basis consistent with that of the preceding year.
Williams & Co., LLP

Phoenix Arizona
February 15, 20X2
Required Identify deviations from the appropriate nonpublic company audit report.
LO 2 17–33. The auditors’ report that follows was drafted by a staff accountant of Smith & Co., CPAs, at
the completion of the audit of the financial statements of Lenses Co. (a public company) for
the year ended December 31, 20X1.
Report of Registered Public Accounting Firm

To the Management of Lenses Co.:
We have examined the accompanying consolidated balance sheet of Lenses Co. as of Decem-
ber 31, 20X1 and 20X0, and the related consolidated statement of income, stockholders’ equity,
and cash flows for each of the three years in the period ended December 31, 20X1. These finan-
cial statements are the responsibility of the Company’s management. Our responsibility is to
express an opinion on these financial statements based on our audits. All PCAOB requirements
were met on this audit.
We conducted our audits in accordance with the standards of generally accepted auditing
standards (United States). Those standards require that we plan and perform the audit to obtain
positive assurance about whether the financial statements are free of all misstatements. An
audit includes examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present, in all material respects, the
consolidated financial position of Lenses Co. at December 31, 20X1 and 20X0, and the consoli-
dated results of its operations and its cash flows for each of the three years in the period ended
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December 31, 20X1, in conformity with U.S. generally accepted accounting principles applied on
a consistent basis.
We also have reviewed, in accordance with the standards of the Public Company Account-
ing Oversight Board (United States), Lenses Co.’s internal control over financial reporting as
of December 31, 20X1, based on criteria established in Internal Control-Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our
report dated February 15, 20X2, expressed an unmodified opinion thereon.
Smith & Co. CPAs

Dallas, Texas
February 15, 20X2
Required Identify deviations from the public company standard report.

LO 4 17–34. Sturdy Corporation (a nonpublic company) owns and operates a large office building in a
desirable section of New York City’s financial center. For many years, management of Sturdy
Corporation has modified the presentation of its financial statement by:
1. Reflecting a write-up to appraisal values in the building accounts.
2. Accounting for depreciation expense on the basis of such valuations.
Wyley, CPA, was asked to audit the financial statements of Sturdy Corporation for the year
ended December 31, 20X3. After completing the audit, Wyley concluded that, consistent with
prior years, an adverse opinion would have to be expressed because the material misstate-
ments were considered pervasive.
Required a. Describe in detail the appropriate content of the basis for modification section of the audi-
tors’ report on the financial statements of Sturdy Corporation for the year ended December
31, 20X3. Do not discuss deferred taxes.
b. Write a draft of the opinion paragraph of the auditors’ report on the financial statements of
Sturdy Corporation for the year ended December 31, 20X3.
LO 1, 3, 4 17–35. Roscoe & Jones, Ltd, a CPA firm in Silver Bell, Arizona, has completed the audit of the finan-
cial statements of Excelsior Corporation as of, and for, the year ended December 31, 20X1.
Findings related to the financial statements and the audit include:
• Excelsior is a nonpublic company that presents only current-year financial statements.
• Roscoe was unable to perform normal accounts receivable confirmation procedures, but
alternate procedures were used to satisfy Roscoe as to the validity of the receivables.
• Excelsior Corporation is the defendant in litigation, the outcome of which is highly uncer-
tain. If the case is settled in favor of the plaintiff, Excelsior will be required to pay a sub-
stantial amount of cash that might require the sale of certain assets. The litigation and the
possible effects have been properly disclosed in Note 11. Roscoe wishes to include discus-
sion of this matter in the audit report.
• During 20X1 Excelsior changed its method of accounting for long-term construction con-
tracts and properly reflected the effect of the change. Roscoe is satisfied with Excelsior’s
justification for making the change. The change is discussed in Note 12.
• Excelsior issued debentures on January 31, 20X1, in the amount of $10 million. The
funds obtained from the issuance were used to finance the expansion of plant facilities.
The debenture agreement restricts the payment of future cash dividends to earnings after
December 31, 20X1. Excelsior declined to disclose these data in the notes to the financial
statements. Roscoe considers this a material, but no pervasive omission.
• Roscoe gathered sufficient appropriate audit evidence as of February 10, 20X2, and
planned a report release date of February 16, 20X2.
Required Consider all facts given and prepare an auditors’ report in an acceptable and complete format,
incorporating any necessary departures from the standard report.
LO 2, 3, 4 17–36. Rotter & Co, Ltd, a CPA firm in Silver Bell, Arizona, has completed the audit of the financial
statements of Exchecker Corporation as of, and for, the year ended December 31, 20X1. Find-
ings related to the financial statements and the audit include:
• Exchecker is a public company that presents two years of balance sheets and three years of
the other financial statements in accordance with SEC reporting requirements.
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• During 20X1, Exchecker changed its method of accounting for long-term construction
contracts and properly reflected the effect of the change. Rotter is satisfied with Excheck-
er’s justification for making the change. The change is discussed in Note 12.
• Rotter was unable to perform normal accounts receivable confirmation procedures, but
alternate procedures were used to satisfy Rotter as to the validity of the receivables.
• Exchecker Corporation is the defendant in litigation, the outcome of which is highly
uncertain. If the case is settled in favor of the plaintiff, Exchecker will be required to pay
a substantial amount of cash that might require the sale of certain assets. The litigation
and the possible effects have been properly disclosed in Note 11. Rotter wishes to include
discussion of this matter in the audit report.
• Rotter gathered sufficient appropriate audit evidence as of February 10, 20X2, and planned
a report release date of February 16, 20X2.
Required Consider all facts given, and prepare an auditors’ report in an acceptable and complete format
incorporating any necessary departures from the standard report.
In-Class LO 3, 4, 5 17–37. For each of the following brief scenarios, assume that you are the CPA reporting on the cli-
ent’s financial statements. Using the form included with this problem, describe the reporting
Team circumstance involved, the type or types of opinion possible in the circumstance, and the
Cases appropriate report alterations. Since more than one report may be possible in several of the
circumstances, a second “type of opinion” and “report alteration” row is added for each cir-
cumstance. For example, if the problem doesn’t tell you whether a misstatement pervasively
misstates the financial statements or doesn’t list a characteristic that indicates pervasiveness,
two reports may be possible.
In most cases, you will not need to use the second row. Do not read more into the circum-
stance than what is presented, and only reply “emphasis of matter” in auditor discretionary
circumstances such as those suggested in the chapter. Unless stated otherwise, assume that the
information presented is material to the financial statements.
Circumstance Type of Opinion Report Alteration

GC Going concern U Unmodified EOM Emphasis of matter paragraph added
CON Consistency Q Qualified OM Other matter paragraph added
EMPH Auditor discretionary emphasis of matter D Disclaimer BFM Basis for modification paragraph added
GROUP Group audit A Adverse OTHER Other alteration, but no paragraph added
GAAP Departure from GAAP NO No alteration
SCOPE Scope limitation
COMP Comparative financial statements
NONE No circumstance
1. Your client has declined to depreciate its assets this year because the depreciation expense
would reduce the year’s small income to a loss.
2. A client’s financial statements follow GAAP, but you wish to emphasize that the client is
a subsidiary of Webster Corporation in the audit report.
3. In auditing the long-term investments account of a new client, you are unable to obtain
audited financial statements for the investee located in a foreign country. You conclude
that sufficient appropriate audit evidence regarding this investment cannot be obtained.
4. Due to a very major lawsuit, you have substantial doubt about a client’s ability to continue
as a going concern for a reasonable period of time. The financial statement disclosures
related to this lawsuit are adequate.
5. You decide not to take responsibility for the work of the component auditors who audited
a 70 percent owned subsidiary and issued an unmodified opinion. The total assets and
revenues of the subsidiary are 5 percent and 8 percent, respectively, of the total assets and
revenues of the entity being audited.
6. You decide to take responsibility for the work of the component auditors who audited a 70
percent owned subsidiary and issued an unmodified opinion. The total assets and revenues
of the subsidiary are 5 percent and 8 percent, respectively, of the total assets and revenues
of the entity being audited.
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7. A company has changed the remaining life of a significant asset from 12 to 10 years. You
believe that the change is reasonable.
8. A company changes from FIFO to LIFO for inventory valuation and you concur with the
change. The change has an immaterial effect on the entity’s financial statements this year,
but it is expected to have a material effect in the future.
9. Your client is a defendant in a major lawsuit. It is probable that the company will experi-
ence a material loss due to the lawsuit, although it is impossible to calculate the likely
amount. The financial statements include a note adequately describing the matter. You
decide that a standard report is inappropriate.
10. Predecessor auditors audited last year’s financial statements and you audited the current
year. You have decided not to ask the predecessor to reissue that audit report. Comparative
financial statements are being issued on the two years.
Circumstance Type Opinion(s) Report Alteration

1
10
LO 3, 4, 5 17–38. For each of the following brief scenarios, assume that you are reporting on a client’s current
year financial statements. Reply as to the type or types opinion possible in the circumstance.
S Standard unmodified
U Unmodified with emphasis of matter or other matter paragraph
Q Qualified
D Disclaimer
A. Adverse
Since more than one report may be possible in several of the circumstances, a second “opin-
ion” column is added for each circumstance. In certain cases you will not need to use the
second column. Do not read more into the circumstance than what is presented, and do not
consider the possibility of an auditors’ discretionary emphasis of matter paragraph being
added to the audit report. Unless stated otherwise, assume that the information presented is
material to the financial statements. If the situation doesn’t tell you whether a misstatement
pervasively misstates the financial statements or doesn’t list a characteristic that indicates
pervasiveness, two reports may be possible.
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Situation Opinion Opinion

1. A company in its first year of existence values its inventory at current replacement cost.
Although you believe that the inventory costs do approximate replacement costs, these costs
do not approximate any GAAP inventory valuation method. The difference involved is material,
but not pervasively material to the financial statements.
2. Due to recurring operating losses and working capital deficiencies, you have substantial doubt
about an entity’s ability to continue as a going concern for a reasonable period of time. The
notes to the financial statements adequately disclose the substantial doubt situation.
3. You have discovered that a client made illegal payoffs to a candidate for president of the United
States. You are unable to determine the amounts associated with the payoffs because of the
client’s inadequate record retention policies. The client has added a note to the financial state-
ments to describe this information, and has stated that the amounts of the payments are not
determinable.
4. In auditing the long-term investments account of a new client, you find that a $2,000,000 con-
tingent liability exists that is material to the consolidated company. It is a reasonably possible
that this contingent liability will be resolved with a material loss in the future. Although no
adjusting entry has been made, the client has provided a note to the financial statements that
describes the matter in detail and includes the $2 million estimate.
5. A client is issuing two years of comparative financial statements. The first year was audited by
other auditors who are not being asked to reissue their audit report.
6. An entity changes its depreciation method for production equipment from the straight-line to
the units-of-production method based on hours of utilization. You concur with the change.
7. A client has changed the method it uses to calculate postemployment benefits from one accept-
able method to another acceptable method. The effect of the change is immaterial this year,
but is expected to be material in the future.
8. Component auditors have audited a subsidiary of your client as a part of a group audit. You
have decided to rely upon the component auditors’ work.
9. A client omits note disclosure related to significant accounting policies that the auditors believe
to be fundamental to users’ understanding of the financial statements.
10. A client does not count its year-end inventory. The auditors are unable to obtain sufficient
appropriate audit evidence related to the inventory, and they consider inventory to represent
an extremely substantial proportion of the financial statements.
Research LO 3, 4 11–39. Your firm audits Metropolitan Power Supply (MPS). The issue under consideration is the
treatment in the company’s financial statements of S700 million in capitalized construction
and Discussion costs relating to Eagle Mountain, a partially completed nuclear power plant.
Case Seven years ago, MPS began construction of Eagle Mountain, with an original cost esti-
mate of $400 million and completion expected within five years. Cost overruns were enor-
mous, and construction has been repeatedly delayed by litigation initiated by the antinuclear
lobby. At present, the project is little more than 50 percent complete, and construction has
been halted because MPS does not have the funds to continue.
If Eagle Mountain is ultimately completed, the state utilities commission will determine
the extent to which MPS may recover its construction costs through its rate structure. The
commission’s rulings are difficult to predict, but it is quite possible that the commission will
not allow MPS to include all of the Eagle Mountain construction costs in its “rate base.” If
Eagle Mountain were abandoned today, none of the construction costs would be recoverable.
The related write-off would amount to over 70 percent of MPS’s stockholders’ equity, but the
company would survive.
MPS’s management, however, remains committed to the completion of the Eagle Moun-
tain facility. Management has obtained authorization from the company’s stockholders to
issue $500 million in bonds and additional shares of common stock to finance completion of
the project. If MPS incurs this additional debt and is still not able to make Eagle Mountain
fully operational, it is doubtful that the company can avoid bankruptcy. In short, management
has elected to gamble—all its chips are riding on Eagle Mountain.
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Required a. Discuss the arguments for and against the auditors insisting that MPS begin expensing
some portion of the construction costs rather than continuing to accumulate an ever-
increasing asset. Indicate the position you would take as the auditor.
b. Discuss whether the auditors should modify their report because of uncertainty about
whether or not MPS can remain a going concern. Indicate the type of opinion that you
would issue. (You need not limit yourself to a “going-concern” modification.)
Part a:
FASB Accounting Standards Codification sections 360-10 and 450-20-25-2.
Part b:
AICPA AU sections 570 and 700–706; PCAOB AU sections 341 and 508.
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LO5 Describe the audi-

Financial Auditors most frequently report upon a complete set of ﬁnan-

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662 Chapter Seventeen

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Auditors’ Reports 663

February 5, 20X2 Phoenix Arizona

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664 Chapter Seventeen

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Auditors’ Reports 665

Ernst & Young LLP

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666 Chapter Seventeen

• Unmodiﬁed opinion with an other matter paragraph. An other matter paragraph

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Auditors’ Reports 667

Reports with an Unmodiﬁed Opinion and

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668 Chapter Seventeen

Regardless of whether the auditors decide to add an emphasis of matter paragraph to a

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Auditors’ Reports 669

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670 Chapter Seventeen

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Auditors’ Reports 671

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672 Chapter Seventeen

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Auditors’ Reports 673

FIGURE 17.1 Component Nature Audit Procedures

Signiﬁcant because it 1. The group auditors or the component auditors:

FIGURE 17.2 Summary of Emphasis of Matter Paragraphs and Group Audits

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674 Chapter Seventeen

FIGURE 17.3 Auditors’ Judgment about the Pervasiveness of the

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Auditors’ Reports 675

Basis for Qualiﬁed Opinion

If the material misstatement is considered pervasive, an adverse opinion is appro-

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676 Chapter Seventeen

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Auditors’ Reports 677

the required evidence, no report modiﬁcation is necessary. If they do not, a decision

Basis for Qualiﬁed Opinion

Scope Limitations versus Uncertainties

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678 Chapter Seventeen

Additional Reporting Issues

FIGURE 17.4 Summary of Auditors’ Reports

Unmodiﬁed Opinion Modiﬁed Opinion

Going GAAP not Auditor Discretionary Group GAAP Scope

Material Qualiﬁed Qualiﬁed

Unmodiﬁed with Emphasis

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Auditors’ Reports 679

and pervasive known misstatements, an adverse opinion would be appropriate, not a