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CHAPTER 28

THE AUDITOR’S REPORT ON FINANCIAL STATEMENTS

I. Review Questions

1. Scope paragraph
(a) The objects of the audit are the financial statements – balance sheet(s),
income statement(s), and cash flow statement(s), and related footnote
disclosure, not the “books and records.”

(b) The description of the audit means:


(1) the auditors were trained and proficient.
(2) the auditors were independent.
(3) due professional care was exercised.
(4) the work was planned and supervised.
(5) internal controls was properly studied and evaluated.
(6) sufficient competent evidential matter was obtained.
(7) the GAAS reporting standards were followed.

* Professional judgment was exercised in performing the tests and choosing


the procedures to perform in the circumstances.

2. Report and the evidence dimension

Fully sufficient Isolated


competent evidence Pervasive lack
evidence deficiency of evidence
Unqualified opinion X
Adverse opinion X
Opinion qualified for a
departure from SFAS X
Paragraph for
inconsistent GAAP
application X
Paragraph for an
uncertainty X
Disclaimer of opinion X
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3. Major reasons for departure from the standard unqualified report


1. Disagreement with management regarding the acceptability of the
accounting policies selected, the method of their application or the
adequacy of financial statement disclosure.
2. Limitation on scope of the audit (resulting in a lack of evidence).
3. Using extra paragraph(s) to emphasize significant matters.
4. Different opinion on prior year comparative statements.
5. Relying on the work and reports of other independent auditors.
6. Required supplementary data omitted or departs from guidelines.
7. “Other information” inconsistent with financial statements or contains
material misstatement of fact.
8. Auditor is not independent.

4. Students may identify more than one description of the “most important”
distinction between an opinion and a disclaimer. All the following are valid,
although (a) is intended to be the “Most Important:”
a. An opinion (unqualified, qualified or adverse) is an explicit statement of the
auditor’s conclusion(s), while a disclaimer is an (empty) assertion of “no
conclusion.”
b. An (unqualified) opinion is the highest level of assurance, while a
disclaimer is the lowest level (no assurance).
c. An opinion requires evidence as a basis, while a disclaimer results from
lack of evidence.
d. Auditors must be independent to give an opinion, while a disclaimer can
result from a CPA’s lack of independence.

5. A material scope restriction occurs when the auditor is unable to gather


sufficient competent evidence to support an unqualified opinion on the financial
statements. Scope restrictions may be client-imposed or they may result from
other circumstances, e.g., appointment of the auditor after the client’s physical
inventory has been taken. A material scope restriction need not result in a
modification of the auditor’s opinion provided the auditor can obtain satisfaction
by alternate means.

6. A principal auditor is one who has examined the major portion of the combined
entity.

7. When financial statements of the prior year are presented together with those of
the current year, a continuing auditor must report on both years. In “updating”
the prior year’s report, the auditor must decide whether to restate the report in its
same form or modify it to reflect current information not available at the date of
issuance of the prior report.
The Auditor’s Report on Financial Statements 28-3

8. A continuing auditor can update a previously-issued report by obtaining and


evaluating information during the current engagement. Thus, an updated report
is a previously-issued report that has been reevaluated in light of current
information and evidence. (The updated report itself may be a compilation
report, a review report, or an audit report).

The reevaluation may cause the updated version to be different from the report
previously issued (for example, a new reason to write a qualification may be
found).

An updated report carries a current date, not the date of the previous report.

A predecessor auditor usually does not have the current information necessary
to update a report.

Either a continuing auditor or a predecessor auditor can reissue previously-


reissued report. The process does not contemplate consideration of information
and evidence obtained during a current engagement. Thus, a reissued report is a
current release of a previously-issued report without benefit of any additional
examination or review of the subject financial statements. The report date
should be the date of the end of field work for the original issue of the report.

9. A principal auditor is the one who (a) audits a material portion of a reporting
entity’s assets, liabilities, revenues and expenses (usually over 50 percent) and
(b) knows enough about the whole entity to sign the audit report.

10. The principal auditor’s reference in his report to another auditor is not a
qualification in scope. The reference only shows the divided responsibility for
the audit work.

11. When an auditor is not independent with respect to a client, a disclaimer of


opinion must be rendered. The disclaimer must be issued because the
statements cannot be audited in accordance with generally accepted auditing
standards. (An accountant, not an auditor, is the person associated with
compiled and reviewed financial statements. An accountant can give a
compilation – disclaimer – report on compiled unaudited financial statements).

12. When the “going concern assumption” is in doubt, auditors have serious
reservations about the recoverability and amounts of reported assets and the
amount and classification of reported liabilities. These opinions may be used,
depending on the circumstances:
a. Standard unqualified report with an uncertainty notice paragraph calling
attention to the going concern problem.
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b. Disclaimer of opinion to express unwillingness to give an opinion on the
presentation.
c. Opinion qualified or adverse for departure from GAAP if all appropriate
disclosures are not made.

13. According to PSA 700,


“In certain circumstances, an auditor’s report may be modified by adding an
emphasis of matter paragraph to highlight a matter affecting the financial
statements which is included in a note to the financial statements that more
extensively discusses the matter. The addition of such an emphasis of matter
paragraph does not affect the auditor’s opinion. The paragraph would preferably
be included after the opinion paragraph and would ordinarily refer to the fact
that the auditor’s opinion is not qualified in this respect.

The auditor should modify the auditor’s report by adding a paragraph to


highlight a material matter regarding a going concern problem.

The auditor should consider modifying the auditor’s report by adding a


paragraph if there is a significant uncertainty (other than a going concern
problem), the resolution of which is dependent upon future events and which
may affect the financial statements. An uncertainty is a matter whose outcome
depends on future actions or events not under the direct control of the entity but
that may affect the financial statements.”

14. Whether to divide responsibility or accept full responsibility is a function of:


a. Relationship of the principal auditor to the other auditors; and
b. Materiality of the component(s) examined by other auditors.

15. The auditor may decide to disclaim an opinion when confronted by a material
scope limitation that precludes gathering sufficient evidence to support an
opinion as to overall fairness of financial presentation. The auditor may also
disclaim an opinion if his/her name is associated with financial statements for
which an audit was not intended (e.g., compilations and reviews), or if the
auditor is not independent.

16. Two conditions are necessary for an unqualified opinion:


a. No material scope restrictions have prevented the auditor from collecting
sufficient, competent evidence; and
b. The financial statements, including footnote disclosures, contain no material
departures from GAAP.
The Auditor’s Report on Financial Statements 28-5
17. An auditor may agree with a departure from a designated principle only when, in
his/her judgment, application of the designated principle would make the
financial statements materially misleading.

18. The audit opinion does not extend to the other information, and therefore, the
opinion is not affected by omission or inconsistency or incorrect supplemental
information.

19. The auditor must evaluate, on every audit, the ability of the entity to meet its
obligations on a continuing basis during a reasonable period (usually 12 months)
following the balance sheet date. Although the auditor is not required to apply
additional procedures in making the initial evaluation, if he/she has substantial
doubt as to ability of the client to continue, added procedures may have to be
applied to resolve the issues.

20. The auditor should add an explanatory paragraph regarding a material


uncertainty, provided the outcome of the events surrounding the uncertainty
cannot be reasonably estimated by management. If the probability of an
unfavorable outcome is remote, the explanatory paragraph is not needed. If a
material loss is probable, but is not susceptible to reasonable measurement, and
is properly footnoted, the auditor should add an explanatory paragraph directing
the reader’s attention to the footnote.

The greater the materiality, and the higher the probability of loss, the more
inclined will be the auditor to add the explanatory paragraph.

21. Upon learning of a change in accounting principle, the auditor should first
determine the materiality and appropriateness of the change. If material and the
auditor agree with the client’s justification for the change, an explanatory
paragraph should be added following the opinion paragraph. The paragraph will
refer to the footnote describing the change. If the change is not properly
accounted for or is inadequately disclosed, the auditor should consider issuing a
qualified or adverse opinion.

II. Multiple Choice Questions

1. c 11. c 21. c 31. b


2. d 12. b 22. c 32. c
3. a 13. d 23. a 33. b
4. c 14. a 24. d 34. c
5. c 15. b 25. c 35. d
6. c 16. d 26. a 36. b
7. c 17. d 27. a 37. d
8. a 18. a 28. c 38. a
9. d 19. b 29. c 39. d
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10. c 20. c 30. b 40. b

III. Comprehensive Cases

Case 1. You must determine whether an unqualified opinion satisfies the GAAS
reporting standard, in particular:
a. Determine whether the financial statements are presented in conformity
with GAAP.
1. Read the footnote description of accounting policies.
2. Use a GAAP checklist.
3. Review the working papers for any indication of accounting policies
not described in the footnote or ones apparently not in conformity with
GAAP.
4. Determine if:
(i) The accounting principles are generally acceptable, having
authoritative support.
(ii) The accounting principles are appropriate in the circumstances.
(iii) The financial statements are informative.
(iv) The information is reasonably summarized.
(v) Material adjustments have not been waived without good reasons.
b. Determine whether any accounting changes have been made and whether
accounting principles have been applied consistently.
c. Determine whether the footnote disclosures are adequate to inform users of
any material information evident in the working papers.

Case 2. 1. The auditor is reporting to the body that has engaged the auditing
services. While the report may be read and used by others who are indirect
beneficiaries of the audit, current custom is not to address the report to the
unknown class of users.

2. The scope paragraph should specifically identify the audited statements by


name so that there can be no mistake about the subject of the report. The
alternative language is not as precise.

3. The standard language effectively bases the audit on an extensive body of


written auditing standards that are known to others and can be cited in case
The Auditor’s Report on Financial Statements 28-7
of controversy. The alternative language, on the other hand, seems to break
loose from profession-wide quality norms and make the audit quality
depend more on “the circumstances,” which introduces an element of
mystery and lack of definition into the report.

4. The alternative wording is similar to the typical British audit report, and
they seem to be able to live with it, but American auditors believe that
“opinion” connotes belief or judgment stronger than impression but less
strong than positive knowledge. American auditors do not wish to appear to
have full, positive knowledge about the statements on the grounds that it’s
not feasible to know all there is to know about the financial statements.
Also, the standard language leans heavily on GAAP as the criteria for fair
presentation whereas the alternative language contains no reference to
authoritative accounting criteria.

Case 3. 1. Title. The report needs a title referring to Rose as the independent
auditor or independent accountant.
2. Notice of audit. The report does not give the proper declaration of an audit
of the financial statements, especially the part about “in accordance with
your instructions,” which suggest that Rose surrendered some audit
independence. The reference to a “complete audit” is ill advised because it
suggests a 100% investigation, which is contradicted by the sentence about
“tests of the sales records.”
3. Responsibilities. The report says nothing about the auditor’s responsibility
for the audit report.
4. Opinion. The opinion sentence should not be modified with the phrase
“with the explanation given above.”
5. Opinion. The opinion sentence should not mention “minor errors we
consider immaterial,” but it should contain the phrase “presents fairly in all
material respects.”
6. Opinion/Identification of Financial Statements. The opinion should not
include reference to cash flows because the introductory paragraph did not
state that the cash flow statement was audited. This may be a deficiency in
the identification of the financial statements that were actually audited.
7. Opinion. The opinion paragraph refers improperly to ASC
pronouncements. It should refer to “generally accepted accounting
principles.”
8. Date. The date accompanying Rose’s signature should be September 23 –
the day the field work was completed – not the company’s fiscal year-end
date.
9. Other. The commentary on the economy and the strike are not generally
appropriate for an audit report. Even if the auditor wanted to draw attention
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to these matters, their relevance for understanding the financial statements
and their manner of expression are both questionable.
10. Other. The negative assurance (concerning the recording of sales) is not
permitted in audit reports.

Case 4.
Independent Auditor’s Report
To the shareholders and board of directors of Various Fabrics, Inc.:
We have audited the accompanying balance sheets of Various
Fabrics, Inc. as of January 31, 2004 and 2003 and the related
statements of income, retained earnings, and cash flows for the
years then ended. These financial statements are the
responsibility of the company’s management. Our
responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with generally accepted
auditing standards. Those standards require that we plan and
perform the audit to obtain reasonable assurance about
whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by
management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present
fairly, in all material respects, the financial position of Various
Fabrics, Inc. as of January 31, 2004 and 2003 and the results of
its operations and its cash flows for the years then ended in
conformity with generally accepted accounting principles.

Aya de Jesus, CPA


March 2, 2004

Case 5. 1. F, L 5. B, I
2. B, I 6. B, I
3. B, Q 7. E, J
4. A, J

Case 6. A. 1, 7c.
The Auditor’s Report on Financial Statements 28-9
B. 2, 7a.
C. 4.
D. 1.
E. 6.
F. 5.
G. 2 (Note: The change in principle should be described in the descriptive
paragraph following the scope paragraph.)
H. 3, 7c.
I. 2, 7b.
J. 3, 7d.
K. 6. (given the materiality of property, plant, and equipment)
L. 1, 7e.
M. 1, 7b and 7e.