Audit Reports Chapter 3 2005 Prentice Hall Business

Learning Objective 1 Describe the parts of the standard unqualified audit report. © 2005

Parts of the Standard Unqualified Audit Report 1. Report title 2. Audit report address 3. Introductory paragraph 4. Scope paragraph 5. Opinion paragraph 6. Name of CPA firm 7. Audit report date © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 -3

Learning Objective 2 Specify the conditions required to issue the standard unqualified audit report. © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 -4

Conditions for Standard Unqualified Audit Report 1. All financial statements are included. 2. The three general standards have been followed in all respects on the engagement. 3. Sufficient evidence has been accumulated to conclude that the three standards of field work have been met. © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 -5

Conditions for Standard Unqualified Audit Report 4. The financial statements are presented in accordance with generally accepted accounting principles. 5. There are no circumstances requiring the addition of an explanatory paragraph or modification of the wording of the report. © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 -6

Four Categories of Audit Reports Standard unqualified Unqualified with explanatory paragraph or modified wording Qualified Adverse or disclaimer © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 -7

Learning Objective 3 Describe the five circumstances when an unqualified report with an explanatory paragraph or modified wording is appropriate. © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 -8

Unqualified Report with Explanation 1. Lack of consistent application of generally accepted accounting principles 2. Substantial doubt about going concern 3. Auditor agrees with a departure from promulgated accounting principles 4. Emphasis of a matter 5. Reports involving other auditors © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 -9

Consistency Versus Comparability Changes that affect consistency and require an explanatory paragraph if they are material: 1. Changes in accounting principles 2. Changes in reporting entities 3. Corrections of errors involving principles © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 10

Consistency Versus Comparability Changes that affect comparability but not consistency: 1. Changes in an estimate 2. Error corrections not involving principles 3. Variations in format and presentation of financial information 4. Changes because of substantially different transactions or events © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 11

Consistency Versus Comparability The Auditing Standards Board has issued a proposal to the PCAOB to eliminate the consistency explanatory paragraph. © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 12

Substantial Doubt About Going Concern 1. Significant recurring operating losses or working capital deficiencies 2. Inability of the company to pay its obligations as they come due 3. Loss of major customers, the occurrence of uninsured catastrophes 4. Legal proceedings, legislation, that might jeopardize the entity’s ability to operate © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 13

Auditor Agrees with a Departure from a Promulgated Principle The auditor must be satisfied and must state and explain, in a separate paragraph or paragraphs in the audit report, that adhering to the principle would have produced a misleading result in that situation. © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 14

Emphasis of a Matter Under certain circumstances, the CPA may want to emphasize specific matters regarding the financial statements, even though the CPA intends to express an unqualified opinion. © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 15

Reports Involving Other Auditors 1. Make no reference in the audit report. 2. Make reference in the report (modified wording report). 3. Qualify the opinion. © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 16

Learning Objective 4 Identify the types of audit reports that can be issued when an unqualified opinion is not justified. © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 17

Departures from an Unqualified Opinion 1. Scope limitation 2. GAAP departure 3. Auditor not independent © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 18

Qualified Opinion A qualified opinion report can result from a limitation on the scope of the audit or failure to follow generally accepted accounting principles. © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 19

Adverse Opinion It is used only when the auditor believes that the overall financial statements are so materially misstated or misleading that they do not present fairly the financial position or results of operations and cash flows in conformity with GAAP. © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 20

Disclaimer of Opinion It is issued when the auditor is unable to be satisfied that the overall financial statements are fairly presented. © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 21

Learning Objective 5 Explain how materiality affects audit reporting decisions. © 2005 Prentice Hall

Materiality A misstatement in the financial statements can be considered material if knowledge of the misstatement would affect a decision of a reasonable user of the statements. © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 23

Levels of Materiality Amounts are immaterial. Amounts are material but do not overshadow the financial statements as a whole. Amounts are so material or so pervasive that overall fairness of the statements is in question. © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 24

Relationship of Materiality to Type of Opinion Materiality Significance in Terms of Level Reasonable Users’ Decisions Users’ decisions are unlikely Immaterial to be affected. Users’ decisions are likely Material to be affected. Highly Users’ decisions are likely material to be significantly affected. Type of Opinion Unqualified Qualified Disclaimer or adverse © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 25

Materiality Decisions Failure to follow GAAP Audit report Unqualified Qualified opinion only Adverse © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 26

Materiality Decisions Scope limitation Audit report Unqualified Qualified scope and opinion Disclaimer © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 27

Materiality Decisions Dollar amount compared with a base Measurability Nature of the item ©

Learning Objective 6 Draft appropriately modified audit reports under a variety of circumstances. © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 29

Discussion of Conditions Requiring Departure Auditor’s scope has been restricted. Statements are not in conformity with GAAP. Auditor is not independent. © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 30

Learning Objective 7 Determine the appropriate audit report for a given audit situation. ©

Auditor’s Decision Process Determine whether any condition exists requiring a departure from a standard unqualified report. Decide the materiality for each condition. Decide the appropriate type of report. Write the audit report. © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 32

Scope Restricted by Client or Conditions Level of Materiality Immaterial Material Extremely Material Qualified scope, additional Unqualified Disclaimer paragraph, and qualified report of opinion (except for) © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 33

Statements Not Prepared in Accordance With GAAP Level of Materiality Immaterial Material Extremely Material Unqualified report Additional paragraph and qualified opinion (except for) Adverse opinion © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 34

The Auditor Is Not Independent Level of Materiality Immaterial Material Extremely Material Disclaimer of opinion (regardless of materiality) © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 35

Number of Paragraphs in the Report Standard unqualified Unqualified with explanatory paragraph Unqualified shared report with other auditors Qualified – opinion only Qualified – scope and opinion Disclaimer – scope limitation Adverse © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 4 4 3 - 36

Learning Objective 8 Understand combined reporting on financial statements and management’s report on internal control over financial reporting. © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 37

Sarbanes-Oxley Act This Act requires the auditor of a public company to attest to management’s report on the effectiveness of internal control over financial reporting. © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 38

Sarbanes-Oxley Act Combined Report on Financial Statements and Management’s Assessment of Internal Control Over Financial Reporting 1. Introductory paragraph 2. Definition paragraph 3. Scope paragraph 4. Inherent limitation paragraph 5. Opinion paragraph © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 39

Learning Objective 9 Discuss the impact of e-commerce on audit reporting. © 2005 Prentice

Impact of E-Commerce on Audit Reporting Most companies provide access to financial information through their home Web page. Auditors are not required to read information contained in electronic sites. Auditing standards note that electronic sites are not considered “documents. ” © 2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 3 - 41