Section 3 Auditors’ Reports

Introduction Expressing and independent and expert opinion Third reporting standard: The auditors’ report should contain either an expression of opinion on the financial statements or an assertion that an opinion cannot be expressed. In the latter case, the reasons therefor should be stated.

Financial Statements What is included in the financial statements? Notes to the Financial Statements Why needed?

Type of information in the notes Financial data Accounting information Other matters

A list of common requirements Significant accounting policies Changes in accounting principles and practices Subsequent events Segmented information Related party transactions

The Auditors’ Standard Report What does the standard report imply? Adopted in 1990 by the Auditing Standards Board Three paragraphs

Carney, Black and Heath, LLP AUDITORS’ REPORT To the Shareholders of XYZ Industries Ltd. We have audited the balance sheet of XYZ Industries LTD. as at December 31, 200X, and the statements of income, retained earnings, and cash flows for the year 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 audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance 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. In our opinion, these financial statements present fairly, in all material respects, the financial position of the company as at December 31, 200X, and the results of its operations and cash flows for the year then ended in accordance with generally accepted accounting principles. Carney, Black and Heath, LLP Chartered Accountants Toronto, Canada March 1, 200Y

Introductory Paragraph The first paragraph Indicates that: 1. 2. 3.

Scope Paragraph The second paragraph Describes: 1. 2. 3.

Opinion Paragraph The last paragraph Indicates what? What does present fairly mean?

Signing The Report In a partnership, not an individual A sole practitioner

Date of The Report What does this date represent? This date is significant

Unqualified Auditors Report Issuance When: No material departure from GAAP Performed in accordance with GAAS

Expression of An Opinion A number of options: Unqualified opinion: Qualified opinion Adverse opinion Denial of opinion

Materiality CICA 5130: A misstatement or the aggregate of all misstatements in financial statements is considered to be material if, in the light of surrounding circumstances, it is probable that the decision of a person who is relying on the financial statements, and who has a reasonable knowledge of business and economic activities, would be changed or influenced by such misstatement or the aggregate of all misstatements.

Why is materiality important? Material departure from GAAP Use material to describe

Fair Presentation, GAAP, and Professional Judgment The auditors’ professional judgment on the fair presentation of financial statements must be made within the framework of GAAP Thus the GAAP used

The Unqualified Report When does the auditor express an unqualified opinion? Additional wording can be added to the standard report

Statutory Requirements CICA 5701 EG: Consistency of application of GAAP

Emphasis of a Matter EG: Separate paragraph after the opinion paragraph

Reservation Inability of the auditor to express an unqualified opinion? Reservation paragraph

Qualified Opinions Restricts the auditors’ responsibility for fair presentation in some area of the financial statements Reservation paragraph

Some specific circumstances Departure From GAAP Some specific circumstances An inappropriate accounting treatment An inappropriate valuation A failure to disclose essential information or to present information in an appropriate manner

Some specific circumstances Scope Limitations Some specific circumstances The timing of the auditors’ appointment and the audit work The unavailability of accounting records The inability to perform necessary audit procedures

A Departure From GAAP Qualified or an adverse opinion Depends on materiality

Why qualify? What usually happens? Introductory and scope paragraphs do not change

Misapplication of Accounting principles: Note 9 to the financial statements describes the depreciation policy with respect to the company’s manufacturing plants and equipment. The note also indicates that the company is not depreciating its head office building, which it acquired five years ago, on the grounds that it is not a producing asset and is maintaining its value as a potential rental or resale property. In this respect the financial statements are not in accordance with generally accepted accounting principles. The estimated useful life of similar buildings is usually considered to be between 30 and 40 years. If depreciation had been provided on the basis of an estimated life of, say, 35 years, depreciation for the current year would have been increased by $200,000 (1999, $220,000), net income after taxes would have decreased by $100,000 (1999, $110,000), accumulated depreciation would have increased by $200,000 (1999, $220,000) and the closing balance of retained earnings would have been reduced by $610,000 (1999, $510,000). In our opinion, except for the effects of the failure to record depreciation as described in the preceding paragraph, these financial statements present fairly, in all material respects, the financial position of the company as at December 31, 2000, and the results of its operations and cash flows for the year then ended in accordance with generally accepted accounting principles.

Inadequate Disclosures: The accompanying financial statements, in our opinion, do not draw attention explicitly to doubts concerning the company’s ability to realize its assets and discharge its liabilities in the normal course of business. These doubts arise because it is uncertain whether the company will be able to refinance long-term debt in the amount of $10,000,000 due on March 26, 2001, in view of the existence of recurring operating losses in the past five years and the deficiency in working capital of $2,000,000 at December 31, 2000. If refinancing cannot be arranged, it is not known whether the company can sell its hotel property for an amount sufficient to realize its carrying value of $9,000,000 and to generate adequate funds to repay this debt. In our opinion, except for the the omission of the disclosure described in the preceding paragraph, these financial statements present fairly, in all material respects, the financial position of the company as at December 31, 2000, and the results of its operations and cash flows for the year then ended in accordance with generally accepted accounting principles.

Consistency of Accounting Principles A change in accounting principle Is a reservation for lack of consistency required?

Limitations on Scope of Examination Inability to perform necessary auditing procedures If the scope limitation is not so material

Scope Limitations: Except as explained in the following paragraph, we conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance 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. Because we were appointed auditors of the company during the current year, we were not able to observe the counting of physical inventories at the beginning of the year nor to satisfy ourselves concerning those inventory quantities by alternative means. Since opening inventories enter into the determination of the results of operations and cash flows, we were unable to determine whether adjustments to cost of sales, income taxes, net income for the year, opening retained earnings, and cash provided from operations might be necessary. In our opinion, except for the effect of adjustments, if any, which we might have determined to be necessary had we been able to examine opening inventory quantities, as described in the preceding paragraph, the statement of income, retained earnings and cash flow present fairly, in all material respects, the results of operations, and cash flows of the company for the year ended December 31, 2000, in accordance with generally accepted accounting principles. Further, in our opinion, the balance sheet presents fairly, in all material respects, the financial position of the company as at December 31, 2000, in accordance with generally accepted accounting principles.

Reliance on Other Auditors Primary auditors, on occasion, must rely on the audit work of another accounting firm Common situation

To Justify Reliance Consider professional qualifications, competence,and integrity of the secondary auditor Communicate with the secondary auditor Read the report of the secondary auditor Obtain a written communication from the secondary auditor Review the work of the secondary auditor

Major Uncertainty Affecting a Client’s Business Can be a wide range here CICA 5510:

A Major Contingency Auditor must obtain sufficient appropriate audit evidence A reservation of opinion?

A Going Concern What conditions could precipitate this? Reservation of opinion?

Adverse Opinions The opposite of an unqualified opinion Disclosure required Standard introductory and scope paragraphs

In the opinion paragraph: Adverse Opinion: In the opinion paragraph: In our opinion, because of the effects of the matters discussed in the preceding paragraph, these these financial statements do not present fairly the financial position of the company as at December 31, 2000, and the results of its operations and cash flows for the year then ended in accordance with generally accepted accounting principles. What would the “preceding paragraph” be?

Denial of Opinion No opinion When required Separate reservation paragraph

Denial of Opinion: Except as explained in the following paragraph, we conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance 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 were not appointed auditor until after December 31, 2000, and thus did not observe the taking of physical inventories at the beginning of the year or the end of the year and were not able to satisfy ourselves concerning inventory quantities by alternative means. Also, our examination indicated serious deficiencies in the accounting records and in internal control. As a consequence, we were unable to satisfy ourselves that all revenues and expenditures of the company had been recorded, nor were we able to satisfy ourselves that the recorded transactions were proper. As a result, we were unable to determine whether adjustments were required in respect of recorded or unrecorded assets, recorded or unrecorded liabilities, and the components making up the statements of income, retained earnings, and cash flow. In view of the possible material effects on the financial statements of the matters described in the preceding paragraph, we are unable to express an opinion whether these financial statements are presented fairly in accordance with generally accepted accounting principles.

Materiality of the Issue Summary of Appropriate Auditors’ Reports Materiality of the Issue Type of Report Not Material Departure from GAAP Unqualified Scope limitation Material Qualified Qualified Very Material Adverse Denial

Comparative F/S in Audit Reports CICA has long supported presentation of comparative F/S When comparative statements are presented

Dating and Double Dating the Auditors’ Report Why is the date important? CICA 5405.06 Substantial completion of examination

Subsequent event and dating Two options Double dating Redating

Auditors’ Responsibility for Information in the Annual Report Other information CICA 7500 Accurately reproduced F/S and Audit Report Is any of this information inconsistent?

Error in Reproduction Inconsistency resulting from an error

Reports to the SEC in the United States Two principal laws Securities Act of 1933 Securities and Exchange Act of 1934 Forms S-1 through S-18 Form 8-K Form 10-Q Form 10-K

Problem 1. Types of report Problem 1. Types of report. What types of report (unqualified, qualified, adverse, denial) should the auditors generally issue in each of the following situations? Client-imposed restrictions limit very significantly the scope of the auditor’s procedures. The auditors decide that it is necessary to make reference in their report of another public accounting firm (the secondary auditor). The auditors believe that the financial statements have been stated in conformity with generally accepted accounting principles in all respects other than a disclosure of a material uncertainty.

Problem 2. Rowe & Myers are the primary auditors of Dunbar Electronics Problem 2. Rowe & Myers are the primary auditors of Dunbar Electronics. During the audit, Rowe & Myers engaged Jones & Abbot, an American public accounting firm, to audit Dunbar’s wholly owned U.S. subsidiary. Must Rowe & Myers make reference to the other auditors in their audit report? Assume that Jones & Abbot issued a qualified report on the U.S. subsidiary. Must Rowe & Myers include the same qualification in their report on Dunbar electronics?

Problem 3. While performing your audit of Williams Paper limited, you discover evidence that indicates that Williams may not have the ability to continue as a going concern. Discuss the types of information that may indicate a going-concern problem. Explain the auditors’ reporting obligation in such situations.

Problem 4: 2-24. Roscoe, public accountant, has completed the examination of the financial statements of Excelsior Corporation as of and for the year ended December 31, 1999. Roscoe also examined and reported on the Excelsior financial statements for the prior year. Roscoe drafted the following report for 1999. We have audited the balance sheet and statements of income and retained earnings of Excelsior Corporation as of December 31, 1999. We conducted our audit in accordance with generally accepted accounting standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of misstatement. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly the financial position of Excelsior Corporation as of December 31, 1999, and the results of its operations for the year then ended in conformity with generally accepted auditing standards, applied on a basis consistent with those of the preceding year. Other Information: 1. Excelsior is presenting comparative financial statements. 2. Excelsior does not wish to present a cash flow statement for either year.

3. During 1999, Excelsior changed its method of accounting for long-term construction contracts, properly reflected the effect of the change in the current year’s financial statements, and restated the prior year’s statements. Roscoe is satisfied with Excelsior’s justification for making the change. The change is discussed in footnote 12. 4. Roscoe was unable to perform normal accounts receivable confirmation procedures, but alternate procedures were used to satisfy Roscoe as to the existence of the receivables. 5. Excelsior Corporation is the defendant in a lawsuit, the outcome of which is highly uncertain. If the case is settled in favour of the plaintiff, Excelsior will be required to pay a substantial amount of cash which might require the sale of certain capital assets. The litigation and the possible effects have been properly disclosed in footnote 11. 6. Excelsior issued debentures on January 31, 1997, in the amount of $10,000,000. 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, 1998. Excelsior declined to disclose this essential data in the footnotes to the financial statements.

Required: Identify and explain any items included in “Other Information” that need not be part of the auditor’s report. Explain the deficiencies in Roscoe’s auditor’s report as drafted.

Problem 5: 2-25. For the following independent situations, assume you are the audit partner on the engagement. During your examination of Debold Brothers Ltd., you conclude there is a possibility that inventory is materially overstated. The client refuses to allow you to expand the scope of your examination sufficiently to verify whether the balance is actually misstated. You are auditing Woodcolt Linen Services, Inc., for the first time. Woodcolt has been in business for several years but has never had an audit before. After the audit is completed, you conclude that the current year balance sheet is stated correctly in accordance with GAAP. The client did not authorize you to do test work for any of the previous years. You were engaged to examine Cutter Steel Corp.’s financial statements after the close of the corporation’s fiscal year. Because you were not engaged until after the balance sheet date, you were not able to physically observe inventory, which is very material. On the completion of your audit, you are satisfied that Cutter’s financial statements are presented fairly, including inventory about which you were able to satisfy yourself by the use of alternative audit procedures.

Four weeks after the year-end date, a major customer of Prince Construction Ltd. Declared bankruptcy. Because the customer had confirmed the balance due to Prince at the balance sheet date, management refuses to charge off the account or otherwise disclose the information. The receivable represents approximately 10 percent of accounts receivable and 20 percent of net earnings before taxes. You complete the audit of Johnson Department Store Ltd., and, in your opinion, the financial statements are fairly presented. On the last day of the examination, you discover that one of your supervisors assigned to the audit had a material investment in Johnson. If you decide no auditor’s report can be issued, explain your decision. Auto Delivery Company Ltd. has a fleet of several trucks. In the past, Auto Delivery had followed the policy of purchasing all equipment. In the current year, they decided to lease the trucks. This change in policy is fully disclosed in the notes.

Problem 6: 2-33. The following is an auditor’s report, except for the opinion paragraph, of Tri-Nation Corp. We have audited the accompanying consolidated balance sheet of Tri-Nation Corp. and subsidiaries as of July 31, 1999, and the related statements of income, shareholders’ equity, and cash flow for the year then ended. These financial statements are the responsibility of management. Our responsibility is to express an opinion on these financial statements based on our audit. Except as explained in the following paragraph, we conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain a reasonable assurance as to 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. The company had significant deficiencies in internal control, including the lack of detailed records and certain supporting data which were not available for our examination. Therefore, we were not able to obtain sufficient evidence in order to form an opinion on the accompanying financial statements, including whether the inventory at July 31, 1999, ($670,490) was stated at lower of cost or market, or whether the deferred subscription revenue ($90,260) is an adequate estimate for the applicable liability, as discussed in notes 5 and 12, respectively. Required: Write the opinion paragraph for this auditor’s report. State any assumptions you have made.