1. 12-1 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. Chapter 12 Reports on Audited Financial Statements The very existence of the accounting profession depends on public confidence in the determination of certified public accountants to safeguard the public interest. --J.L Carey (Professional Ethics of Public Accounting)

2. 12-2 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. Independent Auditor's Report (PCAOB 1) Report of Independent Registered Public Accounting Firm To the Board of Directors and Stockholders Apollo Shoes, Inc. We have audited the balance sheets of Apollo Shoes, Inc. as of December 31,2006 and 2005, and the related statements of income, comprehensive income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of Apollo Shoes, Inc.'s management. Our responsibility is 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 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 Apollo Shoes, Inc. as of December 31, 2006 and 2005, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2006, 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), the effectiveness of Apollo Shoes’s internal control over financial reporting as of December 31, 2006, 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 22, 2007 expressed an unqualified opinion thereon. Smith & Smith, CPAs February 22, 2007 Report Title Report Address Introductory Paragraph: Notice of audit, F/S Examined Auditor, Management responsibilities Scope Paragraph: Description of an audit Opinion Paragraph Signature Report Date Internal Control Paragraph

3. 12-3 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. Presentation Outline I.Unqualified Opinion with Additional Explanation II.GAAP Departure Reports III.Reporting on Unusual Aspects of the Audit IV.Other Issues Affecting the Auditor’s Report V.Reporting on Internal Control Over Financial Reporting

4. 12-4 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. I. Unqualified Opinion with Additional Explanation A.Lack of Consistency B.Going Concern Uncertainties C.Emphasis of a Matter D.Reference to Report on Internal Control Over Financial Reporting

5. 12-5 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. A.Lack of Consistency (Example in Exhibit 12.3 on p. 436) When evaluating a change in accounting principle, auditors must be satisfied that management demonstrates that the change is to an allowable accounting principle that is preferable. Otherwise the change is a GAAP departure. No Paragraph -- Not Consistency Standard –Change in Accounting Estimate –Correction of Error Not Involving Principle –Changes in Classification –Variation in Statement of Cash Flows –Changes not Material to Current but may affect Future F/S

6. 12-6 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. B. Going Concern Uncertainties The auditor must evaluate whether there is substantial doubt about the entity remaining a going concern for a reasonable time after year-end, not to exceed one year beyond F/S date. Apply procedures and evaluate: –negative trends –defaults on debt obligations, restructuring of debt, arrearages of dividends –internal matters - work stoppages, dependence on one project –external matters - legal proceedings, changes in governmental regulations, natural disasters, etc. If going concern problem, auditor may disclaim (e.g., if liquidation values unknown), else add explanatory paragraph after opinion. No standard language, but must include the words substantial doubt and going concern. See Auditing Insights on pages 438 and 439.

7. 12-7 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. C. Emphasis of a Matter Add explanatory paragraph after opinion paragraph discussing the matter (e.g., a subsequent event not affecting year-end F/S’s) Usually items that are difficult to disclose in the financial statements –Often non-quantitative matters –Often subsequent events

8. 12-8 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. D. Reference to Report on Internal Control over Financial Reporting (Example in Exhibit 12.3 on p. 436) Only for companies under guidelines of AS 2 (publicly-traded) Paragraph following opinion paragraph –Indicates that auditor has examined the effectiveness of the company’s internal control over financial reporting –Reference to report, including nature of opinions express on management’s assessment and effectiveness of internal control

9. 12-9 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. II. GAAP Departure Reports A.Unjustified GAAP Departures 1.Qualified opinions 2.Adverse opinions B.Justified GAAP Departures – Rule 203 Report C.GAAP Departures Summary

10. 12-10 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. A1. Qualified (“Except for...”) Opinion (Example in Exhibit 12.6 on p. 443) GAAP departures can cause adverse opinions or qualified opinions -- depends upon severity and materiality. –Key question: Is the GAAP departure relatively contained (“compartmentalized”) or does it permeate the financial statements? Report Modifications: –Intro and scope paragraphs remain the same –Add middle paragraph explaining problem and detailing $ amounts involved –Change opinion paragraph (“In our opinion, except for the matter discussed in the preceding paragraph,….”)

11. 12-11 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. A2. Adverse Opinion (Example in Exhibit 12.7 on p. 443) Issued when statements are “so lacking in fairness” that a qualified opinion would be misleading (i.e., a serious departure from GAAP that permeates the financial statements). Report Modifications: –Intro and scope paragraphs remain the same –Add middle paragraph explaining problem and detailing $ amounts involved –Change opinion paragraph (add “do not” and “because of...”, omit “in all material respects”)

12. 12-12 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. B. Justified GAAP Departures - Rule 203 Report (Example in Exhibit 12.5 on p. 442) Rule 203 allows for non-GAAP solutions to fairly present the company's financial situation. –Rule 203 of the AICPA Code of Professional Conduct recognizes that adherence to certain accounting principles may create situations in which a company's financial condition may not be fairly presented. –Solution: Insert an additional middle paragraph (between scope and opinion paragraphs) stating the deviation from GAAP, but still issue an unqualified report.

13. 12-13 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. C. GAAP Departures Summary

14. 12-14 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. III. Reporting on Unusual Aspects of the Audit A.Scope limitation 1.Qualified opinion 2.Disclaimer of opinion B.Lack of independence C.GAAS Departures Summary

15. 12-15 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. A1. Qualified (“Except for...”) Opinions (Example in Exhibit 12.9 on p. 446) Scope limitations can cause disclaimers or qualified opinions depending upon severity and materiality. –Key question: Is the scope limitation limited, or does it permeate the financial statements? –If alternative procedures are available, the auditor may still be able to issue an unqualified opinion. Report Modifications: –Intro paragraph remain the same –Scope paragraph: “Except for the problem noted, the audit was conducted in accordance with auditing standards generally accepted in the United States”. –Add middle paragraph explaining problem –Change opinion paragraph (“In our opinion, except for the matter discussed in the preceding paragraph,….”)

16. 12-16 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. A2. Disclaimer of Opinion (Example in Exhibit 12.9 on p. 446) Significant scope limitation, usually company-imposed (e.g., no physical inventory taken, confirming A/R not allowed by company (and auditor cannot get satisfaction otherwise), significant subsidiary not examined, etc.) –The problem is that the auditor cannot gather sufficient competent evidence to form an opinion, even an adverse one. Report Modifications: –Intro paragraph: (“We were engaged to audit ….”; omit auditor responsibility) –Omit scope paragraph –Add middle paragraph explaining problem –Change opinion paragraph (“…we do not express an opinion….”)

17. 12-17 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. B. Lack of Independence Should state that CPA is not independent but need not state the reason why I am (We are) not independent with respect to the XYZ Company and the accompanying balance sheet as of December 31, 20XX, and the related statements of income retained earnings, and cash flows for the year then ended were not audited by me (us) and, accordingly, I (we) do not express and opinion on them. No heading on report Do not describe procedures performed BUT must describe material departures from GAAP

18. 12-18 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. C. GAAS Departures Summary

19. 12-19 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. IV. Other Issues Affecting the Auditor’s Report A.Reference to Other Auditors B.Circumstances Concerning Comparative Financial Statements C.Reporting on Other Information Accompanying the Financial Statements

20. 12-20 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. A. Reference to Other Auditors Another auditor has performed a significant portion of the audit (e.g., a partially-owned subsidiary or a branch located elsewhere). –Choice 1 - make no reference to other auditors and just issue Standard Report -- principal auditor assumes responsibility for other auditor's work. –Choice 2 - Make reference to Other Auditors in all three paragraphs. Requirements - In either case, principal auditor must be satisfied that the quality of the other auditor's work is good enough to be relied upon. –Inquiries of Professional Reputation –Obtain representation that other auditor is independent –Communicate with other auditor about GAAP/GAAS matters, awareness that statements will be consolidated (i.e., inter-company transfers, etc.), maybe visit and review other auditor's work if taking full responsibility. –If unable to rely on other auditor's work, consider scope limitation.

21. 12-21 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. B. Circumstances Concerning Comparative Financial Statements Different opinions on the financial statements –Most often occurs in first year audit with disclaimer on income statement and unqualified on balance sheet Updating an opinion –An updated prior year report for comparative financial statements may be the same as previously issued or changed to reflect information learned during the current year audit. –When the opinion differs from the prior report, the auditor must explain the change by adding a paragraph just before opinion paragraph explaining the change.

22. 12-22 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. C. Reporting on Other Information Accompanying The Financial Statements Examples include the president’s letter and management discussion and analysis of operations. Sections are separate and not considered part of the audited financial statements. Standard report is silent about other information unless an inconsistency or material misstatement of fact exists. A company’s financial statements and other information placed on a Web site are not currently subject to auditor review for inconsistencies or material misstatements.

23. 12-23 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. V. Reporting on Internal Control Over Financial Reporting A.Types of Opinions B.Reporting Options for Internal Control Report

24. 12-24 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. A. Types of Opinions Note that an auditor gives two opinions:  An opinion regarding whether management has properly assessed internal control over financial reporting.  Auditor’s assessment of internal control over financial reporting. See Exhibit 12.19 on p. 462 for possible scenarios.

25. 12-25 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. B. Reporting Options for Internal Control Report Present separate reports on company’s financial statements and company’s internal control over financial reporting –Each of the reports would reference other report Present combined report on company’s financial statements and company's internal control over financial reporting. Note components on p. 463 of text.

26. 12-26 McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. Choosing the Right Report