1. CHAPTER 15 AUDIT REPORTS ON FINANCIAL STATEMENTS

2. Learning Objectives
Identify and describe the principles underlying audit reporting on financial statements
Describe the information that is included in a standard unqualified audit report on financial statements and list the requirements for issuing a standard unqualified report on financial statements
Describe financial statement audits requiring an unqualified report with explanatory language and identify the appropriate audit report modifications

3. Learning Objectives
Describe financial statement audits requiring a qualified report and identify the appropriate audit report modifications
Describe financial statement audits requiring an adverse report and identify the appropriate audit report modifications
Describe financial statement audits requiring a disclaimer of opinion and identify the communication the auditor is required to provide

4. Learning Objectives
Assess various reporting situations requiring other than a standard unqualified report and determine the appropriate audit report that should be issued
Describe the information that is included in a standard unqualified audit report on internal control over financial reporting and identify the appropriate audit report modifications for situations requiring other than an unqualified report on internal control over financial reporting

5. Learning Objectives
Apply the frameworks for professional decision making and ethical decision making to issues involving audit reporting situations

6. THE AUDIT OPINION FORMULATION PROCESS

7. PROFESSIONAL JUDGMENT IN CONTEXT - Investors, Auditors, and Standard Setters Debate Changes in Audit Reports
Changes to the standard unqualified audit report that are being debated by auditing standard setters and investors
Addition of auditor commentary on matters significant to users’ understanding of the audited financial statements
More frequent use of Emphasis of Matter paragraphs
Disclosure of which engagement partner at the firm supervised the audit and who from outside the audit firm participated in the audit

8. PROFESSIONAL JUDGMENT IN CONTEXT - Investors, Auditors, and Standard Setters Debate Changes in Audit Reports
The Public Company Accounting Oversight Board (PCAOB) and the International Auditing and Assurance Standards Board (IAASB) have indicated that they will issue proposed standards on the auditor reporting model that may address some of these additional disclosures

9. PROFESSIONAL JUDGMENT IN CONTEXT - Investors, Auditors, and Standard Setters Debate Changes in Audit Reports
What information is currently included in the standard unqualified audit report? (LO 2)
How does the standard unqualified audit report issued for U.S. public companies differ from the standard report issued in other parts of the world or for U.S. nonpublic companies? (LO 2)
What types of additional information could be included in the standard unqualified audit report? (LO 2)
What circumstances require a deviation from the standard unqualified audit report? (LO 3, 4, 5, 6)

10. Learning objective 1
Identify and describe the principles underlying audit reporting on financial statements

11. Principles Underlying Audit Reporting
The American Institute of Certified Public Accountant’s (AICPA) first and seventh principles governing an audit conducted in accordance with generally accepted auditing standards (GAAS) describe the principles underlying audit reporting
These principles require auditors to either:
Express an unqualified opinion on the entire set of financial statements and related footnotes, or
State the reasons that such an opinion cannot be expressed

12. Principles Underlying Audit Reporting
If there is a material deviation from generally accepted accounting principles (GAAP):
Auditor should explicitly state the nature of the deviation and the dollar effects so that a user can appropriately modify the financial statements

13. Learning objective 2
Describe the information that is included in a standard unqualified audit report on financial statements and list the requirements for issuing a standard unqualified report on financial statements

14. Standard Unqualified Audit Reports - U.S. Public Companies
Designed to promote clear communication between auditor and financial statement user by delineating:
Introductory paragraph
Scope paragraph
Opinion paragraph

15. Standard Unqualified Audit Reports - U.S. Public Companies
If a combined report on the financial statements and internal controls, two additional paragraphs are included
Definition paragraph - Defines what is meant by internal control over financial reporting
Inherent limitations paragraph - Discusses why internal control may not prevent or detect misstatements

16. Other important components of an audit report
Includes the word ‘independent’
Title
Board of directors or shareholders of the organization for public companies
Varies depending on the circumstances of the engagement
Addressee
No earlier than the date on which the auditor has obtained sufficient appropriate evidence to support the opinion
Audit report date
Signature of audit firm
City/state from which the auditor’s report has been issued

17. EXHIBIT 15.2 - SEC Reporting Requirements

18. Requirements for a Standard Unqualified Audit Report on the Financial Statements for U.S. Public Companies
There should be no material violations of GAAP
Disclosures should be adequate
Auditor should be able to perform all of the necessary procedures
There should be no change in accounting principles that had a material effect on the financial statements
The auditor should not have significant doubt about the client remaining a going concern
The auditor should be independent

19. Modification of the standard unqualified report
When the conditions are not present, auditor should modify the standard unqualified report
Options include:
Issue an unqualified opinion with explanatory language
Qualify the audit opinion
Issue an adverse opinion
Issue a disclaimer

20. Standard Unqualified Audit Reports - U.S. Nonpublic Companies
Introductory paragraph - What was audited
Management’s responsibility paragraph - Responsibilities of client management
Scope paragraph - Responsibilities of the auditor and the nature of the audit process
Opinion paragraph - Auditor’s opinion on the fairness of the financial statements
For some engagements, financial statements might be audited in accordance with multiple auditing standards

21. Non-U.S. Companies Auditors refer to ISA 700 for guidance
Consistent with the AICPA’s AU-C 700 with a few terminology differences
True and fair view - Used in ISA 700; is not used in the United States auditing standards
Present fairly, in all material respects - GAAS continues to require the use of the term

22. Learning objective 3
Describe financial statement audits requiring an unqualified report with explanatory language and identify the appropriate audit report modifications

23. Unqualified Audit Reports with Explanatory Language
Used to explain:
Justified departure from GAAP
Inconsistent application of GAAP
Substantial doubt about client being a going concern
Emphasis of some matter, such as unusually important subsequent events, risks, or uncertainties associated with contingencies or significant estimates
Reference to other auditors

24. Explanatory Language - Justified Departure from GAAP
Rule 203 of the AICPA Code of Professional Conduct permits auditor to issue an unqualified opinion when there has been a material departure from GAAP
Only if the client can demonstrate, and auditor agrees, that due to unusual circumstances, the financial statements would have been misleading had GAAP been followed

25. Explanatory Language - Justified Departure from GAAP
Auditor should add:
An informational paragraph either before or after the opinion paragraph to describe the departure from GAAP
Its approximate effects
Reasons for which compliance with GAAP would result in misleading statements

26. EXHIBIT 15.3 - Example of Possible Audit Report Language Describing a Justified Departure from GAAP

27. Explanatory Language - Inconsistent Application of GAAP
Change in accounting principles
From one GAAP to another - FIFO to LIFO
From non-GAAP to GAAP - Cash basis to accrual basis
Both changes would require auditor to add an explanatory paragraph to the audit report

28. Explanatory Language - Inconsistent Application of GAAP
Changes in accounting estimates and accounting for new transactions are not considered changes in accounting principles
Change in estimate affected by an accounting principle requires an explanatory language in the audit report
AS 6 requires an additional paragraph for the correction of an error not involving an accounting principle for public companies

29. Explanatory Language - Inconsistent Application of GAAP
The explanatory paragraph serves as a flag directing the user’s attention to the relevant footnote disclosure if client has:
Changed an accounting principle
Reasonable justification for the change
Followed GAAP in accounting for and disclosing this change

30. Explanatory Language - Substantial Doubt About the Client Being a Going Concern
Explanatory paragraph should be clearly worded to indicate:
Auditor’s substantial doubt about client’s continuing as a going concern
Reference to management’s footnote(s) explaining the problems and plans to overcome the problem
Auditor may not feel comfortable expressing any opinion for some going-concern situations in which client is experiencing severe financial distress
Would issue a disclaimer

31. Explanatory Language - Emphasis of a Matter
Significant transactions with related entities
Important subsequent events, such as a board-of-director decision to divest a major segment of the business
Important risks or uncertainties associated with contingencies or significant estimates

32. EMPHASIS-OF-MATTER PARAGRAPHS AND OTHER-MATTER PARAGRAPHS IN INDEPENDENT AUDITOR’S REPORT FOR U.S. NONPUBLIC COMPANIES
Paragraph included:
In the auditor’s report that is required by GAAS, or
At the auditor’s discretion, and that refers to a matter appropriately presented or disclosed in the financial statements
This paragraph should be included immediately after the opinion paragraph in the auditor’s report
Use the heading ‘Emphasis of Matter’ or other appropriate heading

33. EMPHASIS-OF-MATTER PARAGRAPHS AND OTHER-MATTER PARAGRAPHS IN INDEPENDENT AUDITOR’S REPORT FOR U.S. NONPUBLIC COMPANIES
A clear reference to:
The matter being emphasized should be included
Where relevant disclosures that fully describe the matter can be found in the financial statements should be included
Auditor should indicate that auditor’s opinion is not modified with respect to the matter being emphasized

34. Explanatory Language - Reference to Other Auditors
The principal auditor (group engagement partner) needs to decide whether to mention the other auditor in the overall audit report
Care must be taken when relying on other auditors’ reports
Principal auditor should have participated in the audit at a sufficient level
Regardless of reference being made in auditor’s report to the report of another auditor, principal auditor is responsible for the overall opinion

35. Explanatory Language - Reference to Other Auditors
If the principal audit firm chooses to mention the other firm in the audit report
Wording of the standard report is modified
No additional paragraph is needed
Change appears in:
Introductory paragraph to indicate the shared responsibility for the overall opinion
Scope and opinion paragraphs modified to reference the other auditor

36. Explanatory Language - Reference to Other Auditors
For nonpublic clients:
Extensive change would appear in the auditor’s responsibility section
Opinion paragraph would include a reference to the other auditor
If the other auditor’s report is qualified:
Principal auditor must consider whether the subject of the qualification is of such nature and significance in relation to the overall financial statements that it would affect the overall opinion

37. EXHIBIT Reporting Requirements When Part of an Audit Is Performed by Other Independent Auditors

38. EXHIBIT Reporting Requirements When Part of an Audit Is Performed by Other Independent Auditors (CONT.)

39. EXHIBIT Reporting Requirements When Part of an Audit Is Performed by Other Independent Auditors (CONT.)

40. Auditing in Practice - Problems When Serving as a Principal Auditor: Insights from the PCAOB
Many registered public accounting firms located in the United States issue audit reports on financial statements filed by issuers that have substantially all of their operations outside of the U.S
Although it is not inappropriate, the Board’s inspection process suggests that some firms may not be conducting audits in accordance with PCAOB standards

41. Qualified Reports, Adverse Reports, and Disclaimers
When the auditor alters the wording of the standard unqualified report in a manner that affects the type of opinion expressed, the report cannot be issued as an unqualified opinion
Auditor will provide a modified opinion which includes:
A qualified opinion
An adverse opinion, or
A disclaimer of opinion

42. Auditing in Practice - Language in Modified Reports for U. S
Auditing in Practice - Language in Modified Reports for U.S. Nonpublic Companies
When an opinion on the financial statements is modified, auditor should include a basis for modification paragraph in the auditor’s report
It should provide a description of the matter giving rise to the modification
Auditor should place this paragraph immediately before the opinion paragraph and use a heading as appropriate:
Basis for Qualified Opinion
Basis for Adverse Opinion
Basis for Disclaimer of Opinion

43. Learning objective 4
Describe financial statement audits requiring a qualified report and identify the appropriate audit report modifications

44. Qualified Audit Reports
Situations in which an auditor will issue a qualified report
A material unjustified departure from GAAP that is not pervasive
Inadequate disclosure that is not pervasive
A scope limitation such that the possible effects on the financial statements of undetected misstatements, if any, could be material but not pervasive

45. Qualified Report - Material Unjustified Departure from GAAP That is Not Pervasive
Qualified opinion will be expressed if a client has a departure from GAAP that can be isolated to one item
Pervasive GAAP departures, affecting more than one item, would result in an adverse opinion
Pervasive: Describes the effects or the possible effects on the financial statements of misstatements that are undetected due to an inability to obtain sufficient appropriate audit evidence

46. Qualified Report - Inadequate Disclosure
If client refuses to make appropriate disclosures, auditor should:
Express a qualified or adverse opinion, depending on pervasiveness of omitted disclosures
Provide the omitted information in the audit report, if practicable
Explanatory paragraph - Should describe the nature of the omitted disclosures
Opinion paragraph - Should be modified to describe nature of qualification

47. EXHIBIT 15.7 - Opinion Qualification Because of Inadequate Disclosure

48. Qualified Report - Scope Limitation
Restrictions on scope of audit, whether imposed by client or by circumstances beyond the auditor’s or client’s control, may require auditor to qualify an opinion
In some situations circumstances may be such that a disclaimer would be more appropriate
Circumstances that may limit the audit scope
Timing of the fieldwork
Inability to gather sufficient appropriate evidence
Inadequacy in the accounting records

49. Learning objective 5
Describe financial statement audits requiring an adverse report and identify the appropriate audit report modifications

50. Adverse Audit Reports
Adverse report is appropriate when financial statements contain:
Pervasive and material unjustified departure from GAAP
Lack of important disclosures that is pervasive
When a significant number of items in the financial statements violate GAAP

51. EXHIBIT 15.9 - Example of Possible Audit Report Language Describing a Justified Departure from GAAP

52. Adverse Report - Lack of Important Disclosures That Is Pervasive
Auditor can issue an adverse opinion if:
Client’s financial statements have omitted disclosures, such that
Financial statements taken as a whole are not presented fairly in conformity with GAAP

53. Learning objective 6
Describe financial statement audits requiring a disclaimer of opinion and identify the communication the auditor is required to provide

54. Audit Reports with a Disclaimer of Opinion
An auditor issues a disclaimer of opinion report when:
Scope limitation exists
Substantial doubt exists about the client being a going concern
There is lack of independence

55. Disclaimer - Scope Limitation
Scope limitations caused by circumstances are such that it is not possible to form an opinion
Introductory paragraph’s wording modified for a scope limitation
Scope paragraph is omitted
Additional paragraph is inserted to describe the scope limitation(s)
Last paragraph states that no opinion can be expressed

56. Disclaimer - Scope Limitation for Non-U.S. Companies
ISA 705 requires auditor to withdraw from audit when auditor is unable to obtain sufficient appropriate audit evidence because of a management-imposed limitation, and
Auditor concludes that possible effects on financial statements of undetected misstatements could be both material and pervasive

57. Disclaimer - Scope Limitation for Non-U.S. Companies
ISA 705
Auditors required to withdraw from audit
If auditor concludes that possible effects of undetected misstatements could be both material and pervasive
U.S. Standards
Auditors required to consider withdrawal from the engagement
Auditor should consider whether to withdraw or disclaim an opinion on the financial statements

58. Disclaimer - Substantial Doubt About the Client Being a Going Concern
Auditor may issue a disclaimer of opinion if there is a substantial doubt about the client continuing as a going concern
In such cases, auditor would believe that an additional paragraph to an unqualified opinion is not appropriate

59. Disclaimer - Auditor Lacking Independence
When auditors lack independence with respect to a client:
They cannot perform an audit in accordance with professional auditing standards
They are precluded from expressing an opinion on the financial statements
In such cases, a one-paragraph disclaimer should be issued stating the lack of independence
Auditor omits the reasons for lack of independence

60. Disclaimer - Auditor Lacking Independence
Report would have no title or salutation
Such a situation should rarely occur
It could happen when it is discovered late in the audit that one of the auditors on the engagement had a financial interest in the client

61. Learning objective 7
Assess various reporting situations requiring other than a standard unqualified report and determine the appropriate audit report that should be issued

62. Comparisons of Modifications to the Standard Unqualified Audit Report
Deciding on the type of opinion is important
This is particularly true of the decisions based on:
Materiality level and pervasiveness of GAAP violations
Significance of scope limitations
Likelihood of the entity being a going concern
Issuing an inappropriate opinion can lead to legal problems
Report decision often involves consultation

63. EXHIBIT 15. 11 - Summary of Audit Report Modifications for U. S
EXHIBIT Summary of Audit Report Modifications for U.S. Public Companies

64. Learning objective 8
DESCRIBE THE INFORMATION THAT IS INCLUDED IN A STANDARD UNQUALIFIED AUDIT REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING AND IDENTIFY THE APPROPRIATE AUDIT REPORT MODIFICATIONS FOR SITUATIONS REQUIRING OTHER THAN AN UNQUALIFIED REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

65. Audit Reports on Internal Control Over Financial Reporting (ICFR)
Auditor evaluates identified control deficiencies individually, and in aggregate, to assess material weakness in ICFR
Auditor issues an:
Unqualified opinion when it is determined that there are no material weaknesses in ICFR
Adverse opinion when it is determined that there is one or more material weaknesses in ICFR

66. Audit Reports on Internal Control Over Financial Reporting (ICFR)
PCAOB AS 5 identifies situations in which the auditor modifies audit report on ICFR effectiveness
Elements of management’s annual report on internal control are incomplete or improperly presented
There is a restriction on the scope of the engagement
Auditor decides to refer to the report of other auditors as the basis, in part, for the auditor’s own report

67. Audit Reports on Internal Control Over Financial Reporting (ICFR)
There is other information contained in management’s annual report on ICFR
Management’s annual certification pursuant to section 302 of the Sarbanes-Oxley Act is misstated

68. ELEMENTS OF MANAGEMENT’S ANNUAL REPORT ON INTERNAL CONTROL ARE IMPROPERLY PRESENTED
If the management’s report does not describe an identified material weakness, the auditor’s report will include an explanatory paragraph that describes the reasons for this determination

69. Restriction on the Scope of Engagement
If there are restrictions placed on the scope of the engagement the auditor will either:
Withdraw from the engagement
Disclaim an opinion

70. AUDITOR REFERS TO REPORT OF OTHER AUDITORS AS BASIS, IN PART, FOR AUDITOR’S OWN REPORT
In certain situations audit report on ICFR may include a reference by the auditor to work performed by another auditor
The other auditor might be performing the ICFR audit work at a subsidiary, division, branch, or component of the company
Such a decision might differ from the corresponding decision as it relates to audit of financial statements

71. OTHER INFORMATION CONTAINED IN MANAGEMENT’S ANNUAL REPORT ON ICFR
In addition to information required to be provided, in some instances, management may choose to include additional information in its report on ICFR
In such a case, the auditor will disclaim an opinion on that additional information

72. MANAGEMENT’S ANNUAL CERTIFICATION PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT IS MISSTATED
As a result of the audit of ICFR, auditors might believe that modifications to the disclosures about changes in ICFR are necessary
For annual certifications to be accurate
To comply with the requirements of Section 302 of Sarbanes-Oxley
Auditor should modify the report on ICFR to include an explanatory paragraph
Describing reasons auditor believes management’s disclosures should be modified