1. Copyright © 2016 South-Western/Cengage Learning AUDIT REPORTS ON FINANCIAL STATEMENTS CHAPTER 15 Auditing A Risk-Based Approach To Conducting A Quality Audit 10 th edition Karla M. Johnstone | Audrey A. Gramling | Larry E. Rittenberg

2. Copyright © 2016 South-Western/Cengage Learning 15-2 LEARNING OBJECTIVES 1. Identify and describe the principles underlying audit reporting on financial statements 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 3. Describe financial statement audits requiring an unqualified report with explanatory language and identify the appropriate audit report modifications 4. Describe financial statement audits requiring a qualified report and identify the appropriate audit report modifications

3. Copyright © 2016 South-Western/Cengage Learning 15-3 LEARNING OBJECTIVES 5. Describe financial statement audits requiring an adverse report and identify the appropriate audit report modifications 6. Describe financial statement audits requiring a disclaimer of opinion and identify the communication the auditor is required to provide 7. Assess various reporting situations requiring other than a standard unqualified report and determine the appropriate audit report that should be issued 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

4. Copyright © 2016 South-Western/Cengage Learning 15-4 THE AUDIT OPINION FORMULATION PROCESS

5. Copyright © 2016 South-Western/Cengage Learning IDENTIFY AND DESCRIBE THE PRINCIPLES UNDERLYING AUDIT REPORTING ON FINANCIAL STATEMENTS LEARNING OBJECTIVE 1

6. Copyright © 2016 South-Western/Cengage Learning 15-6 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

7. Copyright © 2016 South-Western/Cengage Learning 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 LEARNING OBJECTIVE 2

8. Copyright © 2016 South-Western/Cengage Learning 15-8 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

9. Copyright © 2016 South-Western/Cengage Learning 15-9 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

10. Copyright © 2016 South-Western/Cengage Learning 15-10 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 dateSignature of audit firm City/state from which the auditor’s report has been issued

11. Copyright © 2016 South-Western/Cengage Learning 15-11 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 Watch for new standard where “critical audit matters” will be discussed

12. Copyright © 2016 South-Western/Cengage Learning 15-12 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

13. Copyright © 2016 South-Western/Cengage Learning 15-13 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

14. Copyright © 2016 South-Western/Cengage Learning 15-14 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 Watch for new standard where “key audit matters” will be discussed

15. Copyright © 2016 South-Western/Cengage Learning DESCRIBE FINANCIAL STATEMENT AUDITS REQUIRING AN UNQUALIFIED REPORT WITH EXPLANATORY LANGUAGE AND IDENTIFY THE APPROPRIATE AUDIT REPORT MODIFICATIONS LEARNING OBJECTIVE 3

16. Copyright © 2016 South-Western/Cengage Learning 15-16 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 (group audits and component auditors)

17. Copyright © 2016 South-Western/Cengage Learning DESCRIBE FINANCIAL STATEMENT AUDITS REQUIRING A QUALIFIED REPORT AND IDENTIFY THE APPROPRIATE AUDIT REPORT MODIFICATIONS LEARNING OBJECTIVE 4

18. Copyright © 2016 South-Western/Cengage Learning 15-18 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

19. Copyright © 2016 South-Western/Cengage Learning 15-19 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

20. Copyright © 2016 South-Western/Cengage Learning 15-20 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

21. Copyright © 2016 South-Western/Cengage Learning 15-21 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

22. Copyright © 2016 South-Western/Cengage Learning 15-22 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

23. Copyright © 2016 South-Western/Cengage Learning DESCRIBE FINANCIAL STATEMENT AUDITS REQUIRING AN ADVERSE REPORT AND IDENTIFY THE APPROPRIATE AUDIT REPORT MODIFICATIONS LEARNING OBJECTIVE 5

24. Copyright © 2016 South-Western/Cengage Learning 15-24 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

25. Copyright © 2016 South-Western/Cengage Learning 15-25 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

26. Copyright © 2016 South-Western/Cengage Learning DESCRIBE FINANCIAL STATEMENT AUDITS REQUIRING A DISCLAIMER OF OPINION AND IDENTIFY THE COMMUNICATION THE AUDITOR IS REQUIRED TO PROVIDE LEARNING OBJECTIVE 6

27. Copyright © 2016 South-Western/Cengage Learning 15-27 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

28. Copyright © 2016 South-Western/Cengage Learning 15-28 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

29. Copyright © 2016 South-Western/Cengage Learning 15-29 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

30. Copyright © 2016 South-Western/Cengage Learning 15-30 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

31. Copyright © 2016 South-Western/Cengage Learning 15-31 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

32. Copyright © 2016 South-Western/Cengage Learning 15-32 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

33. Copyright © 2016 South-Western/Cengage Learning 15-33 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

34. Copyright © 2016 South-Western/Cengage Learning ASSESS VARIOUS REPORTING SITUATIONS REQUIRING OTHER THAN A STANDARD UNQUALIFIED REPORT AND DETERMINE THE APPROPRIATE AUDIT REPORT THAT SHOULD BE ISSUED LEARNING OBJECTIVE 7

35. Copyright © 2016 South-Western/Cengage Learning 15-35 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

36. Copyright © 2016 South-Western/Cengage Learning 15-36 EXHIBIT 15.11 - SUMMARY OF AUDIT REPORT MODIFICATIONS FOR U.S. PUBLIC COMPANIES

37. Copyright © 2016 South-Western/Cengage Learning 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 LEARNING OBJECTIVE 8

38. Copyright © 2016 South-Western/Cengage Learning 15-38 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

39. Copyright © 2016 South-Western/Cengage Learning 15-39 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

40. Copyright © 2016 South-Western/Cengage Learning 15-40 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