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AUDIT

Written By:

Roger Philipp, CPA

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Section 7 Audit Reports

Corresponding Videos

Watch the following course videos with this section:


7.01 Audit Reports 45:30
7.02 Standards of Reporting (ANOE) 33:22
7.03 Uncertainty, Scope Limitation, Adverse and Disclaimer of Opinion
29:00
7.04 Comparative Financial Statements 23:04
7.05 Audit Reports Homework Problems 17:02

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Section 7

Audit Reports
(7.01)
There are 5 basic types of Opinions SAS 79 (AU 508):

Unqualified opinion, which is a Standard Report


Unqualified opinion with explanatory language added to the report
Qualified opinion - except for
Adverse opinion do not present fairly
Disclaimer of opinion we do not express an opinion

Standard Unqualified Opinion (Nonpublic Companies - Nonissuer)


Independent Auditors Report (Nonpublic Company)
To: The Board of Directors of X Company (Those charged with Governance)
(INTRODUCTORY)
We have audited the accompanying balance sheet of X Company as of December 31,
20XX, and the related statements of income, retained earnings, and cash flows for the year
then ended. These financial statements are the responsibility of the Companys
management. Our responsibility is to express an opinion on these financial statements
based on our audit.
(SCOPE)
We conducted our audit in accordance with U.S Generally Accepted Auditing Standards.
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 audit provides a reasonable basis for our
opinion.
(OPINION)
In our opinion, the financial statements referred to above present fairly, in all material
respects, the financial position of X Company as of December 31, 20XX, and the results of
its operations and its cash flows for the year then ended in conformity with U.S. Generally
Accepted Accounting Principles.
[Signature]
[Date] (Sufficient Appropriate Audit Evidence is Obtained/ Dual Date )
The identification of the page as "independent auditor's report" is made in order to emphasize
that the other pages of the annual report were prepared by the client, not the auditor. The
report is being addressed "to the Board of Directors of X Company" since it was presumably the
audit committee of the board of directors that hired the auditor and that is the party to which the
auditor is reporting. It is acceptable to address the report directly to the company, or its
shareholders, or to a third party that hired the auditor to examine the statements of X
Company. It is not acceptable to address the report to members of the management team;
since management is the party the auditor is reporting on, the auditor's independence requires
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that management not be the party the auditor is reporting to. The report may also be
addressed to those charged with Governance.
The opening paragraph of the report, often called the introductory paragraph, includes three
sentences that:
1. Identify the financial statements that were audited.
2. Clearly indicate that the financial statements are the responsibility of the client's
management.
3. Define our responsibility as the expression of an opinion.
The second paragraph is known as the scope paragraph, and describes for the user the
manner in which the audit was conducted. Many of the five sentences are complicated and
difficult to remember, but their purposes are straightforward:
1. Indicate that GAAS was the basis of the audit work.
2. Emphasize that reasonable assurance is obtained of the financial statements being free
of material misstatement.
3. Describe the approach we used of examining evidence on a test basis.
4. Indicate that we assessed principles and estimates and evaluated the overall
presentation.
5. State our belief that our work provides a reasonable basis for our opinion.
Perhaps the most importance sentence is the second one, because this emphasizes the
concept of audit risk discussed in the planning area of the course. We state that we've
obtained reasonable, not absolute, assurance, so that the user understands that there remains
a possibility of material misstatement even if our audit was performed properly.
SAS 104 (AU 230) expands the definition of reasonable assurance by stating, While
exercising due professional care, the auditor must plan and perform the audit to obtain sufficient
appropriate audit evidence so that audit risk will be limited to a low level. The high, but not
absolute, level of assurance that is intended to be obtained by the auditor is expressed in the
auditors report as obtaining reasonable assurance about whether the financial statements are
free of material misstatement (whether caused by error or fraud).
The third paragraph of the standard report is the opinion paragraph, in which a single sentence
satisfies two of the requirements of an audit in accordance with GAAS:
1. We express an opinion, meeting the fourth standard of reporting.
2. We refer to GAAP, meeting the first standard of reporting.
The second standard of reporting on consistency and the third standard on disclosure do not
result in explicit statements in a standard report, since these standards only require comment
when there are new principles or inadequate disclosure and would result in a report that is
different from the standard report. We will discuss such variations in other modules.
Notice that the opinion paragraph does not refer to the financial statements by name, but
indicates the matters that are being fairly presented:
Financial position = Balance sheet
Results of operations = Statements of income and retained earnings
Cash flows = Statement of cash flows
The signature is of the in-charge auditor, and no specific exam testing appears to relate to
it. The date is not the date on which the report is signed, but under SAS 103 (AU 339), the
auditor's report should be dated on or after the date on which sufficient appropriate audit
evidence to support the opinion has been obtained. Sufficient appropriate audit evidence
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Section 7

includes evidence that the audit documentation has been reviewed, that the entitys financial
statements, including disclosures, have been prepared, and that management has asserted that
it has taken responsibility for them. This could result in a report date that is close to the report
release date.
This is the last day on which any evidence about the client is obtained, so the auditor's
responsibilities cannot include awareness of information arising after they have stopped seeking
evidence. Even if an auditor is asked to reissue an earlier report on a client or former client, it
will contain the date of the original report.
Occasionally, an auditor will discover information after the date that sufficient appropriate audit
evidence is obtained, but prior to signing the report. If such information requires the preparation
of a footnote referring to a date after the audit report date, it may result in some confusion
on the part of a user who sees an earlier date on the audit report than the date in the
footnote. To eliminate the confusion, the auditor dual dates the report, providing the date on
which the footnote information was obtained to supplement the basic date. For example, if the
auditor discovers on March 8 that a fire destroyed the company's warehouse the night before,
and a footnote is drafted that day referring to the details of the March 7 fire, the report date is as
follows:
March 1, 20X1, except for Note T, as to which the date is March 8, 20X1
No change is necessary to the body of the audit report, since the footnote of the client discusses
the issues involved. Dual dating is not appropriate when information obtained after the audit
report date involves no footnote reference, even if it requires the adjustment of the financial
statements themselves. For example, if the auditor discovers on March 8 that a customer of the
client received a discharge in bankruptcy the day before which included a debt owed to the
client on the balance sheet date, the financial statements of the client will be adjusted to write
off the receivable from the bankrupt customer, but there is no need for a footnote and the audit
report will still simply be dated March 1.
A dual date must always be later than the basic date, since it is used to extend the auditor's
responsibility on a single note to the financial statements. The auditor is already responsible for
everything else in the financial statements and notes up to the completion of fieldwork.

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PCAOB Auditing Standard 1 (AS1) (Issuers)


The audit report must be prepared differently for a company that reports to the SEC and is,
therefore, subject to the requirements of the Public Company Accounting Oversight Board
(PCAOB). The following adjustments to the report are required:
1. The title of the page is Report of Independent Registered Public Accounting Firm.
2. The scope paragraph must not refer to generally accepted auditing standards, and
instead refer to the standards of the Public Company Accounting Oversight Board
(United States).
3. Below the signature of the auditor-in-charge must be listed the city and state (or city and
country for non-US auditors) of the office where the auditor is based.
These changes apply to all audit reports of public companies as well as reviews of interim
financial information.

Report of Independent Registered Public Accounting Firm


TO:
We have audited the accompanying balance sheets of X Company as of December 31, 20X3
and 20X2, and the related statements of operations, stockholders equity, and cash flows for
each of the three years in the period ended December 31, 20X3. These financial statements are
the responsibility of the Companys management. Our responsibility is to express an opinion on
these financial statements based on our audits. (INTRODUCTORY)
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. (SCOPE)
In our opinion, the financial statements referred to above present fairly, in all material respects,
the financial position of the Company as of [at] December 31, 20X3 and 20X2, and the results of
its operations and its cash flows for each of the three years in the period ended December 31,
20X3, in conformity with US Generally Accepted Accounting Principles. (OPINION)
We also have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), X companys internal control over financial reporting as of
December 31, 20X3, based on criteria established in Internal ControlIntegrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission and our
report dated February 24, 20X4, expressed an unqualified opinion thereon. (Reference to
auditors report on internal control)
[Signature]
[City and State or Country]
[Date]

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Section 7

Emphasis of Matter SAS 79 (AU 508)


An auditor has broad discretion to add an explanatory paragraph to the end of a report
whenever the auditor wants to emphasize a matter. Sometimes the client has properly
accounted for and disclosed an item of extreme importance, but the auditor is concerned that a
careless reader of the financial statements might not examine the notes to the financial
statements and, thus, not notice the information provided by the client. Circumstances that may
lead the auditor add an optional explanatory paragraph following the opinion includes:
Significant related party transactions.
Material uncertainties.
Important subsequent events.
Since the client has properly accounted for and disclosed the matter, the opinion will be
unqualified. An example of a report that might result from significant related party transactions
is as follows:

Unqualified Opinion emphasis of a matter


Independent Auditors Report
Standard introductory paragraph
Standard scope paragraph
Standard opinion paragraph
As discussed in Note E to the financial statements, the Company had significant
transactions with another corporation whose majority shareholder is the chief
executive officer of the Company.
In addition to the circumstances just discussed, in which the inclusion of an explanatory
paragraph is optional, there are some circumstances in which the inclusion of such a paragraph
is mandatory. Examples are:
Substantial doubt as to the ability of the client to continue as a going concern.
Omission, misstatement, or auditor inability to review supplementary information
required by the FASB or GASB.
Omission, misstatement, or auditor inability to review required quarterly data for
companies reporting in connection with the Securities Exchange Act of 1934.
o

Emphasis of a matter (Unqualified)

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May add explanatory if auditor considers necessary:


Justifiable departure from GAAP Misleading
Lack of consistency Concur
Uncertainty Contingent liability
Uncertainty - Going concern issue
Division of responsibility
Incorrect or inadequate supplementary information
Info required by FASB or GASB is omitted
Not to refer to specialist unless report modified due to specialist
findings
Emphasis of a matter
For Public companies, additional paragraph after opinion referring
to the auditors report on internal control (this reference is only
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required when the reports on the financial statements and internal
control are separate see below)

We also have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), X companys internal control over financial reporting as of
December 31, 20X3, based on criteria established in Internal ControlIntegrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission and our report dated February 24, 20X4, expressed an unqualified opinion
thereon.

Intro Std
Scope - STD
Explanatory
Before
Opinion
Adjust

CHART FOR AUDIT REPORTS

GAAP
Problem

GAAS
Problem

Disagreement
A Not GAAP
N Inconsistency
O Omitted
Disclosures
Scope Limit

Immaterial
Unqualified

Material
Qualified except
for
BEFORE
opinion

Qualified except
for

Restriction on ability to
get Appropriate audit
evidence

Uncertainty
- Contingent
Liability
- Going Concern
Doubt

Very Material
Adverse

Disclaimer

Proper Unqualified Optional Paragraph


(After Opinion)
Disagree(before)

NOT Properly Disclosed


Going Concern Unqualified
(explanatory paragraph AFTER)

Extreme - Disclaimer
Intro Std
Scope
- Adjust
Explanatory
Before
Opinion
Adjust

Under FAS 130, comprehensive income may be reported in one of 3 ways, this would affect
only the introductory paragraph (no change in opinion paragraph).
A separate mentioned statement statement of comprehensive income
Included with the income statement statement of income and comprehensive income
A component of statement of changes in equity statement of changes in equity and
comprehensive income

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Section 7

(7.02)

4 Standards of Reporting (ANOE)


1. Accordance with U.S. GAAP (Qualified/Adverse)
The first standard of reporting states:
"The report must state whether the financial statements are presented in accordance with U.S.
generally accepted accounting principles." (Explicit)
In a standard report, the opinion paragraph explicitly states that the financial statements are in
conformity with GAAP. To provide guidance, the AICPA has identified several types of
documents that represent the highest authority for GAAP:

AICPA Accounting Research Bulletins


APB Opinions
FASB Statements on Financial Accounting Standards
FASB Interpretations
FASB Staff Positions
FASB Statement 133 Implementation Issues

The Financial Accounting Standards Board (FASB) represents the current authority, but the
earlier documents issued by the AICPA and the Accounting Principles Board (APB) remain
authoritative so long as no official FASB document has superseded them.
In unusual circumstances, a new type of transaction or new legislation may arise that causes
existing official pronouncements to be inapplicable. In such a case, it actually might be
misleading to apply these pronouncements, and GAAP would require presentation of the
transaction in a reasonable manner that would be generally accepted as more appropriate. In
such a justified departure from a promulgated accounting principle, an unqualified opinion will
still be issued, but an explanatory paragraph will be included along with the three standard ones
(either before or after the opinion), mentioning the departure and explaining that unusual
circumstances makes it appropriate.
When the client's management is not preparing the financial statements in conformity with
GAAP, the auditor should, of course, first suggest that the statements be corrected. If
management refuses, then the auditor will normally issue a qualified opinion (also known as an
"except for" opinion). In such an opinion, the auditor indicates that the financial statements are
fairly presented except for the specific departure from GAAP. In rare cases, a departure from
GAAP will be so extreme so as to make the financial statements as a whole misleading, and in
such cases the auditor will issue an adverse opinion, stating the financial statements are not
fairly presented. In either case, the auditor must explain the reasons for the opinion, and
explanatory paragraphs that affect the opinion must always appear immediately before the
opinion paragraph (and immediately after the scope paragraph), in order to forewarn the reader
that the opinion is different from the normal situation.

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Qualified Opinion - Unjustifiable Departure from GAAP


Independent Auditors Report
Standard Introductory Paragraph
Standard Scope Paragraph
The Company has excluded, from property and debt in the accompanying balance
sheets, certain lease obligations that, in our opinion, should be capitalized in order to
conform with U.S. Generally Accepted Accounting Principles. If these lease
obligations were capitalized, property would be increased by $_______, long-term debt
by $______ and retained earnings by $______ as of December 31, 20XX. Additionally,
net income would be increased by $________ for the year then ended.
In our opinion, except for the effects of not capitalizing certain lease obligations as
discussed in the preceding paragraph, the financial statements referred to above present
fairly, in all material respects, the financial position of X Company as of December 31, 20XX,
and the results of its operations and its cash flows for the year then ended in conformity with
U.S. Generally Accepted Accounting Principles.

2. No new principles - Consistency


The second standard of reporting states:
"The report must identify those circumstances in which such principles have not been
consistently observed in the current period in relation to the preceding period." (Implicit)
This standard requires that, even when a client's financial statements conform to GAAP, the
report indicates when the principles used have changed. For example, a client has different
available principles under GAAP for:
Inventory pricing (FIFO, LIFO, Weighted Average, Specific Identification).
Long-term construction contracts (Percentage-of-completion, Completed-contract).
Change to or from the full-cost method in the extractive industry
FASB 154 replaces APBO 20 which classified changes in depreciation, amortization, or
depletion methods as changes in principle. SFAS 154 now requires that a change in
depreciation, amortization, or depletion method for long-lived, nonfinancial assets be accounted
for as a change in accounting estimate effected by a change in accounting principle.
Reclassification from a change in principle to a change in estimate alters whether the auditor
must modify the auditors report when the client has a change in depreciation, amortization, or
depletion method.
GAAP identifies three different types of accounting changes, including changes in principle,
changes in estimate and changes in reporting entity. Corrections of errors are no longer
considered to be an accounting change. These changes are not all considered inconsistencies
requiring identification in the audit report. Those that are considered inconsistencies within
each of the categories are as follows:
Principle - Any change from one acceptable accounting principle to another.
Estimate - Only a change in estimate that is inseparable from a change in principle.
Reporting Entity - Only a change among the use of cost, equity, and consolidation
approaches to an investment in the absence of a change in the level of ownership.

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Section 7

Corrections - A change from an unacceptable principle to an acceptable one or per


PCAOB AS6 the correction of a misstatement in previously issued financial statements
NOT involving Accounting Principle.

Notwithstanding the above, a change will not require identification if it doesn't have a material
impact on the comparability of the current and preceding years.
An inconsistency is not necessarily a departure from GAAP. As long as the auditor concurs
with the change and it is accounted for and disclosed properly, the audit opinion will continue to
be unqualified (as in all of the examples so far in this module). The report may appear as
follows:

Change in Principle - Concur


Standard introductory paragraph
Standard scope paragraph
Standard opinion paragraph

As discussed in Note X to the consolidated financial statements, the company


changed its method of accounting for Goodwill and changed its method of
accounting for Derivative instruments and hedging activities in 20XX.
The essential item to include in the explanatory paragraph is a reference to the footnote in
which the client discusses the change. Notice that the auditor does not explicitly state that they
concur with the change and that it is accounted for and disclosed properly. This is assumed
because of the unqualified opinion.
PCAOB AS6 This standard focuses on the evaluation of whether the comparability of the
financial statements between periods has been materially affected by not only changes in
accounting principles but also by adjustments to correct a misstatement (error) in previously
issued financial statements. This new standard takes the Second Standard of Reporting and
makes it broader by including errors not involving an accounting principle. AS6 says If a
material misstatement in previously issued financial statements is corrected, an explanatory
paragraph should be added to the auditors report describing this situation.

Correction of a Material Misstatement (PCAOB AS6)


Standard introductory paragraph
Standard scope paragraph
Standard opinion paragraph

As discussed in Note X to the financial statements, the 20X1 financial


statements have been restated to correct a misstatement.

There are certain circumstances that will cause an inconsistency to be a GAAP departure
requiring a qualified opinion. In such cases, the explanatory paragraph must appear before
the opinion, since it is affecting it. Examples include:
A change to an unacceptable principle.
A change that is not accounted for in the proper manner.
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A change that is not properly disclosed.


A change that is made without sufficient justification.

A report resulting from an unjustified change in principle might appear as follows:

Change in Principle - Do not Concur


Standard introductory paragraph
Standard scope paragraph
As discussed in Note B to the financial statements, the Company changed its method of
inventory pricing during 20X1 from the last-in, first-out method to the first-in, first-out
method. Although the use of the first-in, first-out method is in conformity with U.S.
generally accepted accounting principles, in our opinion, the Company has not provided
reasonable justification for making the change as required by U.S. generally accepted
accounting principles.
In our opinion, except for the change in accounting principle discussed in the preceding
paragraph, the financial statements referred to above present fairly, in all material respects, the
financial position of X Company as of December 31, 20X1, and the results of its operations and
its cash flows for the year then ended in conformity with U.S. generally accepted accounting
principles.

Subsequent years: If the year in which the change occurred is presented, the explanatory
paragraph is required in the subsequent years reports. If the change was treated as a
retroactive restatement, the explanatory paragraph is not needed in subsequent years.
If it is a First Year Audit and the auditor is satisfied as to the consistency of the accounting
principles, no reference to consistency is made.

3. No Omitted disclosures
The third standard of reporting states:
Informative disclosures in the financial statements are to be regarded as reasonably adequate
unless otherwise stated in the report. (Implicit)

Omitted Disclosures Qualified Opinion


Independent Auditors Report
Standard Introductory Paragraph
Standard Scope Paragraph
The Companys statements do not disclose (describe the nature of the omitted disclosures).
In our opinion, disclosure of this information is required by U.S. Generally Accepted
Accounting Principles.
In our opinion, except for the omission of the information discussed in the preceding
paragraph, the financial statements referred to above present fairly, in all material respects, the
financial position of X Company as of December 31, 20XX, and the results of its operations and its
cash flows for the year then ended in conformity with U.S. Generally Accepted Accounting
Principles.

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Section 7

One special violation is the failure to include a statement of cash flows in a set of financial
statements. GAAP requires the inclusion of such a statement whenever a company is
presenting results of operation, i.e., an income statement. The failure to include the statement
of cash flows results in a qualified opinion, but also requires modification to the introductory and
opinion paragraphs to delete reference to it:
-No cash flows (Qualified Opinion, not a Scope Limit Inadequate disclosure)

Omit Cash flows in Intro paragraph


Explanatory paragraph is added before the opinion explaining that the
company declined to present the statement as required by GAAP.
Opinion paragraph mentions, except that omission of Cash Flows results in
an incomplete presentation.

No statement of Cash Flows


We have audited the balance sheet of X Company as of December 31, 20x1, and the related statements of
income and retained earnings (delete reference to 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.
Standard scope paragraph
The Company declined to present a statement of cash flows for the year ended December 31,
20x1. Presentation of such a statement summarizing the Company's operating, investing, and
financing activities is required by U.S. generally accepted accounting principles.
In our opinion, except that the omission of a statement of cash flows results in an incomplete
presentation as explained in the preceding paragraph, the financial statements referred to above
present fairly, in all material respects, the financial position (delete reference to cash flows) of X
Company as of December 31, 20x1, and the results of its operations for the year then ended in conformity
with U.S. generally accepted accounting principles.

4. Express an opinion on the statements taken as a whole (Division of


Responsibility) (Explicit)
The fourth standard of reporting states:
"The report must either contain an expression of opinion regarding the financial statements,
taken as a whole, or an assertion to the effect that an opinion cannot be expressed. When an
overall opinion cannot be expressed, the reasons therefore should be stated. In all cases where
an auditor's name is associated with financial statements, the report must contain a clear-cut
indication of the character of the auditor's work, if any, and the degree of responsibility the
auditor is taking."
There is sometimes a misunderstanding by the public as to whether the financial statements are
produced by the client or the auditor. This standard is designed to ensure that the report
eliminates any such problem by making clear what responsibility the CPA is taking (and what
they are not taking).

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Note how the various sentences of the standard audit report satisfy the requirements of this
standard:
Introductory (2nd sentence) - This sentence states that the financial statements are the
responsibility of management, making it clear to the reader that the financial statements
were produced by the client and that the auditor is not responsible for their fair
presentation.
Introductory (3rd sentence) - This sentence informs the reader that the auditor's only
responsibility is the expression of an opinion based on the audit.
Scope paragraph - This paragraph describes the character of the auditor's work.
Opinion paragraph - This is where the expression of opinion occurs.
Sometimes, a client will include the name of the CPA firm in a report on financial statements
that were not audited or reviewed by the CPA. By naming the CPA, the client has now
associated them with the financial statements, and it is critical for the CPA to demand that the
client either:
Remove the CPA's name from the client's report, or
Mark each page of the financial statements "Unaudited. No opinion expressed on
them."
A CPA must at least do the level of work equivalent to a compilation in order to attach any report
to such statements. Compilations and reviews are discussed in another section.
Sometimes, there are other auditors involved in the engagement (we are not referring to
predecessor auditors who are not an issue if the client is presenting single-period financial
statements only). If the client owns a subsidiary or has a major investment in another company
requiring the use of the equity method of accounting, the financial statements of the client may
be materially impacted by the investee's results. If the accountant happened to be the auditor of
both the investor and investee companies, no responsibility issue arises. Often, however, the
financial statements of the investor company are audited by one accounting firm while the
statements of the investee are audited by another.
In such cases, a determination must be made as to who is the principal auditor, which refers
to the accounting firm that has examined the company having the largest impact on the overall
report. Most examples on the CPA exam involve a principal auditor of a parent corporation who
needs to rely on the work of other auditors of a subsidiary. Assuming the results of the
subsidiary have a material impact on the consolidated statements of the parent, the principal
auditor must make two decisions:
1.
Can they rely on the work of the other auditors?
2.
Can they accept responsibility for the work of the other auditors?
Before relying on the work of the other auditors, the principal auditor will normally take steps to
verify the credentials and reputation of the other auditors and obtain a representation letter from
them giving permission for reliance on their report on the subsidiary in preparing the
consolidated statements of the parent. If the principal auditor cannot obtain the report of the
other auditors or cannot satisfy themselves as to the independence and reputation of the other
auditors, a scope limitation applies and the report on the consolidated statements must include
either a qualified opinion or disclaimer of opinion.
The principal auditor can also take responsibility for the work of the other auditors when one of
the following applies:
The other auditors are associated with the principal auditor's firm.
The principal auditor hired the other auditors to do the work.
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Section 7

The principal auditor takes reasonable steps to review the work of the other auditors,
possibly visiting them and examining the audit program and audit documentation.

If the principal auditor can both rely on and accept responsibility for the work of the other
auditors, a standard report will be issued by the principal auditor, making no reference to the
other auditors.
If the principal auditor is able to rely on the work of the other auditors, but is unable to accept
responsibility for their work, then a division of responsibility exists. In such a case, the
principal auditor must make reference to their reliance on the report of the other auditors in all
three of the standard paragraphs of the report, but no explanatory paragraph is required. The
other auditors should not be named in the report unless the report of the other auditors on the
company they examined is included in the financial report, which is rarely the case. A sample
report follows:

Division of Responsibility
We have audited the consolidated balance sheet of X Company as of December 31, 20X1,
and the related consolidated 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 did not audit the financial statements of Y Company, a wholly-owned
subsidiary, whose statements reflect total assets of $40,000,000 as of December 31,
20X1, and total revenues of $25,000,000 for the year then ended. Those statements
were audited by other auditors whose report has been furnished to us, and in our
opinion, insofar as it relates to the amounts included for Y Company, is based solely on
the report of the other auditors.
We conducted our audit in accordance with U.S. generally accepted auditing
standards. 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 audit and the report of other auditors provide a
reasonable basis for our opinion.
In our opinion, based on our audit and the report of other auditors, the consolidated
financial statements referred to above present fairly, in all material respects, the financial
position of X Company as of December 31, 20X1, and the results of its operations and its
cash flows for the year then ended in conformity with U.S. generally accepted accounting
principles.
Note the reference in the introductory paragraph to assets and revenues, the largest individual
numbers on the balance sheet and income statement, respectively. If the principal auditor
prefers, these amounts may be stated as percentages of the consolidated total rather than as
dollar amounts.

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(7.03)
Uncertainty (Unqualified or Disclaimer)
Occasionally, an auditor will be unable to determine the effects of an item on the financial
statements, not because of any limitation on the scope of the engagement, but because the
condition itself is one with an uncertain resolution. The most common example is an unresolved
lawsuit.
So long as the client has properly disclosed the uncertainty, and accrued any potential losses
that are probable and estimable, the financial statements are in conformity with generally
accepted accounting principles (there is no GAAP departure). So long as the auditor has been
able to obtain all available information about the matter, the audit is in accordance with
generally accepted auditing standards (there is no scope limitation).
In such a circumstance, the auditor may issue a standard report expressing an unqualified
opinion. If, however, the auditor is concerned that a user might not pay close enough attention
to the financial statement and notes to notice the information provided by the client, the auditor
has the option of adding an explanatory paragraph to the audit report. This paragraph must
appear after the opinion, in order to not detract from it, since it merely represents the auditor's
desire to call the reader's attention to important information that the client has provided. The
auditor will normally consider the likelihood of the loss and its materiality, but the decision on
whether to add this paragraph is based on the auditor's judgment, and this is considered a form
of emphasis of a matter. An example of such a modification follows:

Uncertainty Contingent Liability


Standard introductory paragraph
Standard scope paragraph
Standard opinion paragraph
As discussed in note Q to the financial statements, the Company is a defendant in a
lawsuit alleging patent infringement. The ultimate outcome of the litigation cannot
presently be determined. Accordingly, no provision for any liability that may result
upon adjudication has been made in the accompanying financial statements.

There is one circumstance involving an uncertainty where the auditor is required to add an
explanatory paragraph to the end of the report: substantial doubt as to the ability of the client
to continue as a going concern. Since any company can be considered at risk of going out of
business in the indefinite future (for example, in the next 10,000 years), the AICPA has
established a limit of one year after the balance sheet date for concerns about the client's
status to require the additional paragraph.
When considering the risk of a client going out of existence, the primary issues to be considered
relate to cash flow, since a company is most likely to fail if it is unable to pay its debts as they
come due. Factors that may produce substantial doubt as to the going concern status of the
client include:
Several years of operating losses.
Negative working capital.
Defaults or restructuring of debts.
Losses of key customers.
Denial or losses of licenses or patents.
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Section 7

There are, however, certain mitigating factors that may reduce the risk of going out of
business by improving cash flow, such as plans to:
Increase ownership equity through stock issuances for cash.
Dispose of marketable assets that are not needed in the operations of the business.
Delay or reduce optional expenditures such as research and development.
In performing the engagement, the auditor will apply certain tests that are likely to identify
conditions and events that could lead to substantial doubt as to the client's going concern
status, including:
Review of debt agreements and third party commitments of financial support.
Reading of minutes of board of directors meetings.
Inquiries of the client's legal counsel.
Analytical procedures.
When the auditor concludes that there is substantial doubt as to the ability of the client to
continue as a going concern for a reasonable period of time, the auditor must determine the
adequacy of the client's disclosure of these matters. If the client has made proper disclosure of
going concern doubts in a footnote, the audit report must contain language referring specifically
to substantial doubt and going concern, such as the following:

Uncertainty Going Concern Doubt


Standard introductory paragraph
Standard scope paragraph
Standard opinion paragraph
The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. As discussed in Note C to the financial
statements, the Company has suffered recurring losses from operations and has a net
capital deficiency that raises substantial doubts about its ability to continue as a going
concern. Management's plans in regard to these matters are also described in Note
C. The financial statements do not include any adjustments that might result from the
outcome of this uncertainty.

If the client has not properly disclosed a going concern doubt or other material uncertainty, this
will be considered inadequate disclosure, a form of GAAP departure, and will require a
qualified opinion and explanatory paragraph before the opinion instead of after, discussing the
uncertainty as well as noting that the absence of disclosure is a departure from GAAP. SAS 114
requires the auditor to communicate going concern issues to those charged with governance.

Scope limitation (Qualified or Disclaimer)


Inability to obtain Sufficient Appropriate Audit Evidence may occur.
Sometimes the problem isn't GAAP, but GAAS. Instead of the auditor drawing the conclusion
that the statements depart from generally accepted accounting principles, the auditor is
prevented from performing an audit in accordance with generally accepted auditing standards
and is unable to draw any conclusion. When the auditor is unable to obtain sufficient
appropriate audit evidence as required by the third standard of fieldwork, it may not be possible
to express an opinion on certain accounts or disclosures, or it may even not be possible to
express an opinion on the financial statements at all.
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When circumstances prevent an auditor from performing a particular test that they want to
perform, the auditor's initial response should be to determine if there are alternative tests that
can provide satisfactory evidence. If so, these alternative tests will be performed and there is
no injury to the audit; a standard report with an unqualified opinion can be issued and there is
no need to mention the use of alternative tests from those originally contemplated.
If, however, certain tests that cannot be performed were deemed essential and acceptable
alternative tests cannot be performed, the auditor faces a scope limitation. If the scope
limitation was the result of circumstances out of the control of the auditor and client, it will
normally result in a qualified opinion. If, however, the scope limitation resulted from
interference in the audit by the client or involves so many procedures that it effectively causes
the engagement not to constitute a valid audit, it will result in a disclaimer of
opinion. Examples of scope limitations which virtually always preclude the expression of an
unqualified opinion include:

Failure of the client to provide a management representation letter as requested by


the auditor on the last day of fieldwork.

Refusal of permission for the auditor to send a letter of inquiry to clients legal counsel
on material matters.

Inability to observe inventory or confirm receivables.

Inability of the principal auditor to obtain the audited financial statements of a subsidiary
company whose investment is material to the overall financial position of the
consolidated entity and which was examined by other auditors.

If an auditor is unable to attend the year-end inventory count due to a minor automobile accident
occurring on the drive to the client's offices on the evening of the count, a scope limitation
requiring a qualified opinion will normally be the result (assuming the auditor cannot
satisfactorily obtain evidence using alternative procedures). The report might appear as follows:

Page 7-16

Scope Limit

Circumstances
o Cannot confirm A/R
o Auditor did not observe ending inventory

Client imposed (may be Disclaimer)


o Clients records are inadequate
o Client refuses permission to contact Attorney
o Management will not sign Management
Representation letter

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Section 7

Scope Limitation Qualified Opinion


Independent Auditors Report
Standard introductory paragraph
Except as discussed in the following paragraph, we conducted our audit in accordance
with U.S. generally accepted auditing standards. 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 audit
provides a reasonable basis for our opinion.
We could not observe the taking of the physical inventory as of December 31, 20X1 due
to circumstances unrelated to the client, and we were unable to satisfy ourselves
regarding inventory quantities by means of other auditing procedures. Inventory
amounts as of December 31, 20X1 also enter into the determination of net income and
cash flows for the year ended December 31, 20X1.
In our opinion, except for the effects of such adjustments, if any, as might have been
determined to be necessary had we been able to examine evidence regarding the
inventory, the financial statements referred to above present fairly, in all material respects,
the financial position of X Company as of December 31, 20X1, and the results of its
operations and its cash flows for the year then ended in conformity with U.S. generally
accepted accounting principles.

Notice that the qualification in the opinion paragraph is based on the possible effects on the
financial statements and does not refer to the omitted procedures themselves. Also note that,
as in all qualified opinions, an explanatory paragraph must appear before the opinion to
explain the reasons for the alteration of the opinion.

Limited Reporting Engagements Client asks auditor to report on only one financial
statement and not the others. This is acceptable and is not considered a scope limit.
On occasion, a client will not require a complete set of financial statements to be audited, but
will only be presenting a balance sheet. So long as the auditor is permitted to examine any
evidence that the auditor chooses, this does not constitute any type of scope limitation. Also,
the omission of the statement of cash flows in this circumstance is not a departure from GAAP,
since the client is not presenting an income statement and, thus, is not purporting to present the
results of operations. Finally, it is not considered a piecemeal opinion, since it covers an entire
financial statement and not merely an individual account.
This type of engagement is known as a limited reporting engagement, and so long as the
auditor completes an audit and is satisfied with the fair presentation of the balance sheet, an
unqualified opinion will be issued. The report may appear as follows:

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Limited Reporting Engagement Opinion on Balance Sheet Only


We have audited the balance sheet of X Company as of December 31, 20X1. This financial
statement is the responsibility of the Company's management. Our responsibility is to
express an opinion on this financial statement based on our audit.
Standard scope paragraph
In our opinion, the balance sheet referred to above presents fairly, in all material respects,
the financial position of X Company as of December 31, 20X1, in conformity with U.S.
generally accepted accounting principles.

Adverse opinion
An adverse opinion is rare and would result from a very material departure from GAAP with
which the auditor does not agree, inadequate disclosure or an unreasonable accounting
estimate. An explanatory paragraph would be included before the opinion paragraph to provide
an explanation for the adverse opinion. Anytime the auditor feels the statements are false,
fraudulent, deceptive or misleading, they always have the option of withdrawing from the
engagement.

Independent Auditors Report


Standard Introductory Paragraph
Standard Scope Paragraph
As discussed in Note X to the financial statements, the Company carries its
property, plant, and equipment accounts at appraisal values, and provides
depreciation on the basis of such values. Further, the Company does not provide for
income taxes with respect to differences between financial statement income and
taxable income arising because of the use, for income tax purposes, of the
installment method of reporting gross profit from certain types of sales. U.S.
Generally Accepted Accounting Principles require that property, plant and equipment
be stated at an amount not in excess of cost, reduced by depreciation based on such
amount and that deferred income taxes be provided.

Because of the departures from U.S. Generally Accepted Accounting Principles


identified above, as of December 31, 20XX, inventories have been increased
$________ by inclusion in manufacturing overhead of depreciation in excess of that
based on cost; property, plant and equipment, less accumulated depreciated, is
carried at $_______ in excess of an amount based on the cost to the Company; and
deferred income taxes of $________ have not been recorded; resulting in an increase
of $________ in retained earnings and in appraisal surplus of $________. For the
year ended December 31, 20XX, cost of goods sold has been increased $________,
because of the effects of the depreciation accounting referred to above and deferred
income taxes of $_______ have not been provided, resulting in an increase in net
income of $_______.

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Section 7

In our opinion, because of the effects of the matters discussed in the preceding
paragraphs, the financial statements referred to above do not present fairly, in conformity
with U.S. Generally Accepted Accounting Principles, the financial position of X Company as of
December 31, 20XX, or the results of its operations and its cash flows for the year then ended.

Disclaimer of Opinion
If the auditor is unable to observe inventory because the client refused to allow the auditor to do
so, this constitutes an interference so serious as to make the work performed not constitute a
valid audit and, thus, requires a disclaimer of opinion. So a Disclaimer may result from a very
material Scope limitation or a very material Uncertainty. The report might appear as follows:

Independent Auditors Report


We were engaged to audit the balance sheet of X Company as of December 31, 20X1, and
the related statements of income, retained earnings, and cash flows for the year then
ended. These financial statements are the responsibility of the Company's management
(omit 3rd sentence our responsibility).
Scope paragraph omitted entirely
We could not observe the taking of the physical inventory as of December 31, 20X1,
due to the refusal of the client to permit our presence, and we were unable to satisfy
ourselves regarding inventory quantities by means of other auditing procedures.
Since the Company did not permit us to apply the auditing procedures needed to
satisfy ourselves as to inventory quantities, the scope of our work was not sufficient to
enable us to express, and we do not express, an opinion on these statements.
A disclaimer may cover only some of the financial statements, with an opinion expressed on
others. For example, if the auditor was unable to obtain evidence regarding beginning
inventory, but was able to verify ending inventory, an unqualified opinion might be issued on the
balance sheet as of the ending date, with a disclaimer on the other statements that cover the
entire year.
When an auditor has decided to disclaim an opinion on a financial statement, the disclaimer
applies to all of the individual accounts on that statement. The auditor may not express an
opinion on any of the individual accounts, because this would tend to overshadow the disclaimer
(it is also not acceptable to express an opinion on an individual account when issuing an
adverse opinion on the statement as a result of an extreme GAAP departure). Such a violation
is known as a piecemeal opinion.

Lack of Independence
If the auditor lacks independence 1 paragraph (Do not include reasons)
No intro or scope paragraphs
Disclaimer we do not express an opinion
Do not give reasons for lack of independence.

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Section 7

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(7.04)
Comparative financial statements
When the financial statements of the previous year are shown alongside those of the current
year, the reporting requirements vary depending on the circumstances. If the auditor of the
current year also audited the previous year, then the report will simply be updated so that both
years are included in the audit report. The standard report on comparative statements is
virtually identical to that of single period statements, except for the minor changes needed to
refer to both years. The report date should be the completion of fieldwork.

Comparative - Standard Unqualified


Independent Auditors Report
We have audited the accompanying balance sheets of X Company as of December 31, 20X2
and 20X1, and the related statements of income, retained earnings, and cash flows for the
years then ended. These financial statements are the responsibility of the Companys
management. Our responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with U.S. Generally Accepted Auditing Standards.
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 X Company as of December 31, 20X2 and 20X1, and the results of its
operations and its cash flows for the years then ended in conformity with U.S. Generally
Accepted Accounting Principles.

Prior period examined by us


Qualified X2, unqualified X1
Independent Auditors Report
Standard Introductory Paragraph (2 years)
Standard Scope Paragraph
The Company has excluded, from property and debt in the accompanying 20X2
balance sheet, certain lease obligations that were entered into in 20X2, which, in our
opinion, should be capitalized, in order to conform with U.S. Generally Accepted
Accounting Principles. If these lease obligations were capitalized, property would be
increased by $_______, long-term debt by $______, and retained earnings by $______ as
of December 31, 20X2, and net income and earnings per share would be increased
(decreased) by $________ and $________, respectively, for the year then ended.

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Section 7

In our opinion, except for the effects on the 20X2 financial statements of not
capitalizing certain lease obligations as described in the preceding paragraph, the
financial statements referred to above present fairly, in all material respects, the financial
position of X Company as of December 31, 20X2 and 20X1, and the results of its operations
and its cash flows for the years then ended in conformity with U.S. Generally Accepted
Accounting Principles.
In some cases, the auditor's opinion on the previous year will be different than the opinion
expressed on those statements in the earlier report. One example might be if the previous
opinion was qualified due to inadequate disclosure of a lawsuit, and the lawsuit was settled
during the current year (or the client agrees to disclose the suit in the notes to the current
comparative financial statements).
When the auditor's opinion has changed, the opinion will reflect the current situation but an
explanatory paragraph must refer to the earlier report indicating its date, the opinion expressed,
the reason for the change, and the fact that the current opinion differs. In the above example,
the report might read:

Changing opinion on Prior Year


Independent Auditors Report
Standard Introductory Paragraph
Standard Scope Paragraph
In our report dated March 1, 20X2, we expressed an opinion that the 20X1 financial
statements did not fairly present financial position, results of operations, and cash
flows in conformity with U.S. Generally Accepted Accounting Principles because of
two departures from such principles: (1) the Company carried its property, plant, and
equipment at appraisal values, and provided for depreciation on the basis of such
values, and (2) the Company did not provide for deferred income taxes with respect
to differences between income for financial reporting purposes and taxable income.
As described in Note X, the Company has changed its method of accounting for
these items and restated its 20X1 financial statements to conform with U.S.
Generally Accepted Accounting Principles. Accordingly, our present opinion on the
20X1 financial statements, as presented herein, is different from that expressed in
our previous report.
In our opinion, the financial statements referred to above present fairly, in all material
respects, the financial position of X Company as of December 31, 20X2 and 20X1, and the
results of its operations and its cash flows for the years then ended in conformity with U.S.
Generally Accepted Accounting Principles.
Notice that the explanatory paragraph appears before the opinion paragraph, even though the
opinion on both years is now unqualified, since the paragraph is addressing an issue related to
the change in opinion.

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Section 7

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Unable to observe prior year beginning inventory (5 paragraphs)


Independent Auditors Report
Standard Introductory Paragraph
Except as explained in the following paragraph, we... (remainder is standard scope
paragraph)
We did not observe the taking of the physical inventory as of December 31, 20X0, since
that date was prior to our appointment as auditors for the company, and we were unable
to satisfy ourselves regarding inventory quantities by means of other auditing
procedures. Inventory amounts as of December 31, 20X0, enter into the determination of
net income and cash flows for the year ended December 31, 20X1.
Because of the matter discussed in the preceding paragraph, the scope of our work was
not sufficient to enable us to express, and we do not express, an opinion on the results
of operations and cash flows for the year ended December 31, 20X1.
In our opinion, the balance sheets of X Company as of December 31, 20X2 and 20X1, and the
related statements of income, retained earnings, and cash flows for the year ended December
31, 20X2, present fairly, in all material respects, the financial position of X Company as of
December 31, 20X2 and 20X1, and the results of its operations and its cash flows for the year
ended December 31, 20X2, in conformity with U.S. Generally Accepted Accounting Principles.

Prior period not examined by us (predecessor auditor)


When a predecessor auditor examined the financial statements of the earlier year, the
successor's comparative report of the current year can only express an opinion on the current
year since that is the only year the successor audited. There are two ways of handling the
earlier year:
1. The predecessor's report can be reissued and included along with the successor's audit
report, or
2. The successor can make reference to the predecessor's earlier report.
If the first alternative is chosen, the predecessor must:
1. Compare the financial statements that they reported on with their
presentation in the current comparative form.
2. Obtain a representation letter from the successor auditor.
As long as the successor has not informed the predecessor of any reason for revision of the
original report, the predecessor will simply reissue the original report with the original report
date. If the successor is aware of any such reason, they should arrange for a three-way
meeting (including the client) to discuss the appropriateness of the predecessor applying certain
procedures to verify the need for changes. Any revisions would result in the predecessor's
report being dual-dated to refer to any new information obtained.
If the second alternative is chosen, the successor will add a reference to the predecessor's
previous report date, opinion, and reasons for any qualification of the opinion or inclusion of an
explanatory paragraph by the predecessor in that report. The predecessor's name must not be
included in the successor's report when the predecessor's report is not being reissued.
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Section 7

If predecessor auditor reissues report


o Read F/S
o Obtain Representation letter from successor auditor and client
o If no adjustment to P/Y F/S, use original report date
o If restate P/Y F/S, dual-date report
If predecessor auditor Does NOT agree to reissue report
o Intro paragraph
Other auditors
Date
Type of opinion
If not unqualified, reasons
A comparative report in which a predecessor examined the preceding year and has ceased
operations (e.g., Anderson) must state that the predecessor has ceased operations.

Comparative F/S - Prior period not examined by us (predecessor auditor)


Independent Auditors Report
We have audited the accompanying balance sheet of X Company as of December 31, 20X2,
and the related statements of income, retained earnings, and cash flows for the year then
ended. These financial statements are the responsibility of the Companys management. Our
responsibility is to express an opinion on these financial statements based on our audit. The
financial statements of X Company as of December 31, 20X1, were audited by other
auditors whose report dated March 31, 20X2, expressed an unqualified opinion on those
statements.
Standard Scope Paragraph
In our opinion, the 20X2 financial statements referred to above present fairly, in all material
respects, the financial position of X Company as of December 31, 20X2, and the results of its
operations and its cash flows for the year then ended in conformity with U.S. Generally
Accepted Accounting Principles.

Prior Year Reviewed, Current Year Audited (explanatory paragraph)


The 20X1 financial statements were reviewed by us (other accountants) and our (their) report
thereon, dated March 1, 20X2, stated we (they) were not aware of any material modifications
that should be made to those statements for them to be in conformity with U.S. Generally
Accepted Accounting Principles. A review is substantially less in scope than an audit and does
not provide a basis for the expression of an opinion on the financial statements taken as a
whole.

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Section 7

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Current Year Unaudited, Prior Year Audited (explanatory Paragraph)


The financial statements for the year ended December 31, 20X1, were audited by us (other
accountants) and we (they) expressed an unqualified opinion on them in our (their) report dated
March 1, 20X2, but we (they) have not performed any auditing procedures since that date.

Summary of Non-Standard Reports


Situation
Departure Material

Introductory
Standard

Scope
Standard

Departure Justified

Standard

Standard

Inconsistency Proper
Inconsistency
Improper
Inadequate Disclosure

Standard
Standard

Standard
Standard

Standard

Standard

No Cash Flow
Statement
Accompanying Income
Statement
Division of
Responsibility

Delete Reference
to Cash Flow

Standard

Standard
Qualified or
Adverse
Qualified or
Adverse
Qualified

Refer to % or $
examined by other
auditors
Standard

Refer to report of
other as part of
basis for opinion
Standard

Unqualified, but
refer to report of
other again
Standard

Standard
Standard

Standard
Indicate exception
to GAAS
Omit entire
paragraph
Standard

Standard
Qualified

After or
None
After
Before

Disclaimer

Before

Unqualified, but
only mention
financial position

None

Contingent Liability
Going Concern Doubts
Scope Limitation
Circumstance
Scope Limitation
Client
B/S Only

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Only state we were


engaged to audit
Only refer to B/S as
statement audited

415-346-4CPA

Opinion
Qualified or
Adverse
Standard

Explanatory
Before
Before or
After
After
Before
Before
Before

None

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Section 7

CLASS QUESTIONS:
1. Which of the following statements is a basic element of the auditors standard report?
a. The disclosures provide reasonable assurance that the financial statements are free
of material misstatement.
b. The auditor evaluated the overall internal control.
c. An audit includes assessing significant estimates made by management.
d. The financial statements are consistent with those of the prior period.
2. Which paragraphs of an auditors standard report on financial statements should refer to
generally accepted auditing standards (GAAS) and generally accepted accounting principles
(GAAP)?
GAAS
GAAP
a.
Intro
Scope
b.
Scope
Scope
c.
Scope
Opinion
d.
Intro
Opinion
3. How does an auditor make the following representations when issuing the standard auditors
report on comparative financial statements?

a.
b.
c.
d.

Examination of
evidence on a
Test Basis
Explicitly
Implicitly
Implicitly
Explicitly

Consistent
application of
accounting principles
Explicitly
Implicitly
Explicitly
Implicitly

4. An auditor may issue the standard audit report when the


a. Auditor refers to the findings of a specialist.
b. Financial statements are derived and condensed from complete audited financial
statements that are filed with a regulatory agency.
c. Financial statements are prepared on the cash receipts and disbursements basis of
accounting.
d. Principal auditor assumes responsibility for the work of another auditor.
5. Green, CPA, concludes that there is substantial doubt about JKL Co.s ability to continue as
a going concern. If JKLs financial statements adequately disclose its financial difficulties,
Greens auditors report should

a.
b.
c.
d.

Include an
Explanatory
Paragraph
following the
opinion
paragraph
Yes
Yes
Yes
No

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Specifically
Specifically use the
use the
words
words going substantial
concern
doubt
Yes
Yes
Yes
No
No
Yes
Yes
Yes
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6. For which of the following events would an auditor issue a report that omits any reference to
consistency?
a. A change in the method of accounting for inventories.
b. A change from an accounting principle that is not generally accepted to one that is
generally accepted.
c. A change in the useful life used to calculate the provision for depreciation expense.
d. Managements lack of reasonable justification for a change in accounting principle.
7. Under which of the following circumstances would a disclaimer of opinion not be
appropriate?
a. The auditor is unable to determine the amounts associated with an employee fraud
scheme.
b. Management does not provide reasonable justification for a change in accounting
principles.
c. The client refuses to permit the auditor to confirm certain accounts receivable or
apply alternative procedures to verify their balances.
d. The chief executive officer is unwilling to sign the management representation letter.
8. An auditor concludes that a clients illegal act, which has a material effect on the financial
statements, has not been properly accounted for or disclosed. Depending on the materiality
of the effect on the financial statements, the auditor should express either a(n)
a. Adverse opinion or a disclaimer of opinion.
b. Qualified opinion or an adverse opinion.
c. Disclaimer of opinion or an unqualified opinion with a separate explanatory
paragraph.
d. Unqualified opinion with a separate explanatory paragraph or a qualified opinion.
9. When an auditor qualifies an opinion because of inadequate disclosure, the auditor should
describe the nature of the omission in a separate explanatory paragraph and modify the

a.
b.
c.
d.

Introductory
Paragraph
Yes
Yes
No
No

Scope
paragraph
No
Yes
Yes
No

Opinion
paragraph
No
No
Yes
Yes

10. Park, CPA, was engaged to audit the financial statements of Tech Co., a new client, for the
year ended December 31, 20X1. Park obtained sufficient audit evidence for all of Techs
financial statement items except Techs opening inventory. Due to inadequate financial
records, Park could not verify Techs January 1, 20X1 inventory balances. Parks opinion on
Techs 20X1 financial statements most likely will be

a.
b
c.
d.

Page 7-26

Balance sheet
Disclaimer
Unqualified
Disclaimer
Unqualified

Income statement
Disclaimer
Disclaimer
Adverse
Adverse

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Section 7

11. When disclaiming an opinion due to a client-imposed scope limitation, an auditor should
indicate in a separate paragraph why the audit did not comply with generally accepted
auditing standards. The auditor should also omit the

a.
b.
c.
d.

Scope
paragraph
No
Yes
No
Yes

Opinion
paragraph
Yes
Yes
No
No

12. A scope limitation sufficient to preclude an unqualified opinion always will result when
management
a.
b.
c.
d.

Prevents the auditor from reviewing the working papers of the predecessor auditor.
Engages the auditor after the year-end physical inventory is completed.
Requests that certain material accounts receivable not be confirmed.
Refuses to acknowledge its responsibility for the fair presentation of the financial
statements in conformity with GAAP.

13. An auditor should disclose the substantive reasons for expressing an adverse opinion in an
explanatory paragraph
a.
b.
c.
d.

Preceding the scope paragraph.


Preceding the opinion paragraph.
Following the opinion paragraph.
Within the notes to the financial statements.

14. Jewel, CPA, audited Infinite Co.s prior year financial statements. These statements are
presented with those of the current year for comparative purposes without Jewels auditors
report, which expressed a qualified opinion. In drafting the current years auditors report,
Crain, CPA, the successor auditor, should
I. Not name Jewel as the predecessor auditor.
II. Indicate the type of report issued by Jewel.
III. Indicate the substantive reasons for Jewels qualification.
a.
b.
c.
d.

I only.
I and II only.
II and III only.
I, II, and III.

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SOLUTIONS:
1. (c) The requirement is to identify the statement that is included in the auditors standard
report. Answer (c) is correct because the auditors standard report states that an audit includes
assessing significant estimates made by management; see AU 508 for this and other required
elements included in a standard report.
2. (c) The requirement is to identify which paragraph of an auditors standard audit report should
refer to generally accepted auditing standards and generally accepted accounting
principles. Answer (c) is correct because the scope paragraph indicates that generally accepted
auditing standards have been followed, while the opinion paragraph indicates
that the financial statements follow generally accepted accounting principles.
3. (d) The requirement is to determine the representations made explicitly and implicitly when
issuing the standard auditors report on comparative financial statements. Answer (d) is correct
because the standard audit report explicitly states that the examination of evidence is made on
a test basis and implicitly assumes consistent application of accounting principles. Answer (a) is
incorrect because consistency of application of accounting principles is not indicated explicitly.
Answer (b) is incorrect because examination of evidence on a test basis is referred to explicitly.
Answer (c) is incorrect because examination of evidence on a test basis is explicitly referred to
and because consistent application of accounting principles is not explicitly referred to.
4. (d) The requirement is to identify the situation in which an auditor may issue the standard
audit report. Answer (d) is correct because a standard report may be issued in circumstances in
which the principal auditor assumes responsibility for the work of another auditor. Answer (a) is
incorrect because the standard report does not include reference to a specialist. Thus,
reference to a specialist within a report by definition causes modification of the standard report.
Answer (b) is incorrect because the auditor is required to issue a modified report on condensed
financial statements per AU 552. Answer (c) is incorrect because audit reports on financial
statements prepared on a comprehensive basis other than GAAP are considered to be special
reports which require departures from the standard form.
5. (a) The requirement is to determine an auditors reporting responsibility when there is
substantial doubt about a clients ability to continue as a going concern. Answer (a) is correct
because the audit report must include an explanatory paragraph following the opinion
paragraph, and must use the terms going concern and substantial doubt.
6. (c) The requirement is to identify the circumstances in which an auditor would issue a report
that omits any reference to consistency. Answer (c) is correct because, as discussed in AU 508,
a change in the useful life of assets is a change in estimate, and a change in estimate does not
result in a consistency modification. Answers (a) and (b) are incorrect because they both
represent a change in accounting principle, and a change in accounting principle requires a
consistency modification. Answer (d) is incorrect because managements lack of reasonable
justification for a change in accounting principle is a departure from generally accepted
accounting principles, and the description of the departure will discuss the inconsistency.
7. (b) The requirement is to identify the circumstance in which a disclaimer of opinion is not
appropriate. Answer (b) is correct because when management does not provide reasonable
justification of a change in accounting principles either a qualified or an adverse opinion is
appropriate, not a disclaimer. Answers (a), (c), and (d) are all incorrect because they represent
scope limitations that lead to either a qualified opinion or a disclaimer of opinion.

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Section 7

8. (b) The requirement is to identify the appropriate types of audit reports when an illegal act
with a material effect on the financial statements has not been properly accounted for or
disclosed. Answer (b) is correct because omission of required disclosures, a departure from
generally accepted accounting principles, leads to either a qualified or an adverse opinion.
Answer (a) is incorrect because a disclaimer of opinion is not appropriate when the auditor
knows of such misstatements. Answer (c) is incorrect because neither a disclaimer of opinion
nor an unqualified opinion with a separate explanatory paragraph is appropriate. Answer (d) is
incorrect because an unqualified opinion with a separate explanatory paragraph is not
appropriate.
9. (d) The requirement is to identify the paragraphs of an audit report that are modified when an
auditor qualifies an opinion because of inadequate disclosure. In addition to requiring the
inclusion of a separate explanatory paragraph, AU 508 indicates that only the opinion paragraph
should be modified.
10. (b) The requirement is to identify the type of opinion that should be issued on the balance
sheet and the income statement when an auditor did not observe a clients taking of the
beginning physical inventory and was unable to become satisfied about its accuracy by using
other auditing procedures. Answer (b) is correct because the scope limitation will not affect the
year-end balance sheet account balances. However, because evidence with respect to the
beginning inventory is lacking, verification of cost of goods sold, an income statement element,
is impossible. Although year-end retained earnings will not be affected, both the current and
prior years retained earnings statements will be affected (by an offsetting amount) by the cost
of goods sold misstatement. If no other problems arise, the auditor will be able to issue an
unqualified opinion on the balance sheet and a disclaimer on the income statement (and on the
retained earnings statement). Answer (a) is incorrect because an unqualified opinion may be
issued on the balance sheet. Answer (c) is incorrect because an unqualified opinion may be
issued on the balance sheet with a disclaimer on the income statement. Answer (d) is incorrect
because a disclaimer should be issued on the income statement.
11. (d) The requirement is to determine whether either the scope paragraph, the opinion
paragraph, or both should be deleted when an auditor is disclaiming an opinion due to a clientimposed scope limitation. Answer (d) is correct because the scope paragraph is omitted in this
situation and the opinion paragraph is modified to disclaim an opinion. Answer (a) is incorrect
because it suggests that the scope paragraph is not omitted but that the opinion paragraph is
omitted. Answer (b) is incorrect because it states that the opinion paragraph is omitted. Answer
(c) is incorrect because it states that the scope paragraph is not omitted.
12. (d) The requirement is to identify the circumstance in which a scope limitation is sufficient to
preclude an unqualified opinion. Answer (d) is correct because AU 333 states that
managements refusal to furnish such a written representation constitutes a limitation on the
scope of an audit sufficient to preclude an unqualified opinion. Answers (a), (b), and (c) are all
incorrect because while they represent scope limitations, they may sometimes not result in a
report that is other than unqualified.
13. (b) The requirement is to determine the proper placement of an explanatory paragraph
disclosing the substantive reasons for expressing an adverse opinion. AU 508 requires that
such paragraphs precede the opinion paragraph.

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14. (d) The requirement is to determine the information to be included in an audit report on
comparative financial statements when a predecessor auditors report is not being
reissued. Answer (d) is correct because the introductory paragraph of the successors report
should indicate (1) that the financial statements of the prior period were audited by another
auditor (whose name is not presented), (2) the date of the predecessors report, (3) the type of
report issued by the predecessor, and (4) if the report was other than a standard report, the
substantive reasons therefore.

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Section 7

(7.05)
Task-based Simulation 1
Audit
Reports

Authoritative
Literature

Help

The auditors report below was drafted by Moore, a staff accountant of Tyler & Tyler, CPAs, at the completion of the
audit of the financial statements of Park Publishing Co., Inc., for the year ended September 30, 20X3. The report was
submitted to the engagement partner who reviewed the audit working papers and properly concluded that an
unqualified opinion should be issued. In drafting the report, Moore considered the following:
During fiscal year 20X3, Park changed its inventory valuation method. The engagement partner concurred
with this change in accounting principle and its justification and Moore included an explanatory paragraph in
the auditors report.
The 20X3 financial statements are affected by an uncertainty concerning a lawsuit, the outcome of which
cannot presently be estimated. Moore has included an explanatory paragraph in the auditors report.
The financial statements for the year ended September 30, 20X2, are to be presented for comparative
purposes. Tyler & Tyler previously audited these statements and expressed an unqualified opinion.
Independent Auditors Report
To the Board of Directors of Park Publishing Co., Inc.:
We have audited the accompanying balance sheets of Park Publishing Co., Inc. as of September 30, 20X3
and 20X2, and the related statements of income and cash flows for the years then ended. These financial statements
are the responsibility of the companys management.
We conducted our audits in accordance with US generally accepted auditing standards. Those standards
require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are
fairly presented. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our audits provide a basis for determining
whether any material modifications should be made to the accompanying financial statements.
As discussed in Note X to the financial statements, the company changed its method of computing inventory
valuation in fiscal 20X3.
In our opinion, except for the accounting change, with which we concur, the financial statements referred to
above present fairly, in all material respects, the financial position of Park Publishing Co., Inc. as of September 30,
20X3, and the results of its operations and its cash flows for the year then ended in conformity with US generally
accepted accounting principles.
As discussed in Note Y to the financial statements, the company is a defendant in a lawsuit alleging
infringement of certain copyrights. The company has filed a counteraction, and preliminary hearings on both actions
are in progress. Accordingly, any provision for liability is subject to adjudication of this matter.
Tyler & Tyler, CPAs
November 5, 20X3
Required:
Identify the deficiencies in the auditors report as drafted by Moore. Group the deficiencies by paragraph and
in the order in which the deficiencies appear. Do not redraft the report.

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Task-based Simulation 2
Audit
Reports

Authoritative
Literature

Help

The audit of Park Publishing Co., for the year ended September 30, 20X2, is near completion. Your
senior, Dave Moore, at Tyler & Tyler CPAs, has asked you to draft the audit report, considering the
following:
During fiscal year 20X2, Park changed its depreciation method. The engagement partner
concurred with this change in accounting principle and its justification, and Moore wants it properly
reflected in the auditors report; the change is discussed in Note 7 to the financial statements.
The 20X2 financial statements are affected by an uncertainty concerning a lawsuit over patent
infringement, the outcome of which cannot presently be estimated. Moore has suggested the need
for an explanatory paragraph in the auditors report related to this matter which is discussed in Note
4 to the financial statements.
The last day of fieldwork is October 25, 20X2, while the date the report is expected to be delivered
to the client is October 28, 20X2.
The financial statements for the year ended September 30, 20X1, are to be presented for
comparative purposes. Tyler & Tyler previously audited these statements and expressed a
standard unqualified opinion.
Prepare Tyler & Tyler, CPAs, auditors report on the consolidated financial statements of Park
Publishing Company.

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Section 7

Task-based Simulation 3
Audit
Opinion

Authoritative
Literature

Help

Required:
Items 1 through 7 present various independent factual situations an auditor might encounter in
conducting an audit. List A represents the types of opinions the auditor ordinarily would issue and List B
represents the report modifications (if any) that would be necessary. For each situation, select one
response from List A and one from List B. Select as the best answer for each item, the action the auditor
normally would take. The types of opinions in List A and the report modifications in List B may be selected
once, more than once, or not at all.
Assume:
The auditor is independent.
The auditor previously expressed an unqualified opinion on the prior years financial statements.
Only single-year (not comparative) statements are presented for the current year.
The conditions for an unqualified opinion exist unless contradicted in the factual situations.
The conditions stated in the factual situations are material.
No report modifications are to be made except in response to the factual situation.

Items to be Answered:
1. In auditing the long-term investments account, an auditor is unable to obtain audited financial
statements for an investee located in a foreign country. The auditor concludes that sufficient appropriate
audit evidence regarding this investment cannot be obtained.
2. Due to recurring operating losses and working capital deficiencies, an auditor has substantial doubt
about an entitys ability to continue as a going concern for a reasonable period of time. However, the
financial statement disclosures concerning these matters are adequate.
3. A principal auditor decides to take responsibility for the work of another CPA who audited a whollyowned subsidiary of the entity and issued an unqualified opinion. The total assets and revenues of the
subsidiary represent 17% and 18%, respectively, of the total assets and revenues of the entity being
audited.
4. An entity issues financial statements that present financial position and results of operations but omits
the related statement of cash flows. Management discloses in the notes to the financial statements that it
does not believe the statement of cash flows to be a useful financial statement.
5. An entity changes its inventory valuation method from FIFO to LIFO. The auditor concurs with the
change although it has a material effect on the comparability of the entitys financial statements.
6. An entity is a defendant in a lawsuit alleging infringement of certain patent rights. However, the ultimate
outcome of the litigation cannot be reasonably estimated by management. The auditor believes there is a
reasonable possibility of a significantly material loss, but the lawsuit is adequately disclosed in the notes
to the financial statements.
7. An entity discloses in the notes to the financial statements certain lease obligations. The auditor
believes that the failure to capitalize these leases is a departure from generally accepted accounting
principles.

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List A

List B

Types of Opinions

Report Modifications

An "except for" qualified


opinion

An unqualified opinion

An adverse opinion

D
E

Describe the circumstances in an explanatory


paragraph preceding the opinion paragraph
without modifying the three standard paragraphs.

Describe the circumstances in an explanatory


paragraph following the opinion paragraph without
modifying the three standard paragraphs.

A disclaimer of opinion

Describe the circumstances in an explanatory


paragraph preceding the opinion paragraph and
modify the opinion paragraph.

Either an "except for" qualified


opinion or an adverse opinion

Either a disclaimer of opinion


or an except for qualified
opinion

Describe the circumstances in an explanatory


paragraph following the opinion paragraph and
modify the opinion paragraph.

Either an adverse opinion or a


disclaimer of opinion

Describe the circumstances in an explanatory


paragraph preceding the opinion paragraph and
modify the scope and opinion paragraphs.

Describe the circumstances in an explanatory


paragraph following the opinion paragraph and
modify the scope and opinion paragraphs.

Describe the circumstances within the scope


paragraph without adding an explanatory
paragraph.

Describe the circumstances within the opinion


paragraph without adding an explanatory
paragraph.

Describe the circumstances within the scope and


opinion paragraphs without adding an explanatory
paragraph.

Issue the standard auditors report without


modification.

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Section 7

Task-based Simulation 4
Audit
Opinions and
Modifications

Authoritative
Literature

Help

Assume that items 1 through 8 are situations that Jones, CPA, has encountered during his audit of
Welles Incorporated. List A represents the types of opinions the auditor ordinarily would issue and List B
represents the report modifications (if any) that would be necessary. For each situation, select one
response from List A and one from List B. Select as the best answers for each item the action the
auditor would normally take. The types of opinions in List A and the report modifications in List B may be
selected once, more than once, or not at all.
Assume

A.
B.
C.
D.
E.
F.
G.

The auditor is independent.


The auditor previously expressed an unqualified opinion on the prior years financial statements.
Only single-year (not comparative) statements are presented for the current year.
The conditions for an unqualified opinion exist unless contradicted by the facts.
The conditions stated in the items to be answered are material, unless otherwise indicated.
Each item to be answered is independent of the others.
No report modifications are to be made except in response to the factual situation.
The auditor will not treat a situation as an emphasis of a matter in what remains an unqualified
audit report unless it is one of those circumstances specifically illustrated in the Professional
Standards as an example of a matter an auditor may wish to emphasize.

List A
Types of opinions
Either an except for qualified opinion
or an adverse opinion
Either a disclaimer of opinion or an
except for qualified opinion
Either an adverse opinion or a
disclaimer of opinion
An except for qualified opinion
An unqualified opinion
An adverse opinion
A disclaimer of opinion

H.

I.

J.

K.

L.

M.

N.

O.

P.

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List B
Report modifications
Describe the circumstances in an
explanatory paragraph without modifying
the three standard paragraphs.
Describe the circumstances in an
explanatory paragraph and modify the
opinion paragraph.
Describe the circumstances in an
explanatory paragraph and modify the
scope and opinion paragraphs.
Describe the circumstances in an
explanatory paragraph and modify the
introductory, scope, and opinion
paragraphs.
Describe the circumstances within the scope
paragraph without adding an explanatory
paragraph.
Describe the circumstances within the
opinion paragraph without adding an
explanatory paragraph.
Describe the circumstances within the scope
and opinion paragraphs without adding an
explanatory paragraph.
Describe the circumstances within the
introductory, scope, and opinion
paragraphs without adding an explanatory
paragraph.
Issue the standard auditors report without
modification.

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Types of
opinions
(A-G)

Report
Modifications
(H-P)

1. Jones hired an actuary to assist in corroborating Welles complex


pension calculations concerning accrued pension liabilities that
account for 35% of the clients total liabilities. The actuarys findings
are reasonably close to Welles calculations and support the financial
statements.
2. Welles holds a note receivable consisting of principal and accrued
interest payable in 20X4. The notes maker recently filed a voluntary
bankruptcy petition, but Welles failed to reduce the recorded value of
the note to its net realizable value, which is approximately 20% of the
recorded amount.
3. Jones was engaged to audit a clients financial statements after the
annual physical inventory count. The accounting records were not
sufficiently reliable to enable him to become satisfied as to the yearend inventory balances.
4. Jones found an immaterial adjustment relating to inventory. Welles
has refused to adjust the financial statements to reflect this immaterial
item.
5. Welles financial statements do not disclose certain long-term lease
obligations. Jones determined that the omitted disclosures are
required by FASB.
6. Jones decided not to take responsibility for the work of another CPA
who audited a wholly owned subsidiary of Welles. The total assets
and revenues of the subsidiary represent 27% and 28%, respectively,
of the related consolidated totals.
7. Welles changed its method of accounting for the cost of inventories
from FIFO to LIFO. Jones concurs with the change although it has a
material effect on the comparability of the financial statements.
8. Due to losses and adverse key financial ratios, Jones has substantial
doubt about Welles ability to continue as a going concern for a
reasonable period of time. The client has adequately disclosed its
financial difficulties in a note to its financial statements, which do not
include any adjustments that might result from the outcome of this
uncertainty. Also, Jones has ruled out the use of a disclaimer of
opinion.

Task-Based Simulation 5
Research
Authoritative
Literature

Help

Standard Report Elements


The senior on your job has pointed out to you that the CPA firm always signs the report both with its
signature and its location (Yuma, Arizona) and that she suggests that she thinks it isnt necessary to
provide the location.
1. Identify the section and paragraph of the auditing standards that provide the basic elements that must
be included in the auditors standard report.
2. Is she correct or incorrect concerning inclusion of the location?

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Section 7

Task-based Simulation Solution 1


Audit
Reports

Authoritative
Literature

Help

Deficiencies in the auditors report are as follows:


First (introductory) paragraph:
The statement of retained earnings is not identified.
The auditors responsibility to express an opinion is omitted.
Second (scope) paragraph:
The auditor obtains reasonable assurance about whether the financial statements are free of material
misstatement, not fairly presented.
The auditors assessment of the accounting principles used is omitted.
An audit provides a reasonable basis for an opinion, not a basis for determining whether any material
modifications should be made.
Third (first explanatory) paragraph:
An explanatory paragraph added to the report to describe a change in accounting principle (lack of
consistency) should follow the opinion paragraph, not precede it.
Fourth (opinion) paragraph:
The phrase except for should not be used.
The auditors concurrence with the change in accounting principles is implicit and should not be
mentioned.
Reference to the prior years (2001) financial statements is omitted.
Fifth (second explanatory) paragraph:
The fact that the outcome of the lawsuit cannot presently be estimated is omitted.
It is inappropriate to state that provision for any liability is subject to adjudication because the report is
ambiguous as to whether a liability has been recorded.

Task-based Simulation Solution 2


Audit
Reports

Authoritative
Literature

Help

When preparing a report it is helpful to consider an approach of beginning with the standard short-form
report and modifying it as appropriate for the circumstances presented. The following approach for preparing a report is likely to be helpful:
Step 1. Determine whether the question requires an audit report on whether the financial statements
follow GAAP.
Step 2. Find the standard report and cut/paste it to your solution space.
Step 3. Determine the circumstance(s) involved and the overall type of report to be issued.
Step 4. Research the Professional Standards to identify appropriate report modifications for the
circumstances(s) and overall type of report to be issued.
Step 5. Cut/paste the appropriate modifications to the standard report, and complete report as
necessary.
Step 1: Yes, the type of report is an audit report on whether the financial statements follow GAAP.
Step 2: You should recall that standard audit reports are presented early in AU 508one for a oneyear report and one for comparative statements. Since Tyler & Tyler is reporting upon comparative
statements, the comparative form audit report will be appropriate. We paste that report from AU 508
as follows:

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The form of the auditors standard report on comparative financial statements is as follows:
Independent Auditors Report
We have audited the accompanying balance sheets of X Company as of December
31, 20X2 and 20X1, and the related statements of income, retained earnings, and cash
flows for the years then ended. These financial statements are the responsibility of the
Companys management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. 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 X company as of [at] December 31, 20X2 and 20X1,
and the results of its operations and its cash flows for the years then ended in conformity
with accounting principles generally accepted in the United States of America
[Signature]
[Date]

Step 3: Determining the circumstances involved requires a careful reading of the text of the
simulation.
The simulations first bullet describes a change in depreciation method. This will result in a
consistency modification being added to the report. The overall modification is to simply add a
paragraph on this following the opinion paragraph.
The second bullet describes an uncertainty that the senior wishes to emphasize. This is
treated in the standards in the area of emphasis of a matter. Again this paragraph will not affect the
opinion paragraph. It may be placed either before or after the opinion paragraph.
Step 4: We need to research the Professional Standards to find both a consistency modification and
an emphasis of a matter modification. If you are unfamiliar with the reporting requirements in the
area, you may also need to spend time determining the proper treatments. You may recall that AU
508 provides most audit report modifications and is ordinarily a good place to begin searching.
Searching terms such as lack of consistency or consistency explanatory paragraph may help you
find the following in AU 508.17:
.17

Following is an example of an appropriate explanatory paragraph:


As discussed in Note X to the financial statements, the Company changed its method
of computing depreciation in 20X2.

Conveniently, the illustration is about depreciation, the circumstances included in this simulation.
Make certain that when this is not the case to remember to modify it appropriately.
Searching for emphasis of a matter in that section provides the following:
Emphasis of a Matter
.19

In any report on financial statements, the auditor may emphasize a matter regarding the
financial statements. Such explanatory information should be presented in a separate
paragraph of the auditors report. Phrases such as with the foregoing [following]
explanation should not be used in the opinion paragraph if an emphasis paragraph is
included in the auditors report. Emphasis paragraphs are never required; they may be
added solely at the auditors discretion. Examples of matters the auditor may wish to
emphasize are
That the entity is a component of a larger business enterprise.
That the entity has had significant transactions with related parties.
Unusually important subsequent events.

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Section 7

Accounting matters, other than those involving a change or changes in accounting


principles, affecting the comparability of the financial statements with those of the
preceding period.
Here there is no sample paragraph, although we do receive some guidance on phrases not to use
(With the foregoing [following] explanation).
In sum, we find that we have two explanatory paragraphs to be added to the report, with no
modification of the opinion. The consistency modification must follow the opinion paragraph, while the
emphasis of a matter paragraph may either precede or follow the opinion paragraph.
Step 5: We now make the necessary modifications to the standard report:
Independent Auditors Report
To the Board of Directors of Park Publishing Co.:
We have audited the accompanying balance sheets of Park Publishing Co. X Company
as of September 30, December 31, 20X2 and 20X1, and the related statements of income,
retained earnings, and cash flows for the years then ended. These financial statements are
the responsibility of the Companys management. Our responsibility is to express an opinion
on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the
United States of America. 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 Park Publishing Co. X Company as of [at] September 30,
December 31, 20X2 and 20X1, and the results of its operations and its cash flows for the
years then ended in conformity with accounting principles generally accepted in the United
State of America.
As discussed in Note 4 to the financial statements, the company is involved in a
lawsuit over patent infringement, the outcome of which cannot presently be estimated.
As discussed in Note 7 to the financial statements, the Company changed its
method of computing depreciation in 20X2.
Tyler & Tyler, CPAs
October 25, 20X2

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Task-based Simulation Solution 3


Audit
Opinion

Authoritative
Literature

Help

1.

FL

When the auditor cannot obtain sufficient competent evidence about an investment, it
represents a scope limitation. The auditor will not be able to obtain satisfaction that the
investment is fairly stated in the balance sheet and that investment income is fairly presented
in the income statement. Depending on materiality, the auditor will express either a qualified
except for opinion or a disclaimer of opinion. The circumstances will be described in an
explanatory paragraph preceding the opinion paragraph. In addition, the scope and opinion
paragraphs will both be modified.

2.

BI

When an auditor has substantial doubt about an entitys ability to continue as a going
concern, an unqualified opinion will still be expressed provided that the circumstances are
adequately disclosed. The only modification to the report will be an explanatory paragraph
following the opinion paragraph that describes the circumstances.

3.

BQ

When an auditor decides to take responsibility for the work of another auditor, a standard
unqualified opinion will be issued without modification.

4.

AJ

The omission of a statement of cash flows is a violation of GAAP and would require the
issuance of an except for qualified opinion. The report will modify the opinion paragraph
and explain the omission in an explanatory paragraph preceding the opinion paragraph.

5.

BI

When there is a change in accounting principles that is properly reported and disclosed and
with which the auditor concurs, an unqualified opinion will be expressed. The only
modification to the report will be the inclusion of an explanatory paragraph following the
opinion paragraph.

6.

BI

When the entity has a loss contingency that is reasonably possible, it is required to be
disclosed but not accrued. When it is adequately disclosed, the auditor will issue an
unqualified opinion. The only modification to the report will be the inclusion of an explanatory
paragraph following the opinion paragraph.

7.

EJ

The improper failure to capitalize leases is a violation of GAAP and would require the
issuance of either an except for qualified opinion or an adverse opinion, depending on
materiality. The opinion paragraph will be modified and an explanatory paragraph will be
added preceding the opinion paragraph.

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Section 7

Task-based Simulation Solution 4


Audit
Opinions and
Modifications

Authoritative
Literature

Help
Assets
(A-G)

Liabilities
(H-P)

Jones hired an actuary to assist in corroborating Welles complex pension


calculations concerning accrued pension liabilities that account for 35% of
the clients total liabilities. The actuarys findings are reasonably close to
Welles calculations and support the financial statements.

Welles holds a note receivable consisting of principal and accrued


interest payable in 20X4. The notes maker recently filed a voluntary
bankruptcy petition, but Welles failed to reduce the recorded value of the
note to its net realizable value, which is approximately 20% of the
recorded amount.

Jones was engaged to audit a clients financial statements after the


annual physical inventory count. The accounting records were not
sufficiently reliable to enable him to become satisfied as to the year-end
inventory balances.

4.

Jones found an immaterial adjustment relating to inventory. Welles has


refused to adjust the financial statements to reflect this immaterial item.

5.

Welles financial statements do not disclose certain long-term lease


obligations. Jones determined that the omitted disclosures are required
by FASB.

Jones decided not to take responsibility for the work of another CPA who
audited a wholly owned subsidiary of Welles. The total assets and
revenues of the subsidiary represent 27% and 28%, respectively, of the
related consolidated totals.

Welles changed its method of accounting for the cost of inventories from
FIFO to LIFO. Jones concurs with the change although it has a material
effect on the comparability of the financial statements.

Due to losses and adverse key financial ratios, Jones has substantial
doubt about Welles ability to continue as a going concern for a
reasonable period of time. The client has adequately disclosed its
financial difficulties in a note to its financial statements, which do not
include any adjustments that might result from the outcome of this
uncertainty. Also, Jones has ruled out the use of a disclaimer of opinion.

1.

2.

3.

6.

7.

8.

Explanation of solutions
1. (E,P) When an auditor hires a specialist to assist in corroborating a client estimate (here complex
pension calculations), and that specialists findings are reasonably close to those of the client, no report
modification is required or permitted. Since the specialists findings support the financial statements in
this situation, a standard unqualified audit report is appropriate. When major unresolved differences
between the findings of management and the specialist exist, report modification is appropriate.
2. (A,I) When the clients financial statements materially depart from generally accepted accounting
principles, either a qualified opinion or an adverse opinion is appropriate, depending on the magnitude of
the misstatement. The value of the clients note receivable has been impaired and therefore the client
should write the note receivable down to its net realizable value. The auditor will have to determine
whether to issue a qualified opinion or an adverse opinion on the basis of the materiality of the
misstatement. Factors the auditor will consider include the significance of the account, the pervasiveness
of the misstatement and the misstatements effect on the financial statement taken as whole. The audit
report, for either opinion, will include an explanatory paragraph to describe the substantive reasons for
the modification, and the opinion paragraph will be modified.

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3. (B,J) A situation where the auditor is unable to obtain sufficient competent evidential matter is
referred to as a scope limitation. A scope limitation may require the auditor to either qualify his or her
opinion or to disclaim an opinion altogether. Since the auditor was unable to observe the inventory count
or to obtain evidence through alternative procedures, the auditor will have to decide whether to issue a
qualified opinion or a disclaimer of opinion. The decision will be based on the auditors judgment as to
the nature and magnitude of the potential effects of the matters in question and by their significance to the
financial statements. A qualified opinion will describe the circumstances in an explanatory paragraph and
will modify the scope and opinion paragraphs. A disclaimer of opinion will omit the scope paragraph and
will include modification of the opinion paragraph.
4.

(E,P) An auditor need not modify a report for an immaterial item that the client declines to reflect.

5. (A,I) Since the clients financial statements omitted required disclosures on certain long-term lease
obligations, they are not prepared in accordance with generally accepted accounting principles. As a
result, the auditor should express either a qualified opinion or an adverse opinion. The decision to
express either a qualified or adverse opinion is based on the significance of the lack of disclosure, the
pervasiveness of the misstatement, and the overall effect the lack of disclosure has on the financial
statements. The audit report, for either opinion, will include an explanatory paragraph to describe the
substantive reasons for the modification, and the opinion paragraph will be modified.
6. (E,O) When a principal auditor decides not to take responsibility for the work of another auditor, the
principal auditor should make reference to the work of the other auditor in the audit report. The audit
report should clearly indicate the division of responsibility between the two auditors in the introductory,
scope, and opinion paragraphs. Reference to the other auditor in the audit report does not prevent the
principal auditor from issuing an unqualified opinion. The reference to the other auditor is designed to
emphasize the divided responsibilities between the two auditors.
7. (E,H) When an auditor agrees with a change in accounting principles, a lack of consistency results
in an unqualified opinion with an explanatory paragraph following the opinion paragraph. There is no
modification of the three standard paragraphs.
8. (E,H) The auditor has substantial doubt about the clients ability to remain a going concern for a
reasonable period of time. The audit report should emphasize this concern to the financial statement
users. As a result, the auditors report will include an unqualified opinion with an explanatory paragraph
following the opinion paragraph.

Task-Based Simulation Solution 5


Research
Authoritative
Literature

Help

1. AU 508.08
2. She is correct, as including the location is not required (although it is acceptable).

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Section 7

Audit Reports Homework


Wiley Book
Module 5
Reporting (Audit Report questions only)
Questions 1-5: Overall Reporting Issues
Questions 6-16: Financial Statement Audit Reports-Nonissuer (Nonpublic)
Companies
Questions 17-18: Financial Statement Audit Reports-Issuer (Public) Companies
Questions 19-23: Opinions Based, in Part, On Report of another Auditor
Question 24: Circumstances Requiring a Departure from Promulgated GAAP
Questions 25-37: Going Concern Issues
Questions 38-45: Inconsistency in Application of GAAP
Questions 46-52: Circumstances Affecting Comparative Financial Statements
Questions 53-57: Supplementary Information Required by FASB/GASB
Question 58: Emphasis of a Matter (AU 508)
Questions 59-65: Departures from GAAP
Questions 66-74: Scope Limitations
Question 75: Lack of Independence
Questions 76-79: Report Preparation
Task-Based Simulations (TBS) 1-5
SKIP - Questions 80-164 as they are covered in AUDIT-5

Software Problems
Reporting (REPT)
(Audit Reporting questions only)

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