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Chapter 12 - Reports on Audited Financial Statements

CHAPTER 12
Reports on Audited Financial Statements
LEARNING OBJECTIVES
Review
Checkpoints

Exercises, Problems,
and Simulations

1.

Provide an overview of the types of reports that


accompany the entitys financial statements.

1, 2

2.

List three general functions of the auditors report


on an entitys financial statements.

3.

Explain the significance of each of the


paragraphs in a standard report on an entitys
financial statements.

4, 5, 6, 7

38, 49, 50

4.

Describe the types of auditors reports that may


be issued if an entitys financial statements
contain a departure from generally accepted
accounting principles.

8, 9

40, 44 (partial), 46
(partial), 48 (partial),
56, 57 (partial), 59
(partial), 60 (partial),

5.

Describe the types of auditors reports that may


be issued if auditors are unable to comply with
generally accepted auditing standards.

10, 11

44 (partial), 46
(partial), 48 (partial),
53, 60 (partial)

6.

Describe how the standard report is modified


when auditors issue unqualified opinions but
reference other matters affecting the audit or the
client.

12, 13, 14, 15, 16, 17,


18

39, 42, 43, 44


(partial), 46 (partial),
47, 51, 54, 57
(partial), 58, 59
(partial), 60 (partial)

7.

Identify other circumstances affecting auditors


reporting responsibilities and explain how they
affect auditors reports on an entitys financial
statements.

19, 20, 21, 22, 23, 24

41, 44 (partial), 45,


52, 55, 60 (partial),
61, 62

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Chapter 12 - Reports on Audited Financial Statements

SOLUTIONS FOR REVIEW CHECKPOINTS


12.1

Management prepares a report on the effectiveness of internal control over financial reporting.
The auditors prepare reports on (1) the entitys financial statement and other disclosures and (2) the
effectiveness of the entitys internal control over financial reporting. These can be presented as two separate
reports or a combined report.

12.2

Managements report on internal control over financial reporting consists of the following major components:

A statement indicating that management is responsible for establishing and maintaining adequate internal
control over financial reporting.

A statement identifying the framework used by management to assess the effectiveness of the entitys
internal control.

Managements opinion on the effectiveness of the entitys internal control, including an explicit
statement as to whether the internal control over financial reporting is effective.

A statement that the registered accounting firm auditing the financial statements (auditor) has issued an
attestation report on the entitys internal control over financial reporting.

12.3

The auditors report serves to communicate to users three specific statements with respect to the financial
statements, the conduct of the audit, and the entity in general. First, the report indicates whether the
financial statements are presented in conformity with GAAP. Second, auditors use their report to indicate
any unusual aspects of the audit examination. Third, even if the financial statements are fairly presented and
no problems were noted in the conduct of the audit, the auditors can use the report to communicate
information useful to decision makers that may not appear on the face of the financial statements.

12.4

Nine important elements of the auditors standard report are:


1.

Title. The title should contain the word independent, as in Independent Registered Public
Accounting Firm or Independent Auditors.

2.

Address. The report shall be addressed to the client, which occasionally may be different from
the auditee.

3.

Notice of Audit. A sentence should identify the financial statements and indicate that they were
audited. This appears in the introductory paragraph.

4.

Responsibilities. The report should state managements responsibility for the financial statements
and the auditors responsibility for the report. These statements are also in the introductory
paragraph.

5.

Description of the Audit. The second paragraph (scope paragraph) should declare that the audit
was conducted in accordance with the standards of the Public Company Accounting Oversight
Board (PCAOB) and describe the principal characteristics of an audit, including a statement of
belief that the audit provided a reasonable basis for the opinion.

6.

Opinion. The report shall express an opinion (opinion paragraph) regarding conformity of the
financial statements with accounting principles generally accepted in the United States of
America.

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Chapter 12 - Reports on Audited Financial Statements

12.4

12.5

(Continued)
7.

Internal Control. The report should reference the auditors examination, report, and opinion on
the clients internal control over financial reporting.

8.

Signature. The auditors (partner of the audit team) shall sign the report, manually or otherwise.

9.

Date. The report shall be dated using the date when the auditors have obtained sufficient
appropriate evidence to support their opinion (the audit completion date).

a.

The objects of the audit are the financial statements (balance sheet, income statement, statement of
comprehensive income, statement of shareholders equity, and statement of cash flows) and the
related footnote disclosures.

b.

This statement means that the auditors complied with the general standards and standards of field
work, which require that auditors:
1.
2.
3.
4.
5.
6.

12.6

12.7

are trained and proficient.


are independent.
exercise due professional care.
plan and supervise the work.
obtain an understanding of the entity and its environment.
gather sufficient appropriate evidence.

The major differences in the report issued under AS 5 (for public entities) and SAS 58 (for nonpublic
entities) include:
1.

The AS 5 report is titled Report of Independent Registered Public Accounting Firm while the
SAS 58 report is titled Report of Independent Auditors.

2.

The AS 5 report references standards established by the PCAOB (United States) while the SAS
58 report references auditing standards generally accepted in the United States.

3.

The SAS 58 report does not contain a reference to the auditors examination and report on the
effectiveness of the clients internal control over financial reporting (such examinations are not
required for nonpublic entities).

Major reasons for departures from the wording in the standard report include:
1.

The financial statements contain a departure from GAAP.

2.

Matters (scope limitations) affect the ability of auditors to conduct an audit in accordance with
GAAS.

3.

The auditors wish to reference other matters affecting the audit or the client.

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Chapter 12 - Reports on Audited Financial Statements


12.8
If a departure from GAAP exists and the effect is immaterial, then an unqualified opinion may be issued. If
the effect of the departure is material (but not pervasive) and isolated to a single event, then a qualified opinion
would be issued. If the effect is pervasive, the auditors should issue an adverse opinion.
12.9

Qualified opinions indicate that, except for the effects of an isolated departure from GAAP, the financial
statements are presented in conformity with GAAP. Adverse opinions indicate that the financial statements
are not presented in conformity with GAAP. Clearly, the wording used in the adverse opinions represents
more serious and significant departures from GAAP.

12.10

A client-imposed scope limitation results from managements refusal to let auditors perform auditing
procedures while a circumstance-imposed scope limitation occurs when circumstances beyond the auditors
or clients control result in the inability of auditors to perform certain procedures.
Because of the deliberate and intentional nature of client-imposed scope limitations, these scope limitations
are of greater concern to auditors than circumstance-imposed scope limitations.

12.11

1.

2.

12.12

In comparison to the standard report, a report qualified for a scope limitation has:
a.

An except for phrase in the scope paragraph identifying the scope limitation.

b.

An explanatory paragraph describing the scope limitation, the accounts or disclosures


affected by the scope limitation, and the dollar amounts involved, if determinable.

c.

An except for phrase in the opinion paragraph that recognizes the scope limitation may
have affected auditors ability to identify misstatements.

In comparison to the standard report, a report in which the opinion is disclaimed because of a
scope limitation has:
a.

A modification to the introductory paragraph indicating [w]e have been engaged to


audit instead of [w]e have audited.

b.

The introductory paragraph omits the sentence in which the auditors indicate their
responsibility for an opinion on the financial statements.

c.

The scope paragraph is omitted.

d.

An explanatory paragraph describing the scope limitation, the accounts or disclosures


affected by the scope limitation, and the dollar amounts involved, if determinable.

e.

The opinion paragraph refers to the explanatory paragraph and disclaims an opinion on
the financial statements.

When auditors are not independent with respect to an entity, a disclaimer of opinion should be issued
because auditors are required to be independent to conduct an examination (and express an opinion). While
this disclaimer will indicate that the auditors were not independent, it should not refer to the reason(s) for
the lack of independence.

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Chapter 12 - Reports on Audited Financial Statements

12.13

The following situations cause auditors to modify their reports to identify inconsistent applications of
GAAP:
1.
2.
3.
4.
5.

12.14

Change in accounting principles (from GAAP to GAAP).


Change in the form of reporting entity.
Change from a principle not conforming to GAAP to one that is GAAP.
Change in an accounting principle that is inseparable from a change in accounting estimate.
Change in the presentation and definition of cash equivalents in the statement of cash flows.

The following circumstances may indicate substantial doubt about an entitys ability to continue as a going
concern:

Financial difficulties (negative trends in financial ratios).


Labor problems.
Loss of key personnel.
Significant litigation.

12.15

When going-concern uncertainties exist, auditors may either add an explanatory paragraph to an unqualified
opinion or disclaim an opinion on the entitys financial statements. Disclaimers would typically be issued
when the going-concern uncertainties are more serious and pervasive.

12.16

Rule 203 allows auditors to issue an unqualified opinion on an entitys financial statements when those
statements contain a departure from a FASB or GASB (or their predecessors) standard. This rule relates to
situations in which auditors believe that this departure prevents the financial statements from being
misleading.

12.17

When a division of responsibility exists, principal auditors can assume responsibility for the other auditors
work; if so, no reference is made to the other auditors work in the principal auditors report (the standard
report can be issued). If principal auditors decide to refer to the work and reports of other auditors, they
would modify the introductory, scope, and opinion paragraphs of their report to indicate the division of
responsibility.

12.18

The principal auditors reference in their report to other auditors is not a scope limitation. The reference
only shows the division of responsibility for the audit work.

12.19

Circumstances, events, or transactions that auditors may wish to emphasize to financial statement users
include:

A warning that bankruptcy may be imminent.


A description of the auditee as a subsidiary of a larger entity.
The effects of business events on the comparability of financial statements.
The interaction of the auditee with related parties.
The effect of events that occur after the balance sheet date.

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Chapter 12 - Reports on Audited Financial Statements

12.20

Auditors are associated with financial statements when they consent to the use of their name in some form
of communication containing the financial statements or submit to their clients or others financial
statements they have prepared or assisted in preparing. When associated with an entitys unaudited
financial statements, auditors are required to disclaim an opinion on financial statements.
With respect to unaudited financial statements, in addition to issuing a disclaimer of opinion, the following
guidelines should be observed:

12.21

1.

The report should not mention any auditing procedures applied because readers might erroneously
conclude that these procedures were sufficient to enable an opinion to be expressed on the
financial statements.

2.

If the auditors should learn that the financial statements are not in conformity with generally
accepted accounting principles (including adequate disclosures), the departures should be
explained in the disclaimer.

3.

If prior-years unaudited financial statements are presented, the disclaimer should cover them as
well as the current-year statements.

4.

Each page of the financial statements should be clearly labeled as unaudited.

An updated report is a report on prior-year financial statements that is based on both the prior-year audit
and on information that has come to light in the most recent audit. An updated report may be modified for
events occurring subsequent to the date of the initial report.
A reissued report is a copy of a previously-issued report that auditors provide or grant permission to use in
another document after its delivery date. This report is not modified to consider events occurring
subsequent to the date of the initial report.

12.22

The two types of disclosure issues related to other information are:


a.

Material inconsistency of other information with disclosures and information included in the
audited financial statements.

b.

Material misstatements of fact or omissions related to the other information.

12.23 Auditors are prohibited from issuing a standard report on condensed financial statements because the
condensed financial statements are not a fair presentation of financial position, results of operations, and
cash flows in conformity with GAAP. (These financial statements present only a subset of the necessary
disclosures required for conformity with GAAP).

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Chapter 12 - Reports on Audited Financial Statements

12.24

Problems encountered with supplemental information include:

Required supplemental information is omitted.


The supplemental information materially departs from GAAP.
Auditors cannot perform necessary review procedures related to the supplemental information.
Managements presentation of supplemental information indicates the auditors performed review
procedures without also indicating the auditors do not express an opinion on the supplemental
information.
Management places the supplemental information close to, or within, the basic financial
statements and does not label it as unaudited.

When these problems are encountered, auditors should expand their report on the financial statements or
disclaim an opinion on the supplemental information.

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS


12.25

12.26

12.27

12.28

a.

Correct

b.
c.

Incorrect
Incorrect

d.

Incorrect

a.

Incorrect

b.
c.

Incorrect
Incorrect

d.

Correct

a.

Correct

b.

Incorrect

c.

Incorrect

d.

Incorrect

a.

Incorrect

b.

Incorrect

c.

Correct

d.

Incorrect

Auditors explicitly report on GAAP and express an opinion; auditors implicitly


report on consistency and disclosure.
Consistency is implicitly reported upon.
Auditors explicitly report on GAAP and express an opinion; auditors implicitly
report on consistency and disclosure.
The implicit reporting on consistency is the only correct option in this choice.
The unqualified opinion is not an option with a material GAAP departure, and
the disclaimer of opinion is inappropriate because the auditors are aware of the
GAAP departure.
The unqualified opinion is not an option with a material GAAP departure.
The emphasis paragraph does not compensate for the GAAP departure and the
unqualified opinion is still inappropriate.
Because this is a material departure from GAAP, and the choices are to qualify
or issue the adverse opinion.
The choice depends on the auditors perception of the magnitude of the
uncertainty.
The standard report without an explanatory paragraph is not appropriate in the
circumstances.
Because the disclosures are adequate, a qualified opinion or adverse opinion for
GAAP departure would be inappropriate.
see (b) and (c)
This is not a viable option because the auditors believe the financial statements
would be misleading.
Auditors cannot disclaim an opinion when they have full knowledge of the
GAAP departure.
Rule 203 provides for an explanatory paragraph and unqualified opinion if
GAAP are misleading.
Auditors cannot issue the standard report when there is a departure from GAAP,
even in cases where GAAP might be misleading.

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Chapter 12 - Reports on Audited Financial Statements

12.29.

a.
b.

Incorrect
Incorrect

c.

Incorrect

d.

Correct

Changes in estimates do not require a consistency paragraph.


Error corrections not involving a change in principle do not require a
consistency paragraph.
Changes in the consolidated entity by reason of sale of a subsidiary do not
require a consistency paragraph.
This is a change in accounting principle.

12.30

a.
b.
c.
d.

Incorrect
Correct
Incorrect
Incorrect

The prior audit must be described regardless of the type of opinion issued.
The predecessor auditors should be named only if their report is included.
The type of opinion must be stated.
The predecessor auditors should not be named unless their report is included.

12.31

The key word in the question is may issue a report.


a.

Correct

b.

Correct

c.

Incorrect

d.

Incorrect

a.

Correct

b.
c.
d.

Incorrect
Incorrect
Incorrect

12.33

a.
b.
c.
d.

Incorrect
Incorrect
Incorrect
Correct

A disclaimer when going-concern uncertainties exist is permitted.


A disclaimer based on a scope limitation is permitted.
Auditors must always disclaim an opinion when they are not independent.
Auditors cannot disclaim an opinion when departures from GAAP exist and they
have conducted a GAAS audit (qualified or adverse opinions are appropriate).

12.34

a.

Correct

b.
c.

Incorrect
Incorrect

d.

Incorrect

The auditors responsibility is explicitly stated in the introductory paragraph of


the report.
The auditors responsibility is explicitly stated.
The auditors responsibility is described in the introductory, not the opinion
paragraph.
The auditors responsibility is explicitly stated; in addition, it is stated in the
introductory, not opinion, paragraph.

a.
b.
c.
d.

Incorrect
Incorrect
Correct
Incorrect

12.32

12.35

Modification of the report to indicate division of responsibility with an


unqualified opinion is a viable reporting option.
The principal auditors taking full responsibility by not mentioning the other
auditors is a possibility.
The principal auditors must take some responsibility when a division of
responsibility exists.
When the other auditors are named, their reports must be presented.
The emphasis paragraph is a modification, but otherwise does not change an
unqualified opinion.
See (a) above.
See (a) above.
See (a) above.

Megabank is the user of the financial statements.


Samson & Delilah is the auditor.
Company A hired the auditors (and will pay the fee).
Company B is the auditee.

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Chapter 12 - Reports on Audited Financial Statements

12.36

12.37

NOTE TO INSTRUCTOR: Since this question asks students to identify which statement is not included in
the auditors standard report, the item labeled correct would not be included and those labeled
incorrect would be included.
a.
b.
c.
d.

Incorrect
Incorrect
Incorrect
Correct

The standard report identifies the financial statements.


The standard report provides a general description of an audit.
The standard report expresses an opinion about conformity with GAAP.
The standard report does not call for economic analysis or commentary.

a.

Correct

b.

Incorrect

c.

Incorrect

d.

Incorrect

The report on internal control over financial reporting would be modified to


reference the report on the financial statements; in addition, the report on the
financial statements would be modified to reference the report on internal
control over financial reporting.
The report on internal control over financial reporting would be modified to
reference the report on the entitys financial statements.
The report on the entitys financial statements would be modified to reference
the report on internal control over financial reporting.
Both the report on the financial statements and the report on internal control
over financial reporting would be modified to reference the other report.

SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS


12.38

Audit Simulation: Reports on Financial Statements (Deficiencies and Omissions in the Auditors
Report)
1.

Title. The report needs a title referring to Ross as the Independent Registered Public Accounting
Firm.

2.

The auditors should address the report to the body that has engaged them (the Continental
Corporation Board of Directors). While the report may be read and used by others who are indirect
beneficiaries of the audit, current custom is not to address the report to the unknown class of users.

3.

Financial Statements: The statement of cash flows is not referenced in the introductory paragraph,
yet an opinion is provided in the opinion paragraph on cash flows.

4.

Responsibilities. The introductory paragraph does not address the auditors responsibility for
issuing an opinion on the financial statements.

5.

Scope. The report uses inappropriate language; instead of referencing the standards of the
PCAOB, it indicates that the audit was performed in accordance with your [the clients]
instructions and that a complete audit was conducted, both of which are inappropriate.

6.

Scope: The scope paragraph of the report should explicitly mention that the audit was conducted
in accordance with the standards of the Public Company Accounting Oversight Board (United
States).

7.

Opinion. The opinion paragraph should not be modified with the phrase with the explanation
given above.

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Chapter 12 - Reports on Audited Financial Statements

12.39

8.

Opinion. The opinion paragraph should not mention minor errors we consider immaterial, but it
should contain the phrase presents fairly in all material respects.

9.

Opinion/Identification of Financial Statements. The opinion paragraph should not include


reference to cash flows because the introductory paragraph did not state that the cash flow
statement was audited. This may be a deficiency in the identification of the financial statements
that were actually audited. (See earlier deficiency related to the introductory paragraph).

10.

Opinion. The opinion paragraph refers improperly to FASB pronouncements. It should refer to
accounting principles generally accepted in the United States of America.

11.

Date. The date accompanying Ross signature should be September 23 (the audit completion date)
and not Continental Corporations fiscal year end date (July 31).

12.

Internal Control Paragraph: The date of the Ross report on internal control should be September
23 (the audit completion date) and not Continental Corporations fiscal year end date.

13.

Other. The commentary on the economy and the strike are not generally appropriate for the report.
Even if the auditors wanted to draw attention to these matters, their relevance for understanding
the financial statements and their manner of expression are both questionable.

14.

Other. The negative assurance (concerning the recording of sales) is not permitted in auditors
reports.

Reports on Financial Statements (Consistency)

Item

Should Auditors
Report Be
Modified?

Type of Change

1.

An accounting change involving a change from one


generally accepted accounting principle to another
generally accepted accounting principle.

Yes

2.

An accounting change involving a change in an


accounting estimate.

No

3.

An error correction not involving an accounting principle.

No

4.

An accounting change involving a correction of an error


in principle which is accounted for as a correction of an
error.

Yes

5.

An accounting change involving a change in the reporting


entity which is a special type of change in accounting
principle.

Yes

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Chapter 12 - Reports on Audited Financial Statements

12.40

6.

An accounting change involving both a change in


accounting principle and a change in accounting estimate.
Although the effect of the change in each may be
inseparable and the accounting for such a change is the
same as that accorded a change in estimate only, an
accounting principle is involved.

Yes

7.

Not an accounting change but rather a change in


classification.

No

8.

An accounting change from one generally accepted


accounting principle to another generally accepted
accounting principle.

Yes

Reports on Financial Statements (Errors in an Adverse Opinion)


Deficiencies in the adverse opinion are:
1.

The report is improperly addressed to the president instead of to the board of directors that
engaged the auditors.

2.

The introductory and scope paragraphs are inappropriately combined.

3.

The combined introductory and scope paragraph does not identify the specific financial statements
audited: balance sheet, statements of income, comprehensive income, shareholders equity, and
cash flows.

4.

The combined introductory and scope paragraph does not contain the required sentence about
managements responsibility for the financial statements.

5.

The combined introductory and scope paragraph also does not contain the required sentence about
the auditors responsibility to express an opinion based on the audit.

6.

Reference to Note K in the scope paragraph relating to a subsequent event disclosure is


inappropriate. If the auditors want to bring this matter to the readers attention, a separate
emphasis paragraph should be used.

7.

The explanatory paragraph does not make reference to the requirements of GAAP; specifically,
that property and equipment should be stated at an amount not exceeding historical cost, and
deferred income taxes should be provided. Therefore, all the substantive reasons for the adverse
opinion have not been stated in the report.

8.

The explanatory paragraph should either provide the monetary effects of the departures from
GAAP (appraisal values and installment method) or indicate that the monetary effects are not
reasonably determinable.

9.

The opinion paragraph does not contain a direct reference to the explanatory paragraph that
provides the basis for the adverse opinion.

10.

The report is not properly dual dated for the audit completion date of March 7 and the March 14
subsequent event. The date should be March 7, except for Note K, for which the date is March
14.

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Chapter 12 - Reports on Audited Financial Statements

11.

12.41

12.42

The internal control paragraph following the opinion paragraph inappropriately disclaims an
opinion on Cooks internal control over financial reporting. Since the case facts indicate that an
engagement was performed and the internal control was found to be effective, an unqualified
opinion on internal control over financial reporting should be expressed.
Reports on Financial Statements (Errors in a Comparative Report with Change from Prior Year)
1.

The financial statements are not individually identified in the introductory paragraph.

2.

The description of the time period for results of operations and cash flows is inappropriate; instead
of indicating as of, the report should indicate for the two years ended.

3.

The type of opinion (adverse) previously issued on the prior-years financial statements is not
identified.

4.

The date of the previous auditors report is incorrect. It should be March 5 instead of the prior
balance sheet date (December 31).

5.

The substantive reason for changing the prior-years opinion during the current year is not given
(change from an unacceptable accounting principle, NIFO, to an acceptable one, FIFO).

6.

The phrase based upon the preceding in the opinion paragraph is not appropriate and may be
misinterpreted as some sort of qualification.

7.

The opinion paragraph refers only to the current-year financial statements, but should refer to both
the current-year and the prior-years financial statements presented in comparative form.

8.

The consistency phrase (consistently applied) is inappropriate; the change in method of


computing inventory cost should be mentioned in a separate explanatory paragraph.

9.

The consistency matter should not be phrased using except for terms because this language is
reserved for use to qualify an opinion for a GAAP departure or a scope limitation (GAAS
departure).

Reports on Financial Statements (Division of Responsibility)


a.

Michaels should:
1.

Make inquiries concerning the professional reputation and standing of Thomas

2.

Obtain a representation from Thomas that Thomas is independent under the requirements
of the AICPA or the requirements of the SEC, as appropriate

3.

Adopt appropriate measures to ensure the coordination of activities with Thomas in order
to achieve a proper review of matters affecting the consolidating or combining of
accounts in the financial statements. In order to accomplish this, Michaels must ascertain
that:

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Chapter 12 - Reports on Audited Financial Statements

12.43

Thomas is aware that the financial statements of the component Thomas has
examined are to be included in the financial statements on which Michaels will
report and that Thomass report thereon will be relied upon (and, where
applicable, referred to) by Michaels.

Thomas has knowledge of the relevant financial reporting requirements for


statements and schedules to be filed with regulatory agencies such as the SEC, if
appropriate.

A review will be made of matters affecting elimination of intercompany


transactions and accounts and, if appropriate in the circumstances, the
uniformity of accounting practices among the components included in the
financial statements.

b.

If Michaels decides to make reference to the examination of Thomas, Michaelss report should
indicate the division of responsibility. The report should disclose the magnitude of the portion of
the financial statements examined by Thomas by stating the dollar amounts or percentages of one
or more of the following: total assets, total revenues, or other appropriate criteria, whichever most
clearly represents the portion of the financial statements examined by Thomas. Thomas may be
named, but only with Thomass express permission and provided Thomass report is presented
together Michaels report.

c.

If Michaels can neither assume responsibility for Thomas work nor indicate division of
responsibility by referring to Thomas work and report, Michaels (the principal auditor) faces a
scope limitation (a portion of the financial statements is essentially unaudited insofar as Michaels
is concerned, assuming that Michaels is not able to audit the portion). As a result, Michaels scope
paragraph will be qualified to explain the unaudited portion (provided it is material), and the
opinion paragraph will express a qualified opinion or disclaimer of opinion.

Reports on Financial Statements (Division of Responsibility and Other Operating Matters)


INTRODUCTORY PARAGRAPH
1.

The statement of cash flows is not identified, but the opinion paragraph references cash flows
when expressing an opinion.

2.

The sentence identifying managements responsibility for the financial statements is omitted.

3.

The magnitude of the assets and revenues audited by the other auditors is not disclosed.

4.

The other auditors name is disclosed, but it can be used only if the other auditors report is also
included. Here we see no indication that the other auditors report is printed along with the
principal auditors report.

SCOPE PARAGRAPH
5.

The scope paragraph should not be is qualified because of reliance on the work of other auditors.
This phrase should be removed.

6.

The scope paragraph should not contain any mention of assessing control risk.

7.

The concluding sentence should refer both to our audit and to the report of other auditors.
The latter reference is omitted.

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Chapter 12 - Reports on Audited Financial Statements

OPINION PARAGRAPH

12.44

8.

The opinion should not appear to be qualified by use of the phrase except for the report of the
other auditors. The proper wording is In our opinion, based on our audit and the report of other
auditors, the financial statements...

9.

The opinion paragraph expresses an opinion on the presentation of cash flows, but this financial
statement was not identified in the introductory paragraph as being audited (see earlier reference
to this deficiency in the introductory paragraph section).

10.

The opinion omits the required reference to accounting principles generally accepted in the United
States of America.

Reports on Financial Statements: Various Reporting Situations


1.

a.

Either a qualified opinion or a disclaimer of opinion, depending upon the reason for the
scope limitation (client-imposed versus circumstance-imposed) and the degree of
materiality and pervasiveness.

b.

If a qualified opinion is issued, the scope paragraph would be modified, an explanatory


paragraph would be added, and the opinion paragraph would be modified to indicate that
except for the effects of such adjustments, if any...
If a disclaimer of opinion is issued, the introductory paragraph would be modified, the
scope paragraph would be omitted, an explanatory paragraph would be added, and the
opinion paragraph would be modified to indicate an opinion cannot be expressed.

2.

3.

4.

a.

Either a qualified opinion or adverse opinion, depending upon degree of materiality and
pervasiveness of the GAAP departure.

b.

Explain the departure from GAAP in an explanatory paragraph before the opinion
paragraph and modify the opinion paragraph to express the appropriate opinion.

a.

Either a qualified opinion or adverse opinion, depending upon degree of materiality and
pervasiveness of the GAAP departure.

b.

Explain the departure from GAAP in an explanatory paragraph before the opinion
paragraph and modify the opinion paragraph to express the appropriate opinion.

a.

Either a qualified opinion or a disclaimer of opinion, depending upon the degree of


materiality and pervasiveness.

b.

If a qualified opinion is issued, the scope paragraph would be modified, an explanatory


paragraph would be added, and the opinion paragraph would be modified to indicate that
except for the effects of such adjustments, if any...
If a disclaimer of opinion is issued, the introductory paragraph would be modified, the
scope paragraph would be omitted, an explanatory paragraph would be added, and the
opinion paragraph would be modified to indicate an opinion cannot be expressed.

5.

a.

Unqualified opinion.

12-14

Chapter 12 - Reports on Audited Financial Statements

6.

b.

Without modifying the paragraphs of the standard report, describe the omitted
information in a separate paragraph following the opinion paragraph.

a.

Unqualified opinion.

b.

12.44

Describe the other auditors work in the introductory paragraph; modify the concluding
sentence of the scope paragraph to indicate [w]e believe that our audit and the reports of
other auditors provide a reasonable basis for our opinion; modify the opinion paragraph
to indicate In our opinion, based upon our audit and the reports of other auditors, the
financial statements... Do not add a separate explanatory paragraph.
Reports on Financial Statements: Various Reporting Situations (Continued)
7.

8.

12.45

a.

Unqualified opinion.

b.

Without modifying the paragraphs of the standard report, identify the change in
accounting principle and refer to the financial statement note discussing this change in
principle in a paragraph following the opinion paragraph.

a.

Unqualified opinion.

b.

Without modifying the paragraphs of the standard report, identify the going-concern
uncertainty and refer to the financial statement note discussing the going-concern
uncertainty in a separate paragraph following the opinion paragraph.

Reports on Financial Statements (Explain Deficiencies in a Disclaimer of Opinion)


Deficiency

Reason

Correction

1.

The first sentence of the


report states that the
examination was made in
accordance with the
standards of the Public
Company Accounting
Oversight Board.

The examination has not been


made in accordance with the
standards of the Public Company
Accounting Oversight Board
because the second general
standard requires that the audit be
independent. This sentence is also
inconsistent with the sentence of
the report which states that the
financial statements were not
audited.

Delete the first sentence.

2.

The auditors disclosed the


reason for their lack of
independence (his wife owns
5% of the stock of the entity).

This disclosure might confuse the


reader. For example, the reader
may not believe that this
investment prevents the auditors
from being independent and cause
him to place undue reliance on the
report and the financial statements.
Since independence is a matter of
professional judgment, the reader
should not be called upon to make
this judgment.

Delete the reference to the


reason for the lack of
independence.

12-15

Chapter 12 - Reports on Audited Financial Statements


12.46

Reports on Financial Statements (Evidence Required for Various Auditors Reports)


a.

The following reports require fully sufficient appropriate evidence.

b.

The following reports result from pervasive evidence deficiencies.

c.

Disclaimer on unaudited financial statements of public entities


Disclaimer resulting from significant scope limitations or client-imposed scope
limitations

The following report results from compartmentalized matters.

12.47

Standard report
Rule 203 report justifying departures from official pronouncements.
Updated reports on prior-years comparative financial statements.
Reports modified for a division of responsibility.
Adverse opinion for departures from generally accepted accounting principles.
Qualified opinion for departures from generally accepted accounting principles.
Reports modified by including an explanatory paragraph for consistency.
Reports modified by including an explanatory paragraph to emphasize a matter.
Reports modified by including an explanatory paragraph for going-concern uncertainties.
Reports modified by including an explanatory paragraph to identify inconsistencies,
misstatements, or omissions of other information and quarterly and supplemental
information

Qualified opinion resulting from material (but not pervasive) scope limitations.

Reports on Financial Statements (Unqualified Opinion, Accounting Change, and Uncertainty)


First (introductory) paragraph:

The statement of shareholders equity is not identified.

The sentence mentioning the auditors responsibility to express an opinion is omitted.

Second (scope) paragraph:

The auditors obtain reasonable assurance about whether the financial statements are free of
material misstatement, not fairly presented.

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.

12-16

Chapter 12 - Reports on Audited Financial Statements


12.47

Audit Simulation: Reports on Financial Statements (Unqualified Opinion, Accounting Change, and
Uncertainty) (Continued)
Fourth (opinion) paragraph:

The phrase except for should not be used in conjunction with the consistency issue.

The auditors concurrence with the change in accounting principles is implicit and should not be
mentioned.

Reference to and opinion on the prior-year balance sheet (2007) is omitted.

Fifth (second explanatory) paragraph:

12.48

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.

Reports on Financial Statements (Reports and the Effect of Materiality)


If the amounts involved are immaterial, auditors can issue the standard report (unqualified opinion);
otherwise, materiality affects the choice of auditors reports as follows:

12.49

Material

Pervasive

a.

Scope limitation on
examination of
accounts receivable.

Except for language used to


qualify the opinion.

Disclaimer of opinion.

b.

Departure from GAAP


(failure to accrue
revenue)

Except for language used to


qualify the opinion for the GAAP
departure.

Adverse opinion.

c.

Departure from GAAP


(failure to capitalize
leases)

Except for language used to


qualify the opinion for the GAAP
departure.

Adverse opinion.

d.

Uncertainty related to
the amount of damage
that might eventually
be confirmed by an
appeals court ruling.

Except for language for a GAAP


departure from the failure to record
a loss and liability.

Disclaimer, if auditors think the


amount that might be awarded
seriously threatens the goingconcern status of the entity.
Adverse opinion, if unrecorded
loss and related disclosures are
pervasive.

Reports on Financial Statements (Internet Exercise)


The students answers will be dependent on the companies that they choose to examine. One thing that we
do is to collect and summarize the students information to get an idea of the relative frequencies of the
different types of opinions/modifications.

12-17

Chapter 12 - Reports on Audited Financial Statements

12.50

Reports on Internal Control Over Financial Reporting (Internet Exercise)


The students answers will be dependent on the companies that they choose to examine. One thing that we
do is to collect and summarize the students information to get an idea of the relative frequencies of the
different types of opinions/modifications.

SOLUTIONS TO REPORT WRITING CASES


12.51

Financial Difficulty: The Going-Concern Problem


a.

Reporting on financial difficulty with an additional explanatory paragraph


Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders
Pitts Company
[Standard introductory paragraph]
[Standard scope paragraph]
In our opinion, the financial statements referred to above present fairly, in all material respects, the
financial position of Pitts Company as of December 31, 2008, and the results of its operations and
its cash flows for the year then ended, in conformity with accounting principles generally accepted
in the United States of America.
As shown in the financial statements, Pitts Company has current liabilities that exceed current
assets by $1 million. Cash balances have been drawn down to $10,000, and the interest on the long
term debt has not been paid. As explained in Note 3 to the financial statements, a customer has
sued for $500,000 on a product liability claim. These factors, along with other matters discussed in
Note 3, indicate substantial doubt that Pitts Company may be able to continue in existence as a
going concern. The financial statements do not include any adjustments relating to these
uncertainties.
[Standard internal control paragraph]
Anderson, Olds & Watershed
February 10, 2009

12-18

Chapter 12 - Reports on Audited Financial Statements


12.51

Financial DifficultyThe Going Concern Problem (Continued)


b.

Reporting on financial difficulty with a disclaimer of opinion.


Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders
Pitts Company
[Standard introductory paragraph]
[Standard scope paragraph]
As shown in the financial statements, Pitts Company has current liabilities that exceed current
assets by $1 million. Cash balances have been drawn down to $10,000, and the interest on the long
term debt has not been paid. As explained in Note 3 to the financial statements, a customer has
sued for $500,000 on a product liability claim. These factors, along with other matters discussed in
Note 3 indicate substantial doubt that Pitts Company may be able to continue in existence. The
financial statements do not include any adjustments relating to these uncertainties.
Because of the possible material effect on the financial statements of the matters discussed in the
preceding paragraph, we cannot and do not express an opinion on the financial statements referred
to above.
[Standard internal control paragraph]
Anderson, Olds & Watershed
February 10, 2009

12.52

Disagreement with Auditors


NOTE TO INSTRUCTOR: The following report assumes that the auditors have decided to resign from the
engagement and that the threatened litigation has impaired AOWs independence. One additional option
for the following report would be including some disclosure of the litigation that has resulted in the
auditors resignation if AOW feels that the failure to disclose this litigation would result in the financial
statements not being in conformity with GAAP.
To the Board of Directors and Stockholders
Richnow Company
We are not independent with respect to Richnow Company, and the accompanying balance sheet as of
December 31, 2008, and the related statements of income, comprehensive income, shareholders equity, and
cash flows for the year then ended were not audited by us and, accordingly, we do not express an opinion on
them.
Anderson, Olds & Watershed
February 10, 2009

12-19

Chapter 12 - Reports on Audited Financial Statements

12.53

Late Appointment of Auditors


NOTE TO INSTRUCTOR: When inventory quantities are determined solely by means of physical count, as
in this case, the auditors ordinarily cannot obtain sufficient appropriate evidence by means of alternative
procedures that do not include making or observing some physical counts of the inventory. Depending upon
the degree of materiality of the amounts involved, the auditors should describe the limitation on the
examination in the scope paragraph (or an explanatory paragraph) and either qualify the opinion or
disclaim an opinion. The following opinion is an example of a qualified opinion.
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders
Musgrave Company
[Standard introductory paragraph]
Except as discussed in the following paragraph, 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 audit provides a reasonable basis for our opinion.
We were unable to perform a physical observation of the inventory carried in the accounts in the amount of
$1,940,000, which is approximately 39% of total assets and approximately 69% of current assets. The
inventory enters into the determination of cost of goods sold and net income to a significant extent.
Musgrave Company determines inventory quantities and, hence, inventory valuations, solely by means of
physical count.
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 inventories described above, the financial
statements referred to above present fairly, in all material respects, the financial position of Musgrave
Company at December 31, 2008 and the results of its operations and cash flows for the year then ended in
conformity with accounting principles generally accepted in the United States of America.
[Standard internal control paragraph]
Anderson, Olds & Watershed
February 10, 2009

12.54

Division of Responsibility
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders
Ferguson Company

12-20

Chapter 12 - Reports on Audited Financial Statements

We have audited the accompanying balance sheets of Ferguson Company and subsidiaries as of December
31, 2008 and 2007 and the related statements of income, comprehensive income, shareholders equity, and
cash flows for each of the years in the two-year period ended December 31, 2008. These financial
statements are the responsibility of Ferguson Companys management. Our responsibility is to express an
opinion on these financial statements based on our audits. We did not examine the financial statements of
certain consolidated subsidiaries, which statements reflect total assets and revenues constituting 29 percent
and 36 percent in 2008 and 31 percent and 41 percent in 2007, respectively, of the related consolidated
totals. These statements were examined by other auditors whose reports have been furnished to us, and our
opinion expressed herein, insofar as it relates to the amounts included for these subsidiaries, is based solely
on the reports of the other auditors.
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 and the reports
of other auditors provide a reasonable basis for our opinion.
In our opinion, based upon our audits and the reports of other auditors, the financial statements referred to
above present fairly, in all material respects, the consolidated financial position of Kingston Company and
subsidiaries at December 31, 2008 and 2007, and the consolidated results of their operations and their cash
flows for each of the years in the two-year period ended December 31, 2008 in conformity with accounting
principles generally accepted in the United States of America.
[Standard internal control paragraph]
Anderson, Olds & Watershed
February 10, 2009
12.55

Other Information in a Financial Review Section of an Annual Report


a.

The financial review section contains statements inconsistent with the audited financial statements.
This case does not address the materiality of the inconsistency.
Calculations:

Operating income

Current
Year

Prior
Year

$ 400,000

$ 360,000

Incremental
Basis
$ 40,000

Extraordinary gain
realization of tax
benefits

100,000

Interest expense

( 81,250)

( 60,000)

( 21,250)

Income taxes

(127,500)

(120,000)

( 7,500)

Net income

$ 291,250

100,000

$ 180,000

Ratio of operating income to interest expense:

12-21

$ 111,250

Chapter 12 - Reports on Audited Financial Statements

$400,000 /
$81,250

$360,000 /
$60,000

$40,000 /
$21,250

Ratio

4.92:1

6:1

1.88:1

Ratio including
Extraordinary gain in
Numerator

6.15:1

6:1

6.59:1

Notice that the officers have managed to find the combination of numbers that produces the
highest (most favorable) ratio in the current year. They compared the ratio of operating income to
interest expense for the previous year to that same ratio on an incremental basis. While the
calculations are correct, a more appropriate comparison would be to compare the current-years
ratio (excluding the extraordinary gain) to that for the prior year.
b.

Explanatory paragraph in auditors report:


The financial review on page xx contains a statement to the effect that, on an incremental basis,
operating income coverage of interest expense increased to a ratio of 6.59 to 1. We believe this
relationship is inconsistent with the audited financial statements. The ratio of operating income
(before extraordinary gains, interest expense and income taxes) to interest expense was 6 to 1 in
the prior year and 4.92 to 1 in the current year. On an incremental basis, operating income
increased $40,000, and interest expense increased $21,250, a ratio of 1.88 to 1. When the
extraordinary gain is included for the current year, the ratio of operating income to interest
expense is 6.15 to 1 in the current year, 6 to 1 in the prior year, and 6.59 to 1 on an incremental
basis.

12.56

Departures from GAAP


a.

Report qualified for GAAP exception.


Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders
Graham Company
[Standard introductory paragraph]
[Standard scope paragraph]
As explained in Note 1 to the financial statements, Graham Company reports its investment in
land at appraisal value, and reports the amount in excess of cost in a stockholder equity account
entitled Current value increment. In our opinion, generally accepted accounting principles do
not permit reporting appraisal values in financial statements that purport to show financial position
and results of operations in conformity with generally accepted accounting principles. If the cost
of the land were reported in the financial statements, total assets would be $400,000 (8%) lower,
and shareholders equity would also be $400,000 (11%) lower.
In our opinion, except for the effects of reporting land at appraisal value as described in the
preceding paragraph, the financial statements referred to above present fairly, in all material
respects, the financial position of Graham Company as of December 31, 2008, and the results of
its operations and its cash flows for the year then ended, in conformity with accounting principles
generally accepted in the United States of America.

12-22

Chapter 12 - Reports on Audited Financial Statements

[Standard internal control paragraph]


Anderson, Olds & Watershed
February 10, 2009
12.56

Departures from GAAP (Continued)


b.

Adverse opinion based on same facts.


Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders
Graham Company
[Standard introductory paragraph]
[Standard scope paragraph]
As explained in Note 1 to the financial statements, Graham Company reports its investment in
land at appraisal value, and reports the amount in excess of cost in a shareholder equity account
entitled Current value increment. In our opinion, generally accepted accounting principles do
not permit reporting appraisal values in financial statements that purport to show financial position
and results of operations in conformity with generally accepted accounting principles. If the cost
of the land were reported in the financial statements, total assets would be $400,000 (8%) lower,
and shareholders equity would also be $400,000 (11%) lower.
In our opinion, because of the effects of the appraisal value reporting described in the preceding
paragraph, the balance sheet and statement of shareholders equity referred to above does not
present fairly the financial position of Graham Company as of December 31, 2008, in conformity
with accounting principles generally accepted in the United States of America.
However, because the reported land appraisal values do not affect the results of operations or cash
flows, in our opinion the statements of income, comprehensive income, and cash flows present
fairly the results of operations and cash flows of Graham Company for the year ended December
31, 2008, in conformity with accounting principles generally accepted in the United States of
America.
[Standard internal control paragraph]

12.56

Anderson, Olds & Watershed


February 10, 2009
Departures from GAAP (Continued)
c.

There are two possibilities. On one hand, if one takes the view that fixed assets (including land)
should not reflect appraisal values, the case could be made that the reporting options in (a) or (b)
are appropriate, depending upon materiality. On the other hand, a report conforming to Rule 203
could be prepared, assuming that the auditors felt that presentation in conformity with GAAP
would create misleading financial statements. Ordinarily, because of the strict prohibitions of
reflecting appraisal values for fixed assets under GAAP, most students would argue that a report
conforming to Rule 203 would not be appropriate in this situation.

12-23

Chapter 12 - Reports on Audited Financial Statements

When discussing this with students, it is interesting to ask students to identify the pros and cons of
the different types of presentations. After all, an individual reading the reports shown in (a), (b),
and (c) (shown below) would have access to exactly the same information with respect to the
valuation of the land; only the auditors opinion (and accompanying language) differs.
If prepared, a report conforming to Rule 203 that could be prepared is shown below.
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders
Graham Company
[Standard introductory paragraph]
[Standard scope paragraph]
As explained in Note 1 to the financial statements, Graham Company reports its investment in
land on which its buildings stand at appraisal value, and reports the amount in excess of cost in a
stockholder equity account entitled Current value increment. The asset total of $5,394,000 and
the shareholders equity of $3,594,000, each reflect the $600,000 appraisal increment reduced by
implicit disposal taxes at the rate of 33 percent; as a result, total assets and total shareholders
equity are $400,000 than if Graham accounted for the land at its historical cost. While Accounting
Principles Board Opinion No. 6 provides that property shall not be written up to reflect appraisal
values in excess of cost, we believe nonrecognition of the significant increase in land value would
omit relevant information from the financial statements and cause the report of total asset and
shareholders equity values to be materially misleading.
In our opinion, the financial statements referred to above present fairly, in all material respects, the
financial position of Graham Company as of December 31, 2008, and the results of its operations
and its cash flows for the year then ended, in conformity with accounting principles generally
accepted in the United States of America.
[Standard internal control paragraph]
Anderson, Olds & Watershed
February 10, 2009
12.57
a.

Reporting on an Accounting Change

Reporting on an accounting change with which the auditors concur.


Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders
Williams Company
[Standard introductory paragraph]
[Standard scope paragraph]
In our opinion, the financial statements referred to above present fairly, in all material respects, the
financial position of Williams Company as of December 31, 2008, and the results of its operations
and its cash flows for the year then ended, in conformity with accounting principles generally
accepted in the United States of America.

12-24

Chapter 12 - Reports on Audited Financial Statements

As described in Note 2 to the financial statements, Williams Company changed its accounting
principles from the last-in first-out method to the first-in first-out method for the year ended
December 31, 2008.
[Standard internal control paragraph]

12.57

Anderson, Olds & Watershed


February 10, 2009
Reporting on an Accounting Change (Continued)
b.

Reporting on an accounting change the auditors think is not justified in accordance with SFAS 154.
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders
Williams Company
[Standard introductory paragraph]
[Standard scope paragraph]
As disclosed in Note 2 to the financial statements, Williams Company has adopted the FIFO
method of accounting for the cost of inventory and goods sold, whereas it previously used the
LIFO method. Although the FIFO method is in conformity with generally accepted accounting
principles, in our opinion Williams Company has not provided reasonable justification, in this
period of rising prices, for making a change as required by Statement of Financial Accounting
Standards No. 154. Inventories that would have been reported at $1.5 million (LIFO) are reported
at $1.9 million (FIFO); operating income before tax that would have been $130,000 is reported at
$530,000. As a result of this change, current assets, total assets, and shareholders equity are
increased by 17, 9, and 14 percent, respectively.
In our opinion, except for the change in accounting principle as stated above, the aforementioned
financial statements present fairly, in all material respects, the financial position of Williams
Company as of December 31, 2008, and the results of its operations and its cash flows for the year
then ended, in conformity with accounting principles generally accepted in the United States of
America.
[Standard internal control paragraph]
Anderson, Olds & Watershed
February 10, 2009

12.58

Mini-Case: Other Auditors


NOTE TO INSTRUCTOR: For this assignment, question 4 from this Mini-Case is applicable.
4.

This issue is a tricky one because the firm is dealing with another accounting firm conducting a
significant part of the audit. However, when large balances make up a significant portion of an
entitys consolidated balance sheet (in this case, 38 percent of Parmalats assets were in the
subsidiarys bank account), auditors should take additional care to obtain additional corroboration.
They certainly should have visited the other auditors offices to examine their documentation.

12-25

Chapter 12 - Reports on Audited Financial Statements

12.59

Kaplan CPA Exam Simulation: Reports on Financial Statements (General Auditors Reports)
A

Specifies that the financial statements are the responsibility of the companys
management.
(This is included in the first, or introductory, paragraph.)

Specifies that the financial statements present accurately in all material respects the
financial position, results of operations, and cash flows.
(Replace the word accurately with fairly and the statement is correctly included in
the third, or opinion, paragraph. This is a subtle but important point to remember.
Accurately suggests absolute precision, which is generally not ascertainable in an
audit for many reasonsfor instance, cost-benefit.)

Specifies that there is a going-concern uncertainty (not disclaiming an opinion).


(An explanatory paragraph is added after the opinion paragraph if substantial doubt
exists as to the companys ability to continue in business for 12 months from the date
of the balance sheet.)

Specifies that the financial statements contain a significant number of related-party


transactions.
(An explanatory paragraph is added to draw attention to a matter of particular
importance that the auditors would like to emphasize to the readers of the financial
statements.)

Specifies that an assessment was made of accounting principles, significant estimates,


and financial statement presentation.
(This is included in the second, or scope, paragraph.)

Specifies that evidence supporting amounts and disclosures has been examined, but
only on a test basis.
(This is included in the second, or scope, paragraph.)

12-26

Chapter 12 - Reports on Audited Financial Statements


12.60

Kaplan CPA Exam Simulation: Reports on Financial Statements (Opinions and Report
Modifications)
A

A consolidated subsidiary of the Ferreira Company was audited by another CPA firm.
Riley & Associates has carried out the necessary procedures and has decided not to
indicate the division of responsibility in its auditors report.
(If the CPA firm chooses not to indicate the division of responsibility with the other
auditors, a standard report can be issued.)

Riley & Associates was not able to observe the physical inventory count because of the
date on which the firm was hired. The inventory is a material amount, but the firm is
not able to gain sufficient, satisfactory evidence by other means.
(The CPA firm was not able to follow generally accepted auditing standards so that the
assurance level must be reduced or eliminated. A scope qualification or a disclaimer
should be issued. Those reports necessitate changes in the scope paragraph and
opinion paragraph along with an added explanatory paragraph prior to the opinion
paragraph.)

Riley & Associates believes that there is substantial doubt that Ferreira Company can
remain a going concern for a period of 12 months from the companys balance sheet
date. Ferreira Company has made appropriate disclosure of this uncertainty in its
financial statements.
(The CPA firm needs to draw attention to this problem although it has no impact on
the auditors opinion. An explanatory paragraph is added at the end of the report
without any change in the wording of the other paragraphs. In extreme cases, the
CPA does have the right to issue a disclaimer of opinion.)

Ferreira Company wants to present the current-year financial statements audited by


Riley & Company along with the financial statements from the prior year that were
audited by a different firm. Ferreira does not want to include the previous auditors
report, although it was unqualified.
(If the previous report is not presented, the current CPA firm must provide
information about that earlier opinion. This information is included at the end of the
introductory paragraph.)

In the current year, Ferreira Company switched from double-declining balance


depreciation to straight-line depreciation. Riley & Associates concurs with this
change although it is viewed to be of a material amount.
(The CPA firm should draw attention to this change although it does not affect the
auditors opinion. An explanatory paragraph is added at the end of the report without
changing the wording of the other paragraphs.)

12-27

Chapter 12 - Reports on Audited Financial Statements


12.60

Kaplan CPA Exam Simulation: Reports on Financial Statements (Opinions and Report
Modifications) (Continued)
C

Riley & Associates discovers that Ferreira Company has not provided adequate
disclosure of required information of a material nature about its employee pension
plan and refuses to do so because of employee confidentiality.
(The financial statements contain a material misstatement so that either a qualified
opinion or an adverse opinion should be rendered. In both cases, an explanatory
paragraph is added and the opinion paragraph is modified.)

A consolidated subsidiary of the Ferreira Company was audited by another CPA firm.
Riley & Associates has carried out the necessary procedures and has decided to
indicate the division of responsibility in its auditors report.
(When the CPA chooses to indicate the division of responsibility for the opinion with
another CPA, all three paragraphs must be modified. However, no explanatory
paragraph need be added.)

A letter from the president of Ferreira Company that is attached to the financial
statements contains information that Riley & Associates believes to be misleading.
(This information is outside of the financial statements, but it is still misleading to the
user of the financial statements. Thus the CPA needs to draw attention to the problem
by adding an extra paragraph at the end of the auditors report although an
unqualified opinion is still expressed.)

12-28

Chapter 12 - Reports on Audited Financial Statements

12.61

Kaplan CPA Exam Simulation: Reports on Financial Statements (Comparative Financial


Statements)

The predecessor auditors must agree


to the inclusion of their report with
the current report.

Required
if Previous
Opinion is
Included
(X)

Required
if Previous
Opinion is
Omitted

The date of the previous report must


be included.
The predecessor auditors should
review the earlier financial
statements to make certain that
nothing has been changed since the
original examination.

(X)

(X)

(X)

The current auditors must refer to the


earlier report.
The predecessor auditors must obtain
an updated representation letter from
management similar to the one that is
required at the end of an audit.

(X)
(X)

The predecessor auditors must


perform analytical procedures
sufficient to ensure that the previous
statements do not require adjustment.
The predecessor auditors must make
certain that the original opinion is
still appropriate.

Not
Required

(X)

An explanation, if the report varied


from a standard report, should be
included in the introductory
paragraph of the report.
The current auditors must issue a
representation letter stating that
nothing has been found to indicate
that the previous statements require
adjustment.

Required in
Both
Situations

(X)

(X)

12-29

Chapter 12 - Reports on Audited Financial Statements

The statements being presented that


were audited by the predecessor
auditors must be identified in the
introductory paragraph of the
successor auditors report.
12.62

(X)

Kaplan CPA Exam Simulation: Reports on Financial Statements (Comparative Financial


Statements)
For comparative purposes, both reports (the
successor auditors and the predecessor auditors
reports) must be included with the financial
statements being released in year 2.

False. Both reports could be presented, but


this is not a requirement. If the previous report
is omitted, the successor auditors must refer to
the previous report in the first paragraph of the
current report.

The predecessor auditors must give permission to the


successor auditors for their previous opinion to be
included in year 2.

True

If in year 2, an audit is being performed and only a


review was performed in year 1, then additional audit
work will have to be performed on year 1 to ensure
that the year 2 financial statements are comparable.

False. Because Kerklaan Enterprises is not a


publicly traded company, a review would be
permissible in the previous year. The current
auditors report would contain a separate
paragraph to indicate the level of assurance
provided on the year 1 financial statements.

The successor auditors are not allowed to change the


opinion issued by the predecessor auditors on the
year 1 financial statements unless permission is
given from the predecessor auditors.

False. If the opinion is changed from that


issued in a prior year, an explanatory
paragraph is added prior to the opinion
paragraph. There is no need to seek
permission from the predecessor
auditors prior to doing so.

When a previous opinion is included along with the


year 2 auditors report (and the predecessor auditors
have granted permission for its inclusion), the
predecessor auditors should, but are not required to,
obtain a representation letter from the successor
auditors stating that nothing has been found to
indicate that the year 1 statements require
adjustment.

False. The predecessor auditors are required


to obtain management representations from
the current auditors indicating that nothing has
been found to indicate that the year 1
statements require adjustment.

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