15-61.

The following are independent audit situations for which you are to recommend an
appropriate audit report. For each situation listed as 1, through 6, below, identify the appropriate
type of audit report from the list below and briefly explain the rationale for selecting the report.

Appropriate type of audit:

a. Unmodified
b. Modified, qualified
c. Modified, disclaimer
d. Modified, adverse

1. An audit client has a significant amount of loans receivable outstanding (40% of assets), but
has an inadequate internal control system over the loans. The auditor cannot locate sufficient
information to prepare an aging of the loans or to identify the collateral for about 75% of the
loans, even though the client states that all loans are collateralized. The auditor sent out
confirmations to verify the existence of the receivables, but only 10 of the 50 sent out were
returned. The auditor attempts to verify the other loans by looking at subsequent payments, but
only eight had remitted payments during the month of January, and the auditor wants to wrap up
the audit by February 15. The auditor estimates that if only 10 of the 50 loans were correctly
recorded, loans would need to be written down by $7.5 million.

Answer:

c. Modified, disclaimer

If the auditor thinks that the loans can be written down by $7.5 million, the decision to do
so is appropriate. If the auditor suspects any fraud, in that case, additional audit work is
required to be performed. If there is insufficient evidence, a disclaimer of opinion should
be issued.

2. During the audit of a large manufacturing company, the auditor did not observe all locations of
physical inventory. The auditor chose a random number of sites to visit, and the company’s
internal auditors visited the other sites. The auditor has confidence in the competence and
objectivity of the internal auditors. The auditor personally observed only about 20% of the total
inventory, but neither the auditor nor the internal auditors noted any exceptions in the inventory
process.

Answer:
a. Unmodified

The appropriate type of audit to be observed for this situation would be an unmodified
opinion considering the fact that the auditor has done a well-developed sampling plan in
order to check the company’s inventory. The auditor also utilized the work of the internal
auditors in order to validate such approach. Moreover, there were no exceptions that were
noted and the amount of work done by both the auditor and the internal auditors support
both the existence of the inventory and the auditor’s claims. Therefore, an unmodified
opinion would be more appropriate in order to show that the company has presented its
inventory in the statement of financial position in accordance with the generally accepted
accounting principles.

3. During the past year, Network Computer, Inc. devoted its entire research and development
efforts to develop and market an enhanced version of its state-of-the-art telecommunications
system. The costs, which were significant, were all capitalized as research and development
costs. The company plans to amortize these capitalized costs over the life of the new product.
The auditor has concluded that the research to date will likely result in a marketable product. A
full description of the research and development, and the costs, is included in a note. The note
also describes that basic research costs are expensed as incurred, and the auditor has verified the
accuracy of the statement.

Answer:

a. Unmodified

The type of audit report appropriate for this situation is an unmodified one. The company
has included and written on its notes the full description of the research and development,
its costs and how the expenses were recorded in accordance to the applicable and
appropriate accounting standard. Adequate disclosures were observed and the auditor has
not claimed some significant doubts by verifying the statements to be accurate. Thus, an
unmodified opinion purporting that Network Computer Inc. has, in all material respects,
presented fairly its statements in conformity with the generally accepted accounting
principles is appropriate.

4. During the course of the audit of Sail-Away Company, the auditor noted that the current ratio
had dropped to 1.75. The company’s loan covenant requires the maintenance of a current ratio of
2.0, or the company’s debt is all immediately due. The auditor and the company have contacted
the bank, which is not willing to waive the loan covenant because the company has been
experiencing operating losses for the past few years and has an inadequate capital structure. The
auditor has substantial doubt that the company can find adequate financing elsewhere and may
encounter difficulties staying in operation. Management, however, is confident that it can
overcome the problem. The company does not deem it necessary to include any additional
disclosure because management members are confident that an alternative source of funds will
be found by pledging their personal assets.

Answer:

c. Modified, disclaimer

The auditor has many substantial doubts about the company's ability to continue as a
going concern. Although management is confident about the occurrence of alternative
sources, doubts still exist. In a note to statements, the management's plans and issues
were not adequately described. It is a GAAP violation, and a qualified opinion must be
given, indicating that the auditor has substantial doubts regarding the client's going
concern and missing disclosures. Furthermore, if the loan is not reclassified as a current
liability, the auditor's report must disclose the GAAP violation.

5. The Wear-Ever Wholesale Company has been very profitable. It recently received notice of a
10% price increase for a significant portion of its inventory. The company believes it is
important to manage its products wisely and has a policy of writing all inventory up to current
replacement cost. This assures that profits will be recognized on sales sufficient to replace the
assets and realize a normal profit. This operating philosophy has been very successful, and all
salespeople reference current cost, not historical cost, in making sales. Only inventory has been
written up to replacement cost, but inventory is material because the company carries a wide
range of products. The company’s policy of writing up the inventory and its dollar effects is
adequately described in a footnote to the financial statements. For the current year, the net effect
of the inventory write-up increased reported income by only 3% and assets by 15% above
historical cost.

Answer:

b. Modified, qualified

The financial statements show the material deviation from GAAP, but it is only for the
single asset account. Its implications could be easily described and identified. Few
students believe that an adverse audit opinion can be issued because of materiality. Many
auditors would issue a qualified opinion because the figures were not convincingly
material.
6. The audit of NewCo was staffed primarily by three new hires and a relatively inexperienced
audit senior. The manager found numerous errors during the conduct of the audit and developed
very long to-do lists for all members of the audit to complete before the audit was concluded.
Although the manager originally doubted the staff’s understanding of the audit procedures, by
the time the audit was finished, he concluded that the new auditors did understand the company
and the audit process and that no material errors existed in the financial statements.

Answer:

a. Unmodified

The type of audit report to be observed in this situation would be an unmodified opinion.
For one, the auditors had integrated a long list of processes developed by the
management into the audit before doing the audit itself. Moreover, the auditors were able
to come to a conclusion that there are no material errors existing in the financial
statements of NewCo. Therefore, an unmodified opinion would be more appropriate in
order to show that NewCo has, in all material aspects, presented its financial statements
in accordance with the generally accepted accounting principles.