CHAPTER 18

Reports on Audited Financial Statements

Section 1: The auditor’s standard unqualified audit report for a public
company.

Section 2: Explanatory Language Added to the Standard Unqualified/

Unmodified Financial Statement Audit Report.

Section 3: Departures from an Unqualified/Unmodified Financial

Statement Audit Report.(Brief explanation)

Section 4: Types of Financial Statement Audit Reports.

Section 5: Discussion of Conditions Requiring Other Types of

Financial Statement Audit Reports.(Detailed explanation)
 Reference page :598
Section 1: The Standard Unqualified/Unmodified Audit Report

The Standard Unqualified Audit Report for Public Companies

The auditor’s standard unqualified audit report for a public company.

This report contains eight elements:
(1) the report title,
(2) the addressee,
(3) the introductory paragraph,
(4) the scope paragraph,
(5) the opinion paragraph,
(6) an explanatory paragraph referring to the audit of internal control over
financial reporting,
(7) the name of the auditor,
(8) the audit report date.
Section 2: Explanatory Language Added to the Standard
Unqualified/Unmodified Financial Statement Audit Report

• Sometimes circumstances arise that require the auditor to

add explanatory language to the standard unqualified report.

• This is accomplished either by adding explanatory language

to the existing paragraphs of the report (referred to as
“modified wording”) or

• by inserting an additional explanatory paragraph, depending

on the circumstances.
 Circumstances Requiring a modified wording (without
adding an additional paragraph):

Modified Wording for Opinion Based in Part on the Report

of Another Auditor:

• Auditor’s opinion is based in part on the report of another auditor.

• Parts of the audit may be completed by a separate, unaffiliated public

accounting firm.

• For example, one of the entity’s subsidiaries might be located in a foreign

country where the auditor of the parent company does not have a strong
presence and thus may request that another firm audit these subsidiaries.

• The auditor for the parent company must be satisfied that he or she is the
“principal auditor.”
 Circumstances Requiring a modified wording (without
adding an additional paragraph):

• The principal auditor at this point must decide whether or not to refer to
the other auditors in the report.

• The principal auditor first assesses the professional reputation and

independence of the other auditors.

• If the principal auditor does not refer to the other auditors, he accepts full
responsibility for the work done and conclusions drawn by the other
auditors.

• In most situations where the subsidiary represents a material amount in the

consolidated financial statements, the principal auditor refers to the other
auditors(sharing responsibility for the audit report with the other auditors).
Circumstances Requiring a modified wording (without
adding an additional paragraph):
Circumstances Requiring Explanatory Language in an
Additional Paragraph

There are four situations that require the auditor to add an explanatory
paragraph to a standard unqualified report on an entity’s financial
statements. They are as follows:
1. Reference to the report on the audit of internal control for public
companies.
2. Substantial doubt about an entity’s ability to continue as a going concern.
3. Lack of consistency in the application of accounting principles due to
accounting changes.
4. The need for additional emphasis.

• PCAOB standards refer to all such paragraphs simply as “explanatory

paragraphs“
• ASB’s standards, which apply to audits of all entities except for public
companies, refer to explanatory paragraphs as either “emphasis-of-
matter” or “other-matter” paragraphs.
Circumstances Requiring Explanatory Language in an
Additional Paragraph

1.Reference to the report on the audit of internal control for public

companies.

Explained in chapter 1:
• The auditor will express an opinion about the effectiveness of internal
control

• This is called an integrated audit (of financial statements and of

internal control)
Circumstances Requiring Explanatory Language in an
Additional Paragraph

2. Substantial doubt about an entity’s ability to continue as a going

concern.

• A basic assumption that underlies financial reporting is that an entity will

continue as a going concern.

• When the auditor concludes that there is substantial doubt about an entity’s
ability to continue as a going concern, the auditor should consider the
possible effects on the financial statements and the related disclosures.
Circumstances Requiring Explanatory Language in an
Additional Paragraph

2. Substantial doubt about an entity’s ability to continue as a going

concern.
• 3 situations(reports) are present here:

1. If management has adequately disclosed the entity’s financial problems,

the audit report typically will express an unqualified opinion but will
include an emphasis-of-matter paragraph (see Exhibit 18–4)

2. If the entity’s disclosures with respect to its ability to continue as a going

concern are inadequate, a departure from GAAP exists, resulting in a
qualified or an adverse opinion (discussed later in this chapter).

• In rare cases of extreme and immediate financial distress (e.g., impending

bankruptcy), the auditor may disclaim an opinion on the entity.
Circumstances Requiring Explanatory Language in an
Additional Paragraph

3. Lack of consistency in the application of accounting pronciples

due to accounting changes.

Changes Affecting Comparability and Consistency

• If an entity makes a change in an accounting principle or in the
method of its application that materially affects the comparability
and the consistency of the financial statements, the auditor must
decide whether she or he concurs with the change.

• If the auditor concurs, she or he will issue an unqualified opinion

but would add a discussion of the change in an explanatory or
emphasis-of-matter paragraph to highlight the lack of consistency
changes as affecting both comparability and consistency and
requiring an explanatory or emphasis-of-matter paragraph.
Changes Affecting Comparability and Consistency

1.Change in accounting principle. An example is a change from

straight-line depreciation to an accelerated method for depreciating
equipment.(GAAP to GAAP)

2.Change in reporting entity. An example is the consolidation of a

major subsidiary’s financial statements with the parent company’s
financial statements in the previous year and accounting for the
subsidiary on a cost or equity basis in the current year.

3.Correction of a misstatement in previously issued financial

statements. This includes two situations: first, a change in the use of
an accounting principle in prior years (for example, replacement cost
for inventory) to an acceptable accounting principle (such as FIFO)
in the current year and, second, adjustments to correct a material
misstatement in previously issued financial statements. (non-GAAP
to GAAP)
• The auditor will add an explanatory paragraph
if:

1. The amount is material (if not, the auditor

will issue a standard unqualified/ unmodified
audit report

2. The auditor is concurring with the change

and the company has adequately disclosed the
matter.
Changes Affecting Comparability but Not Consistency

Other changes may affect comparability but not consistency in the use
of accounting principles and do not require the inclusion of an
explanatory paragraph. These include:

1.Change in accounting estimate. A change in an accounting estimate,

such as reducing the expected service life of a garbage truck from 7 to
5 years, can affect the comparability of financial statements with no
change in accounting principles.

2.Change in classification and reclassification. A change in

classification but not in accounting principle occurs when a balance is
classified differently from one period to the next, such as when an
item that was included in operating expenses last year is included in
administrative expenses in the current year.
Summary of reports issued in case of Lack of consistency in the application
of accounting principles due to accounting changes:

1. Changes affecting consistency and comparability:

A. If material and the auditor is concurring with the change and
adequately disclosed:  unqualified + Explanatory Paragraph

B. If material and the auditor is not concurring with the change or not
adequately disclosed:  Qualified or Adverse

C. If not material : Standard Unqualified

2. Changes Affecting Comparability but Not Consistency:  Standard

Unqualified
Circumstances Requiring Explanatory Language in an
Additional Paragraph

4. The need for additional emphasis

• Auditor may want to emphasize a specific matter regarding the financial

statements even though he or she intends to express an unqualified or
unmodified opinion.

• Two examples of situations that might cause the auditor to add

explanatory paragraph in an emphasis-of-matter paragraph are:

1. Significant related-party transactions that are appropriately disclosed

by the entity(if not disclosed  Qualified or Adverse)

2. Important events occurring after the balance sheet date

Section 3: Departures from an Unqualified/Unmodified
Financial Statement Audit Report

To this point we have been discussing the unqualified audit report, with
or without additional modified wording or explanatory paragraphs. Let’s
now take a look at the circumstances in which an audit report might
depart from an unqualified opinion. An auditor may be unable to express
such an opinion in three situations:
Departures from an Unqualified/Unmodified Financial
Statement Audit Report

1.Scope limitation. A scope limitation results from an inability to

collect sufficient appropriate evidence, such as when management or
some set of circumstances prevents the auditor from conducting an
audit procedure that the auditor considers necessary.
2.Departure from GAAP. A departure from GAAP exists when the
financial statements are prepared or presented in a manner that
conflicts with GAAP, whether due to error or fraud.
3.Lack of independence of the auditor. A lack of independence arises
when the auditor and the entity have any financial, business, or
personal relationship prohibited by professional standards.
Section 4: Types of Financial Statement Audit Reports:

• Unqualified Report :
Clean opinion and financial statements are fair.

• Qualified Report:
The auditor qualifies his or her opinion when either a scope limitation or
a specific departure from GAAP exists, but overall the financial
statements present fairly in conformity with GAAP. If the auditor decides
to qualify a report for a scope limitation, the report describes why the
limitation arose and indicates that the financial statements present fairly
except for the possible effects of the limitation.
If the auditor qualifies a report for a GAAP departure, the report
describes the nature and impact of the faulty accounting and indicates
that the financial statements present fairly except for the effects of the
departure. Note that a qualified report always uses the words “except
for.”
Types of Financial Statement Audit Reports:

• Disclaimer Report :
The auditor disclaims an opinion on the financial statements either
because there is insufficient appropriate evidence to form an opinion
on the overall financial statements or because there is a lack of
independence. In a disclaimer the auditor explains the reasons for
withholding an opinion and explicitly indicates that no opinion is
expressed.

• Adverse Report:
The auditor issues an adverse opinion when the financial statements do
not present fairly due to a GAAP departure that materially affects the
financial statements overall. In an adverse report the auditor explains the
nature and size of the misstatement and states the opinion that the
financial statements do not present fairly in accordance with GAAP.
The Effect of Materiality on Financial Statement Reporting

The concept of materiality plays a major role in the auditor’s choice of

audit reports. If the departure is judged by the auditor to be immaterial, a
standard unqualified report can be issued. As the materiality of the
condition increases, the auditor must judge the effect of the item on the
financial statements overall.
The choice of audit report depends on both the nature and the
materiality of the condition giving rise to the departure from the
unqualified report.
Section 4: Discussion of Conditions Requiring Other Types
of Financial Statement Audit Reports

A scope limitation results from an inability to obtain sufficient

appropriate evidence about some component of the financial statements.
This occurs because the auditor is unable to apply all the audit
procedures considered necessary either because of restrictions on the
scope of the audit imposed by the client or by the circumstances of the
engagement.
Auditors should be particularly cautious when a client restricts the scope
of the engagement, because in such a situation the client may be trying to
prevent the auditor from discovering material misstatements.
Discussion of Conditions Requiring Other Types of Financial
Statement Audit Reports

Auditing standards suggest that when restrictions imposed by the client

significantly limit the scope of the engagement, the auditor should
consider disclaiming an opinion on the financial statements. However,
some scope limitations arise due to reasons beyond the control of the
client, such as a fire that destroys accounting records.
If the auditor can overcome such a scope limitation by acquiring
sufficient, appropriate evidence about the area in question through
alternative procedures, a standard unqualified/unmodified audit report can
be issued. A number of these types of situations can occur on audit
engagements.
Discussion of Conditions Requiring Other Types of Financial
Statement Audit Reports

For example, circumstances may prevent the auditor from observing the period-end
physical inventory count. This could be the case if the auditor is not engaged to
conduct the audit until after the end of the period. If such deficiencies in audit
evidence cannot be overcome by employing other auditing procedures, the auditor
will have to issue a qualified opinion or a disclaimer, depending on the materiality
of the inventory account. Exhibit 18–5 shows an example of a
disclaimer of opinion due to a scope limitation. Note that in both examples the
paragraph that explains the scope limitation is presented before the opinion or
disclaimer paragraph. As illustrated in Figure 18–1, the reporting options for a
scope limitation are to qualify the opinion or to disclaim an opinion, depending on
the materiality of the limitation.
Discussion of Conditions Requiring Other Types of Financial
Statement Audit Reports

STATEMENTS NOT IN CONFORMITY WITH GAAP:

If the financial statements are materially affected by a departure from

GAAP, the auditor should express a qualified or adverse opinion,
depending on the pervasiveness of the misstatement.
Examples of these types of departures include the use of an accounting principle that is not
acceptable, inadequate disclosure, or an unjustified change in accounting principle.
When the financial statements include the use of an accounting
principle that is not acceptable, the auditor should issue a qualified or
adverse opinion, depending on materiality.
When the auditor expresses a qualified opinion, a separate paragraph
is added to the report before the opinion paragraph. The paragraph
discloses the effects of the departure on the financial statements. Note
that whenever a qualified opinion is issued, the opinion paragraph will
include the words “except for.”
Discussion of Conditions Requiring Other Types of Financial
Statement Audit Reports

STATEMENTS NOT IN CONFORMITY WITH GAAP:

Exhibit 18–7 is an example of a report that is qualified because of the

use of an accounting principle that is not in accordance with GAAP.
Discussion of Conditions Requiring Other Types of Financial
Statement Audit Reports

STATEMENTS NOT IN CONFORMITY WITH GAAP:

If the departure’s effect is so pervasive that the financial statements taken

as a whole do not fairly present the entity’s financial position, results of
operations, and cash flows in accordance with GAAP, the auditor should
issue an adverse opinion. When an adverse opinion is issued, the auditor
should add a paragraph just before the opinion paragraph discussing the
reasons for the adverse opinion and the effects of the departure on the
financial statements. The opinion paragraph is modified to state that the
financial statements do not present fairly in conformity with GAAP.
Exhibit 18–8 is an example of an adverse report.
Discussion of Conditions Requiring Other Types of Financial
Statement Audit Reports

If an entity fails to disclose information in the financial statements or

footnotes as required by GAAP (e.g., significant related-party
transactions), the auditor should issue a qualified or adverse report,
depending on the materiality of the omission. The auditor should provide
the omitted information in the report, if practicable, unless the auditor is
specifically not required by auditing standards to do so.

For example, one situation in which the auditor would modify the opinion but would
not have to provide the missing information is where the client has declined to
include a statement of cash flows. Auditing standards do not require that the auditor
prepare a statement of cash flows when one has been omitted by the client.
Discussion of Conditions Requiring Other Types of Financial
Statement Audit Reports

Much of the value that users of financial statements place on the auditor’s
report is based on the assumption of an unbiased relationship between
the auditor and the entity . It is extremely unlikely that an auditor would
knowingly agree to audit an entity’s financial statements where
independence between the two parties did not exist
LO 18-1, 18-2, 18-3, 18-22 For each of the following independent situations, indicate the type of financial 18-4,
18-8 statement audit report that you would issue and briefly explain your reasoning. Assume that all companies
mentioned are private companies and that each item is at least material.
a. Barefield Corporation, a wholly owned subsidiary of Sandy, Inc., is audited by another CPA firm. As the
auditor of Sandy, Inc., you have assured yourself of the other CPA firm’s independence and professional
reputation. However, you are unwilling to take complete responsibility for its audit work.
b. The management of Bonner Corporation has decided to exclude the statement of
cash flows from its financial statements because it believes that its bankers do not find the statement to be very
useful.
c. You are auditing Diverse Carbon, a manufacturer of nerve gas for the military, for the year ended September
30. On September 1, one of its manufacturing plants caught fire, releasing nerve gas into the surrounding area.
Two thousand people were killed and numerous others paralyzed. The company’s legal counsel indicates that the
company is liable and that the amount of the liability can be
622 Part 6 Completing the Audit and Reporting Responsibilities
reasonably estimated, but the company refuses to disclose this information in the financial statements.
d. During your audit of Cuccia Coal Company, the controller, Tracy Tricks, refuses to allow you to confirm
accounts receivable because she is concerned about complaints from her customers. You are unable to satisfy
yourself about accounts receivable by other audit procedures and you are concerned about Tracy’s true motives.
e. On January 31, Asare Toy Manufacturing hired your firm to audit the company’s financial statements for the
prior year. You were unable to observe the client’s inventory on December 31. However, you were able to satisfy
yourself about the inventory balance using other auditing procedures.
f. Gelato Bros., Inc., leases its manufacturing facility from a partnership controlled
by the chief executive officer and major shareholder of Gelato. Your review of the lease indicates that the rental
terms are in excess of rental terms for similar buildings in the area. The company refuses to disclose this related-
party transaction in the footnotes.
g. Johnstone Manufacturing Company has used the double-declining balance method to depreciate its
machinery. During the current year, management switched to the straight-line method because it felt that it better
represented the utilization of the assets. You concur with its decision. All information is adequately disclosed in
the financial statements.
 LO 18-1, 18-2, 18-3, 18-23 For each of the following independent situations, indicate the reason for and the type
18-4, 18-8 of financial statement audit report that you would issue. Assume that all companies mentioned are private
companies and that each item is at least material.
a. Thibodeau Mines, Inc., uses LIFO for valuing inventories held in the United
States and FIFO for inventories produced and held in its foreign operations.
b. Walker Computers is suing your client, Super Software, for royalties over patent
infringement. Super Software’s outside legal counsel assures you that Walker’s case is completely without merit.
c. In previous years, your client, Merc International, has consolidated its Panama-
nian subsidiary. Because of restrictions on repatriation of earnings placed on all foreign-owned corporations in Panama,
Merc International has decided to account for the subsidiary on the equity basis in the current year. You concur with the
change.
d. In prior years, Worcester Wool Mills has used current market prices to value its
inventory of raw wool. During the current year, Worcester changed to FIFO for valuing raw wool.
e. Upon review of the recent history of the lives of its specialized automobiles, Gas
Leak Technology justifiably changed the service lives for depreciation purposes on its autos from five years to three
years. This change resulted in a material amount of additional depreciation expense.
f. During the audit of Brannon Bakery Equipment, you found that a material amount of inventory had been excluded
from the company’s financial statements. After discussing this problem with management, you become convinced that it
was an unintentional oversight. Management appropriately corrected the error prior to your finalization of field work.
g. Jay Rich, CPA, holds 10 percent of the stock in Rothenburg Construction Com-
pany. The board of directors of Rothenburg asks Rich to conduct its audit. Rich completes the audit and determines that
the financial statements present fairly in accordance with generally accepted accounting principles.
h. Ramamoorthi Savings and Loan’s financial condition has been deteriorating for the last five years. Most of its
problems result from loans made to real estate developers in Saint Johns County. Your review of the loan portfolio
indicates that there should be a major increase in the loan-loss reserve. Based on your calculations,
Chapter 18 Reports on Audited Financial Statements 623
the proposed writedown of the loans will put Ramamoorthi into violation of the state’s capital requirements. The client
refuses to make the adjustment or to disclose the possible going concern issue in the notes to the financial statements.