Exam (elaborations) MSA 103 audit report graded A+

Audit Reports 1) Explain why auditors’ reports are important to users of financial statements and why it is desirable to have standard wording. : Auditor's reports are important to users of financial statements because they inform users of the auditor's opinion as to whether or not the statements are fairly stated or whether no conclusion can be made with regard to the fairness of their presentation. Users especially look for any deviation from the wording of the standard unqualified report and the reasons and implications of such deviations. Having standard wording improves communications for the benefit of users of the auditor’s report. When there are departures from the standard wording, users are more likely to recognize and consider situations requiring a modification or qualification to the auditor’s report or opinion. 2) List the seven parts of a standard unqualified audit report and explain the meaning of each part. How do the parts compare with those found in qualified report? : The unqualified audit report consists of: 1. Report title Auditing standards require that the report be titled and that the title includes the word independent. 2. Audit report address The report is usually addressed to the company, its stockholders, or the board of directors. 3. Introductory paragraph The first paragraph of the report does three things: first, it makes the simple statement that the CPA firm has done an audit. Second, it lists the financial statements that were audited, including the balance sheet dates and the accounting periods for the income statement and statement of cash flows. Third, it states that the statements are the responsibility of management and that the auditor's responsibility is to express an opinion on the statements based on an audit. 4. Scope paragraph. The scope paragraph is a factual statement about what the auditor did in the audit. The remainder briefly describes important aspects of an audit. 5. Opinion paragraph. The final paragraph in the standard report states the auditor's conclusions based on the results of the audit. 6. Name of CPA firm. The name identifies the CPA firm or practitioner who performed the audit. 7. Audit report date. The appropriate date for the report is the one on which the auditor has completed the most important auditing procedures in the field. The same seven parts are found in a qualified report as in an unqualified report. There are also often one or more additional paragraphs explaining reasons for the qualifications. 3) What are the purposes of the scope paragraph in the auditor’s report? Identify the most important information included in the scope paragraph. : The purposes of the scope paragraph in the auditor's report are to inform the financial statement users that the audit was conducted in accordance with generally accepted auditing standards, in general terms what those standards mean, and whether the audit provides a reasonable basis for an opinion. The information in the scope paragraph includes: 1. The auditor followed generally accepted auditing standards. 2. The audit is designed to obtain reasonable assurance about whether the statements are free of material misstatement. 3. Discussion of the audit evidence accumulated. 4. Statement that the auditor believes the evidence accumulated was appropriate for the circumstances to express the opinion presented. 4) What are the purposes of the opinion paragraph in the auditor’s report? Identify the most important information included in the opinion paragraph. : The purpose of the opinion paragraph is to state the auditor's conclusions based upon the results of the audit evidence. The most important information in the opinion paragraph includes: 1. The words "in our opinion" which indicate that the conclusions are based on professional judgment. 2. A restatement of the financial statements that have been audited and the dates thereof or a reference to the introductory paragraph. 3. A statement about whether the financial statements were presented fairly and in accordance with generally accepted accounting principles. 5) On February 17, 2006, a CPA completed the field work on the financial statements for the Buckheizer Technology Corporation for the year ended December 31, 2005. The audit in satisfactory in all respects except for the existence of a change in accounting principle from FIFO to LIFO inventory valuation., which results in an explanatory paragraph to consistency. On February 26, the auditor completed the tax return and the draft of the financial statements. The final audit report was completed, attached to the financial statements, and delivered to the client on March 7. What is the appropriate date on the auditor’s report? : The auditor's report should be dated February 17, 2006, the date on which the auditor completed the most important auditing procedures in the field. 6) What five circumstances are required for a standard unqualified report to be issued? : An unqualified report may be issued under the following five circumstances: 1. All statements—balance sheet, income statement, statement of retained earnings, and statement of cash flows—are included in the financial statements. 2. The three general standards have been followed in all respects on the engagement. 3. Sufficient evidence has been accumulated and the auditor has conducted the engagement in a manner that enables him or her to conclude that the three standards of field work have been met. 4. The financial statements are presented in accordance with generally accepted accounting principles. This also means that adequate disclosures have been included in the footnotes and other parts of the financial statements. 5. There are no circumstances requiring the addition of an explanatory paragraph or modification of the wording of the report. 7) Describe the additional information included in the introductory, scope, and opinion paragraphs in a combined audit report on financial statements and the effectiveness of internal control over financial reporting. What is the nature of the additional paragraphs in the audit report? : The introductory, scope and opinion paragraphs are modified to include reference to management’s report on internal control over financial reporting, and the scope of the auditor’s work and opinion on internal control over financial reporting. The introductory and opinion paragraphs also refer to the framework used to evaluate internal control. Two additional paragraphs are added between the scope and opinion paragraphs that define internal control and describe the inherent limitations of internal control. 8) What type of opinion should an auditor issue when the financial statements are not in accordance with GAAP because such adherence would result in misleading statements? : When adherence to generally accepted accounting principles would result in misleading financial statements there should be a complete explanation in a separate paragraph. The separate paragraph should fully explain the departure and the reason why generally accepted accounting principles would have resulted in misleading statements. The opinion should be unqualified, but it should refer to the separate paragraph during the portion of the opinion in which generally accepted accounting principles are mentioned. 9) Distinguish between an unqualified report with explanatory paragraph or modified wording and a qualified report. Give examples when an explanatory paragraph or modified wording should be used in an unqualified opinion. : An unqualified report with an explanatory paragraph or modified wording is the same as a standard unqualified report except that the auditor believes it is necessary to provide additional information about the audit or the financial statements. For a qualified report, either there is a scope limitation (condition 1) or a failure to follow generally accepted accounting principles (condition 2). Under either condition, the auditor concludes that the overall financial statements are fairly presented. Two examples of an unqualified report with an explanatory paragraph or modified wording are: 1. The entity changed from one generally accepted accounting principle to another generally accepted accounting principle. 2. A shared report involving the use of other auditors. 10) Describe what is meant by a reports involving the use of other auditors. What are the three options available to the principal auditor and when should each be used? : When another CPA has performed part of the audit, the primary auditor issues one of the following types of reports based on the circumstances. 1. No reference is made to the other auditor. This will occur if the other auditor audited an immaterial portion of the statement, the other auditor is known or closely supervised, or if the principal auditor has thoroughly reviewed the other auditor's work. 2. Issue a shared opinion in which reference is made to the other auditor. This type of report is issued when it is impractical to review the work of the other auditor or when a portion of the financial statements audited by the other CPA is material in relation to the total. 3. The report may be qualified if the principal auditor is not willing to assume any responsibility for the work of the other auditor. A disclaimer may be issued if the segment audited by the other CPA is highly material. 11) The client has restated the prior-year statements because of a change from LIFO to FIFO. How should be this reflected in the auditor’s report? : Even though the prior year statements have been restated to enhance comparability, a separate explanatory paragraph is required to explain the change in generally accepted accounting principles in the first year in which the change took place. 12) Distinguish between changes that affect consistency and those that may affect comparability but not consistency. Give an example of each. : Changes that affect the consistency of the financial statements may involve any of the following: a. Change in accounting principle b. Change in reporting entity c. Corrections of errors involving accounting principles. An example of a change that affects consistency would be a change in the method of computing depreciation from straight line to an accelerated method. A separate explanatory paragraph is required if the amounts are material. Comparability refers to items such as changes in estimates, presentation, and events rather than changes in accounting principles. For example, a change in the estimated life of a depreciable asset will affect the comparability of the statements. In that case, no explanatory paragraph for lack of consistency is needed, but the information may require disclosure in the statements. 13) List the three conditions that require a departure from unqualified opinion and give one specific example of each those conditions. : The three conditions requiring a departure from an unqualified opinion are: 1. The scope of the audit has been restricted. One example is when the client will not permit the auditor to confirm material receivables. Another example is when the engagement is not agreed upon until after the client's year-end when it may be impossible to physically observe inventories. 2. The financial statements have not been prepared in accordance with generally accepted accounting principles. An example is when the client insists upon using replacement costs for fixed assets. 3. The auditor is not independent. An example is when the auditor owns stock in the client's business. 14) Distinguish between a qualified opinion, adverse opinion, and a disclaimer of opinion, and explain the circumstances under which each is appropriate. : A qualified opinion states that there has been either a limitation on the scope of the audit or a departure from GAAP in the financial statements, but that the auditor believes that the overall financial statements are fairly presented. This type of opinion may not be used if the auditor believes the exceptions being reported upon are extremely material, in which case a disclaimer or adverse opinion would be used. An adverse opinion states that the auditor believes the overall financial statements are so materially misstated or misleading that they do not present fairly in accordance with GAAP the financial position, results of operations, or cash flows. A disclaimer of opinion states that the auditor has been unable to satisfy him or herself as to whether or not the overall financial statements are fairly presented because of a significant limitation of the scope of the audit, or a non-independent relationship under the Code of Professional Conduct between the auditor and the client. Examples of situations that are appropriate for each type of opinion are as follows: OPINION TYPE EXAMPLE SITUATION Disclaimer Material physical inventories not observed and the inventory cannot be verified through other procedures. Lack of independence by the auditor. Adverse A highly material departure from GAAP. Qualified Inability to confirm the existence of an asset which is material but not extremely material in value. 15) Define materiality as it is used in audit reporting. What conditions will affect the auditor’s determination of materiality? : The common definition of materiality as it applies to accounting and, therefore, to audit reporting is: A misstatement in the financial statements can be considered material if knowledge of the misstatement would affect a decision of a reasonable user of the statements. Conditions that affect the auditor's determination of materiality include:  Potential users of the financial statements  Dollar amounts of the following items: net income before taxes, total assets, current assets, current liabilities, and owners' equity Nature of the potential misstatements—certain misstatements, such as fraud, are likely to be more important to users of the financial statements than other misstatements. 16) Explain how materiality differs for failure to follow GAAP and for lack of independence. : Materiality for lack of independence in audit reporting is easiest to define. If the auditor lacks independence as defined by the Code of Professional Conduct, it is always considered highly material and therefore a disclaimer of opinion is always necessary. That is, either the CPA is independent or not independent. For failure to follow GAAP, there are three levels of materiality: immaterial, material, and highly material. 17) How does the auditor’s opinion differ between scope limitations caused by client restrictions and limitations resulting from conditions beyond the client’s control? Under which of these two would the auditor be most likely to issue a disclaimer of opinion? Explain. : The auditor's opinion may be qualified by scope limitations caused by client restrictions or by limitations resulting from conditions beyond the client's control. The former occurs when the client will not, for example, permit the auditor to confirm material receivables or physically observe inventories. The latter may occur when the engagement is not agreed upon until after the client's year-end when it may not be possible to physically observe inventories or confirm receivables. A disclaimer of opinion is issued if the scope limitation is so material that the auditor cannot determine if the overall financial statements are fairly presented. If the scope limitation is caused by the client's restriction the auditor should be aware that the reason for the restriction might be to deceive the auditor. For this reason, a disclaimer is more likely for client restrictions than for conditions beyond anyone's control. When there is a scope restriction that results in the failure to verify material, but not pervasive accounts, a qualified opinion may be issued. This is more likely when the scope limitation is for conditions beyond the client's control than for