Solution manual auditing and services 2e by louwers chap012

Chapter 12 - Reports on Audited Financial Statements CHAPTER 12 Reports on Audited Financial Statements LEARNING OBJECTIVES Review Checkpoints Exercises, Problems, and Simulations Provide an overview of the types of reports that accompany the entity’s financial statements 1, 2 List three general functions of the auditors’ report on an entity’s financial statements 3 Explain the significance of each of the paragraphs in a standard report on an entity’s financial statements 4, 5, 6, 38, 49, 50 Describe the types of auditors’ reports that may be issued if an entity’s financial statements contain a departure from generally accepted accounting principles 8, 40, 44 (partial), 46 (partial), 48 (partial), 56, 57 (partial), 59 (partial), 60 (partial), 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) 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) Identify other circumstances affecting auditors’ reporting responsibilities and explain how they affect auditors’ reports on an entity’s financial statements 19, 20, 21, 22, 23, 24 41, 44 (partial), 45, 52, 55, 60 (partial), 61, 62 12-1 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 entity’s financial statement and other disclosures and (2) the effectiveness of the entity’s internal control over financial reporting These can be presented as two separate reports or a combined report 12.2 Management’s 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 entity’s internal control  Management’s opinion on the effectiveness of the entity’s 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 entity’s 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: Title The title should contain the word independent, as in “Independent Registered Public Accounting Firm” or “Independent Auditors” Address The report shall be addressed to the client, which occasionally may be different from the auditee Notice of Audit A sentence should identify the financial statements and indicate that they were audited This appears in the introductory paragraph Responsibilities The report should state management’s responsibility for the financial statements and the auditors’ responsibility for the report These statements are also in the introductory paragraph 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 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 12-2 Chapter 12 - Reports on Audited Financial Statements 12.4 12.5 (Continued) Internal Control The report should reference the auditors’ examination, report, and opinion on the client’s internal control over financial reporting Signature The auditors (partner of the audit team) shall sign the report, manually or otherwise 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: 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 (for public entities) and SAS 58 (for nonpublic entities) include: The AS report is titled “Report of Independent Registered Public Accounting Firm” while the SAS 58 report is titled “Report of Independent Auditors” The AS report references “standards established by the PCAOB (United States)” while the SAS 58 report references “auditing standards generally accepted in the United States” The SAS 58 report does not contain a reference to the auditors’ examination and report on the effectiveness of the client’s 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: The financial statements contain a departure from GAAP Matters (scope limitations) affect the ability of auditors to conduct an audit in accordance with GAAS The auditors wish to reference other matters affecting the audit or the client 12-3 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 management’s refusal to let auditors perform auditing procedures while a circumstance-imposed scope limitation occurs when circumstances beyond the auditors’ or client’s 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 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 12-4 Chapter 12 - Reports on Audited Financial Statements 12.13 The following situations cause auditors to modify their reports to identify inconsistent applications of GAAP: 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 entity’s 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 entity’s 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 entity’s 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 12-5 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 entity’s 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 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 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 If prior-years’ unaudited financial statements are presented, the disclaimer should cover them as well as the current-year statements 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) 12-6 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 Management’s presentation of supplemental information indicates the auditors performed review procedures without also indicating the auditors 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 12-7 Chapter 12 - Reports on Audited Financial Statements 12.29 a b Incorrect Incorrect c Incorrect d Correct Changes in estimates not require a consistency paragraph Error corrections not involving a change in principle not require a consistency paragraph Changes in the consolidated entity by reason of sale of a subsidiary 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 12-8 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 entity’s financial statements The report on the entity’s 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) Title The report needs a title referring to Ross as the Independent Registered Public Accounting Firm 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 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 Responsibilities The introductory paragraph does not address the auditors’ responsibility for issuing an opinion on the financial statements 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 client’s] instructions” and that a “complete audit” was conducted, both of which are inappropriate 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) Opinion The opinion paragraph should not be modified with the phrase “with the explanation given above.” 12-9 Chapter 12 - Reports on Audited Financial Statements 12.39 Opinion The opinion paragraph should not mention “minor errors we consider immaterial,” but it should contain the phrase “presents fairly in all material respects.” 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 Corporation’s 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 Corporation’s 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 An accounting change involving a change from one generally accepted accounting principle to another generally accepted accounting principle Yes An accounting change involving a change in an accounting estimate No An error correction not involving an accounting principle No An accounting change involving a correction of an error in principle which is accounted for as a correction of an error Yes An accounting change involving a change in the reporting entity which is a special type of change in accounting principle Yes 12-10 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 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 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 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 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 Difficulty–The “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 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 indicate substantial doubt that Pitts Company may be able to continue in existence The financial statements 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 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 AOW’s 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 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 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 Company’s 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-year’s 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 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 to in the prior year and 4.92 to 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 When the extraordinary gain is included for the current year, the ratio of operating income to interest expense is 6.15 to in the current year, to in the prior year, and 6.59 to 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 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 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 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 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 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 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 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 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 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 from this Mini-Case is applicable 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 entity’s consolidated balance sheet (in this case, 38 percent of Parmalat’s assets were in the subsidiary’s 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 company’s management (This is included in the first, or introductory, paragraph.) F 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 reasons—for instance, cost-benefit.) E 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 company’s ability to continue in business for 12 months from the date of the balance sheet.) E 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.) B Specifies that an assessment was made of accounting principles, significant estimates, and financial statement presentation (This is included in the second, or scope, paragraph.) B 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.) D 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.) B Riley & Associates believes that there is substantial doubt that Ferreira Company can remain a going concern for a period of 12 months from the company’s 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.) F 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.) B 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 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.) E 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.) B 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 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 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 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 to ensure that the year 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 financial statements The successor auditors are not allowed to change the opinion issued by the predecessor auditors on the year 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 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 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 statements require adjustment 12-30 ... 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,... 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... Independent Auditors” The AS report references “standards established by the PCAOB (United States)” while the SAS 58 report references auditing standards generally accepted in the United States”