ACCT 4240: Auditing

1
ACCT 4240 Auditing
Audit Reports Other Than Unqualified
2
Three Conditions Requiring a Departure from an
Unqualified Audit Report

• The scope of the audit has been restricted.
  (Auditor has not accumulated sufficient evidence
  to conclude whether financial statements are
  stated in accordance with GAAP.)
• Restrictions imposed by the client, for example
• Unable to observe inventories.
• Unable to confirm material receivables.

3
Three Conditions Requiring a Departure from an
Unqualified Audit Report

• Circumstances beyond either the clients or the
  auditors control
• Unable to observe inventories.
• Unable to confirm material receivables.
• The financial statements have not been prepared
  in accordance with GAAP.
• The auditor is not independent.

4
Audit Reports Other than Unqualified

• A Qualified Opinion
• An Adverse Opinion
• A Disclaimer of Opinion

5
Qualified Opinions

• The auditor must conclude that the overall
  financial statements are fairly presented.
• Qualified opinions can result from two
  conditions
• A limitation on the scope of the audit.
• Failure to follow GAAP.
• If the auditor believes the condition being
  reported on is highly material, a disclaimer or
  an adverse report must be used.

6
Qualified Opinions

• A qualified opinion is considered to be the least
  severe type of departure from an unqualified
  report.
• A qualified report can take the form of a
  qualification of both the scope and the opinion,
  or of the opinion alone.
• When a qualified report is issued, the term
  except for must be used in the opinion paragraph.
  Except for cannot be used with any other type of
  opinion.
• Explanatory paragraphs always are inserted before
  the opinion paragraph.

7
Qualified OpinionScope Limitations

• Examples of scope limitations include
• Failure to observe clients ending inventories,
  because of clients requests or a late
  appointment of the auditor by the client.
• Failure to confirm accounts receivable, because
  of clients requests or missing or incomplete
  customer records.
• Other situations where inadequate accounting
  records exist.

8
Qualified OpinionScope Limitations
Perform procedures and issue standard report
Yes
Are alternative procedures available?
No
Is the restriction a significant limitation?
Yes
Issue a disclaimer of opinion
No
Assuming that no departures from GAAP
are noted
Issue a qualified opinion
9
Adverse Opinion

• Used only when the auditor believes the overall
  financial statements are so materially misstated
  or misleading that they do not present fairly the
  financial position or the results of operations
  and cash flows in conformity with GAAP.
• The adverse opinion can be given only when the
  auditor has specific knowledge of the absence of
  conformity with GAAP.

10
Disclaimer of Opinion

• A disclaimer is issued whenever the auditor has
  been unable to satisfy himself that the overall
  financial statements are fairly presented.
• Two conditions may lead to a disclaimer
• A severe limitation on the scope of the audit.
• A nonindependent relationship between the auditor
  and the client.
• A disclaimer is distinguished from an adverse
  opinion in that it can arise only from a lack of
  knowledge by the auditor.

11
Circumstances Concerning Comparative Financial
Statements

• Different opinions on the financial statements
• Most often occurs in first-year audit with
  disclaimer on income statement and unqualified on
  balance sheet.
• Updating an opinion
• Opinion or report may be different than
  previously reported (on comparative financial
  statements) and auditor must explain the change
  in the report. Add paragraph just before opinion
  paragraph explaining the change.

12
Comparative Statements

• The SEC requires two years of balance sheets and
  three years of income statements and statements
  of cash flows.
• The auditor updates previous reports when issuing
  a new report.
• The updated report carries the same date as the
  current report.

13
Opinion Interrelationships
Qualified opinion Adverse opinion
Inconsistency Accounting principles violation Inadequate disclosure Scope limitation Material contingency or uncertainty Accounting principles violation Inadequate disclosure _____Disclaimer_____ Lack of independence Scope limitation Material contingency or uncertainty
Indicates increasing degree of materiality of condition causing the other-than-unqualified opinion. Indicates increasing degree of materiality of condition causing the other-than-unqualified opinion. Indicates increasing degree of materiality of condition causing the other-than-unqualified opinion.
14
Comparison of Compilation, Review, and Audit
Engagements
Type of Engagement Type of Engagement Type of Engagement
Compilation Review Audit
1. Engagement objective No assurance as to GAAP Limited assurance as to GAAP Statements are fairly presented in accordance with GAAP
2. Entities covered Nonpublic only Nonpublic Public or nonpublic
3. CPA knowledge of clients industry Knowledge of accounting principles and practices of industry and general understanding of business. Knowledge same as compilation plus increased understanding of the entitys business. Extensive knowledge of economy, industry, and clients business (SAS 22).
15
Comparison of Compilation, Review, and Audit
Engagements
Type of Engagement Type of Engagement Type of Engagement
Compilation Review Audit
4. Inquiry procedures Inquiries not required unless information supplied by entity is questionable. Inquiry and analytical procedures required plus additional procedures if information appears questionable. Inquiry, analytical (SAS 23), and audit procedures.
5. Disclosures omitted Substantially all disclosures required by GAAP may be omittedwithout restriction on use. All disclosures required by GAAP must be included. Inadequate disclosure requires qualifiedexcept foror adverse opinion.
6. Departures from GAAP measurement Disclosure required in compilation report. Disclosure required in review report. Departure from GAAP requires qualifiedexcept for or adverse audit opinion.
16
Comparison of Compilation, Review, and Audit
Engagements
Type of Engagement Type of Engagement Type of Engagement
Compilation Review Audit
7. CPAs independence CPA does not have to be independent. Lack of independence precludes review engagement. Non-independence disclaimer required.
8. Standard report form Two paragraphs. Disclaimer. Three paragraphs. Negative assurance. Two paragraphs.
9. Representation letter. No mention. May obtain. Required.
10. Engagement letter May wish to obtain. May wish to obtain. No mention, see International Audit Guide.
17
Comparison of Audits, Reviews and Compilations of
Financial Statements
AUDIT REVIEW COMPILATION
Level of assurance provided? Reasonable Limited None
Study and evaluation of internal control required? Yes No No
Procedures required? Sufficient to express an opinion Inquiry and analytical review None, unless information appears to be unacceptable
Independence required? Yes Yes No
Omission of footnotes allowed? No No Yes
18
Comparison of Audits, Reviews and Compilations of
Financial Statements
AUDIT REVIEW COMPILATION
Modification of report for departure from GAAP? Except for qualification or adverse opinion Paragraph describing departure Paragraph describing departure
Modification of report for change in accounting principle? Except for qualification None None
Modification of report for material uncertainty? Unqualified with explanatory paragraph None None
Modification of report for scope limitation? Except for qualification or disclaimer Report cannot be issued Report cannot be issued
19
Special Reports

• Reports on financial statements prepared in
  accordance with a comprehensive basis of
  accounting other than generally accepted
  accounting principles.
• Reports on specific elements, accounts, or items
  of financial statements.
• Reports on compliance with aspects of contractual
  agreements or regulatory requirements related to
  audited financial statements.
• Reports on audited financial information
  presented in prescribed forms or schedules that
  require a prescribed form of auditors report.

20
Quarterly Information

• Form 10-Q required by SEC.
• Quarterly information is in more condensed form.
• Quarterly reports are not audited but must be
  reviewed by an independent accountant.
• If the company states in the 10-Q that the
  statements have been reviewed, the auditor must
  include a report.

21
Managements Assessment of Controls

• The Sarbanes-Oxley Act requires each annual
  report of an issuer to contain an "internal
  control report", which
• states the responsibility of management for
  establishing and maintaining an adequate internal
  control structure and procedures for financial
  reporting
• contains an assessment, as of the end of the
  issuer's fiscal year, of the effectiveness of the
  internal control structure and procedures of the
  issuer for financial reporting.

22
Managements Assessment of Controls

• Each issuer's auditor must attest to, and report
  on, the assessment made by the management of the
  issuer.
• The attestation should be performed in accordance
  with standards for attestation engagements.
• An attestation engagement should not be the
  subject of a separate engagement.

23
Overview Internal/Disclosure Controls
Section 302(a)4-6 Section 103/404
Definition Disclosure Controls and Procedures Internal ControlFinancial Reporting Internal ControlFinancial Reporting
Requirement CEO/CFO certifies Established and maintained DCP Effective designmaterial information Evaluated effectiveness Disclosed any fraud and deficiencies to auditors and audit committees Disclosed changes and any corrective action 103 Auditors report describes scope of testing of internal control 404 Management provides report that states Their responsibility Their assessment accompanied by auditors attestation report
Timing CurrentPeriodic evaluation, within 90 days prior to filing date ProposedAs of the end of the period Annual assessmentas of the end of the most recent fiscal year
Source Deloitte Touche
24
Internal Control Financial Reporting
Notes
Financial Reporting Controls
Cash Flow
Income Statement
Balance Sheet
Financial Statements
Source Deloitte Touche
25
Internal Control
Authorization of Transactions
Safeguarding of Assets
Financial Reporting
Assets Compared to Accounting Records
Accounting Records
Source Deloitte Touche
26
Internal Control
FCPA/ Attest
Disclosure Controls
Certify/ Report on Evaluation
Laws and Regulations
Operations
Source Deloitte Touche
27
Missing Link
The weakest link is a compliance program and
infrastructure to measure and monitor
the effectiveness and alignment between corporate
governance and business unit/functional control
activities to provide a basis for certification.
Source Deloitte Touche
28
Audit Scope Pre 404 vs. Post 404
Source Deloitte Touche
29
PCAOB Auditing Standard No. 2And Section 404

1. Section 404 of the Act requires the management of
   a public company to (1) assess the effectiveness
   of the companys internal control over financial
   reporting and (2) include in the annual report
   managements assessment about whether the
   internal control is effective.
2. Section 404 also requires (1) auditors to attest
   to and report on managements assessment of
   internal controls and (2) the PCAOB establish
   professional standards governing the auditors
   attestation.

30
Benefits of the New Internal Control Reporting

• Enhance companies internal control over
  financial reporting by enabling more timely
  identification and remediation of weaknesses.
• Through the creation of an ongoing management
  requirement, companies will learn from their
  evaluation process and remediate identified
  deficiencies on an ongoing basis, which should
  result in more reliable financial reporting and
  greater investor confidence.
• Internal control over financial reporting is
  intended to provide reasonable assurance about
  the reliability of financial reporting.
• Cost of compliance with Section 404 (significant
  for many public companies).

31
Roles and ResponsibilitiesInternal Control over
Financial Reporting

• Management Designs and implements the system of
  internal control over financial reporting
  evaluates the effectiveness of the companys
  internal control over financial reporting and
  provides a public report on that assessment
  prepares the financial statements.
• Audit Committee Has responsibility for oversight
  of the companys financial reporting process.
• Independent Auditor Performs an audit of
  internal control over financial reporting and
  issues a report on managements assessment of
  internal control over financial reporting and on
  the effectiveness of internal control over
  financial reporting also performs an audit of
  the companys financial statements.

32
What Managements Report Will Include

• Under the SEC rules, managements report on
  internal control over financial reporting should
  include the following information
• Statement of managements responsibility for
  establishing and maintaining adequate internal
  control over financial reporting.
• Statement identifying the framework used by
  management to evaluate the effectiveness of
  internal control over financial reporting.
• Managements assessment of the effectiveness of
  the companys internal control over financial
  reporting as of the end of the companys most
  recent fiscal year, including an explicit
  statement as to whether that control is effective
  and disclosing any material weakness identified
  by management in that control.
• Statement that the registered public accounting
  firm that audited the financial statements
  included in the annual report has issued an
  attestation report on managements internal
  control assessment.

33
PCAOB Auditing Standard No. 2An Audit of
Internal Control over Financial Reporting
Performed in Conjunction with an Audit of
Financial Statements

• AS No. 2 required three integrated reports on
• Financial statements audited by registered public
  accounting firms.
• Managements assessment of the effectiveness of
  internal control over financial reporting
  (Section 404).
• The effectiveness of internal control over
  financial reporting over financial reporting
  based on the auditors attestation of internal
  control.
• AS No. 2 was effective beginning June 17, 2004.

34
The Independent Auditors Opinion

• The content of the auditors report is prescribed
  by the PCAOB standard. The most common opinions
  on the effectiveness of internal control over
  financial reporting will be
• Unqualified Opinion. An opinion that internal
  control over financial reporting is effective no
  material weaknesses in internal control over
  financial reporting exist as of the fiscal
  year-end assessment date.
• Adverse Opinion. An opinion that internal control
  over financial reporting is not effective one or
  more material weaknesses exist as of the fiscal
  year-end assessment date.
• Disclaimer of Opinion. A report stating that
  restrictions on the scope of the auditors work
  prevent the auditor from expressing an opinion on
  the companys internal control over financial
  reporting.

35
Report of Independent Registered Public
Accounting Firm
1. Introductory Paragraph
2. Scope Paragraph
3. Definition Paragraph
6. Inherent Limitations Paragraph
5. Explanatory Paragraph
4. Opinion Paragraph
7. Signature
8. City and State or County
9. Date
The explanatory paragraph is required only when
the auditors opinion is other than unqualified
and may also be placed after the opinion
paragraph when the auditor issues two separate
reports on the audit of financial statements and
internal controls, thus making reference to
opinion on the financial statement audit in the
report on the internal control audit.
36
Source Release No. 2004-001, pages 116-137,
Appendix AIllustrative Reports, available at
pcaobus.org.
37
Source Release No. 2004-001, pages 116-137,
Appendix AIllustrative Reports, available at
pcaobus.org.
38
Source Release No. 2004-001, pages 116-137,
Appendix AIllustrative Reports, available at
pcaobus.org.
39
Suitable Internal Control Framework (Example
COSO)
Source Deloitte Touche
40
Framework of Integrated Financial and Internal
Control Reporting (IFICR)

41
Integrated Financial and Internal Control
Reporting (IFICR)
Pre-SOX Post-SOX Post-SOX
SEC Rules and PCAOB AS No. 2 (20042006) SEC Interpretive Guidance and PCAOB AS No. 5 (2007beyond)
Audit Committee Very limited involvement of the audit committee in IFICR Review of audited financial statements and recommendation to the board of directors that financial statements be disseminated to shareholders Review of managements assessment of the effectiveness of ICFR Review of the auditors opinion on Managements assessment of the effectiveness of ICFR Effectiveness of ICFR Fair presentation of financial statements in conformity with GAAP Review of audited financial statements and recommendation to the board of directors that financial statements be disseminated to shareholders Review of managements assessment of the effectiveness of ICFR Review of the auditors opinion on Effectiveness of ICFR Fair presentation of financial statements in conformity with GAAP
Management Fair presentation of financial statements in conformity with GAAP Design and maintenance of adequate and effective internal control system to prevent, detect, and correct material misstatements, whether caused by error or fraud Fair presentation of financial statements in conformity with GAAP. Design and maintenance of adequate and effective internal control system to prevent, detect, and correct material misstatements whether caused by error or fraud Report on managements assessment of the effectiveness of ICFR Disclosure of significant deficiencies to the audit committee Disclosure of material weakness in ICFR to shareholders Fair presentation of financial statements in conformity with GAAP Design and maintenance of adequate and effective internal control system to prevent, detect, and correct material misstatements whether caused by error or fraud Report on managements assessment of the effectiveness of ICFR Disclosure of significant deficiencies to the audit committee Disclosure of material weaknesses in ICFR to shareholders More cost-effective, efficient, and scalable management involvement and reporting on ICFR
42
Integrated Financial and Internal Control
Reporting (IFICR) (cont.)
Pre-SOX Post-SOX Post-SOX
SEC Rules and PCAOB AS No. 2 (20042006) SEC Interpretive Guidance and PCAOB AS No. 5 (2007beyond)
Independent Auditor Opinion on fair presentation of financial statements in conformity with GAAP Combination of internal control and account balance testing to achieve financial statement efficiency Internal control testing Account balance testing Opinion on whether managements assessment of the effectiveness of ICFR is fairly stated Opinion on the effectiveness of ICFR Opinion on fair presentation of financial statements in conformity with GAAP Internal control testing Account balance testing Opinion on whether managements assessment of the effectiveness of ICFR is fairly stated Opinion on the effectiveness of ICFR Opinion on fair presentation of financial statements in conformity with GAAP More cost-effective, efficient, and scalable testing of ICFR with a keen focus on a top-down, risk-based, and principles-based audit
Internal Auditors Limited involvement in financial reporting and ICFR process Extensive involvement with management reporting on ICFR Assisting management with its report on ICFR Cooperation with external auditors in their reporting on ICFR A more-balanced engagement in operational, compliance, and ICFR internal audit activities Internal auditor assurance report on ICFR
43
Other Overriding Causes of the Financial Crisis

• Greedy and incompetent executives
• Subprime mortgage crisis
• Falling asset pricing, including houses
• Highly leveraged financials
• Inactive credit markets
• Credit-driven rather than equity-driven markets

• Government policies promoting home ownership
• Securitization of mortgage-backed assets
• Inadequate risk assessment of business
  transactions
• Lack of transparency of public financial
  information
• Failure of accounting standards to properly
  measure fair value of financial instruments

44
Overriding Effects of Financial Crisis

1. Results in a global crisis that will take time
2. Encourages regulatory reforms
3. Creates significant risk to GDP growth
4. Causes a global economic meltdown
5. Increases likelihood of bankruptcy
6. Causes unemployment
8. http//www.youtube.com/watch?vSwRFoxgEcHcfeature
   related (VIDEO)

45
Practice Opinions
46
Assume the following facts about the auditor

• The auditor is independent.
• The auditor previously expressed an unqualified
  opinion on the prior year's financial statements.
• Only single-year (not comparative) statements are
  presented.
• The conditions for an unqualified opinion exist
  unless contradicted in the factual situations.
• The conditions stated in the factual situations
  are material.
• No report modifications are to be made except in
  response to the factual situation.

47
Situation 1
Burgandy's consolidated financial statements show
that during the year just ended, the company
incurred a net loss of 400 million and at year
end had a shareholders' deficit of 125 million.
The current ratio has been steadily declining and
is below that required in a loan agreement.
Company officials believe that Burgandy's
existing financial resources are adequate to
finance operations during the next fiscal year,
as disclosed in a note to the financial
statements.
48
Situation 2
The chief financial officer of Fine Concrete
Company will not permit you to confirm accounts
receivable from a major customer. You are unable
to use alternative procedures to satisfy
yourself. The amount of the receivable is
material in relation to the financial statements.
49
Situation 3
Two weeks after year end, Regal Wholesale, Inc.,
sold the franchise for the appliances it has sold
for the past twenty years. Regal plans to dispose
of its appliance inventory and convert its
facility to a retail outlet for pottery.
50
Situation 4
Management of Marks Corporation has declined to
include a statement of cash flows among its basic
financial statements. Cash has increased for the
past five years, and Marks's liquidity exceeds
the average of the industry.
51
Situation 5
Drug Development Corporation is a defendant in
litigation. The nature of the company's business
and its primary product lines inherently subject
the company to the hazards of product liability
litigation. The company is currently a defendant
in several product liability lawsuits. At this
time, the company's legal counsel is unable to
determine whether the outcome of the litigation
will have a material impact on the company.
Accordingly, no provision has been made in the
consolidated financial statements for any
liability that may result, but notes include the
litigation information.
52
Situation 6
Seigel Corporation has provided for depreciation
primarily by the declining-balance method on
substantially all property acquired prior to the
current year. At the beginning of the period, the
company adopted the straight-line method for
financial statements purposes for all new
property acquired. The new method conforms with
that prevalent in the industry. The effect of the
change for the current year was to increase net
earnings by an amount material in relation to net
income.
53
More Practice
54
Situation 7
In auditing the long-term investments account, an
auditor is unable to obtain audited financial
statements for an investee located in a foreign
country. The auditor concludes that sufficient
competent evidential matter regarding this
investment cannot be obtained.
55
Situation 8
Due to recurring operating losses and working
capital deficiencies, an auditor has substantial
doubt about an entity's ability to continue as a
going concern for a reasonable period of time.
However, the financial statement disclosures
concerning these matters are adequate.
56
Situation 9
A principal auditor decides to take
responsibility for the work of another CPA who
audited a wholly owned subsidiary of the entity
and issued an unqualified opinion. The total
assets and revenues of the subsidiary represent
17 percent and 18 percent, respectively, of the
total assets and revenues of the entity being
audited.
57
Situation 10
An entity issues financial statements that
present financial position and results of
operations, but it omits the related statement of
cash flows. Management discloses in the notes to
the financial statements that it does not believe
the statement of cash flows to be a useful
financial statement.
58
Situation 11
An entity changes its depreciation method for
production equipment from the straight-line
method to a units-of-production method based on
hours of utilization. The auditor concurs with
the change although it has a material effect on
the comparability of the entity's financial
statements.
59
Situation 12
An entity is a defendant in a lawsuit alleging
infringement of certain patent rights. However,
the ultimate outcome of the litigation cannot be
reasonably estimated by management. The auditor
believes there is a reasonable possibility of a
significant material loss, but the lawsuit is
adequately disclosed in the notes to the
financial statements.
60
Situation 13
An entity discloses in the notes to the financial
statements certain lease obligations. The auditor
believes that the failure to capitalize these
leases is a departure from generally accepted
accounting principles.
61
Key Themes of AS No. 5

1. Audit opinion on only the effectiveness of ICFR.
2. Consideration of the work of previous audits.
3. Reliance on the work of others.
4. Use of a risk-based approach for focusing on risk
   areas.
5. Use of a top-down approach for focusing on
   materiality and what does matter.
6. Consideration of size and complexity.
7. A principles-based approach of reducing
   unnecessary prescriptive audit standards.
8. More congruence with SEC Interpretive Guidance.

62

• AS No. 2 was criticized for escalating Section
  404 compliance costs by
• Promoting a bottom-up and control-based approach
  to testing ICFR.
• Requiring extensive control documentation of the
  process-level controls, and less focus on
  entity-level controls and assessment of risk
  related to significant controls.
• The top-down, risk-based approach promoted in
  both the SECs Interpretive Guidance and AS No. 5
  is designed to refocus both management and
  auditors on controls that matter and risks that
  threaten the integrity and reliability of
  financial reports.

63
Definitions

• The SECs Interpretive Guidance and AS No. 5
  provide the following definitions of significant
  deficiency and material weakness of ICFR
• A significant deficiency is a deficiency, or a
  combination of deficiencies, in internal control
  over financial reporting that is less severe than
  a material weakness, yet important enough to
  merit attention by those responsible for
  oversight of the companys financial reporting.
• A material weakness is a deficiency, or a
  combination of deficiencies, in internal control
  over financial reporting, such that there is a
  reasonable possibility that a material
  misstatement of the companys annual or interim
  financial statements will not be prevented or
  detected on a timely basis.1

1 Public Company Accounting Oversight Board
(PCAOB). 2007. Auditing Standard No. 5 An Audit
of Internal Control over Financial Reporting That
Is Integrated with an Audit of Financial
Statements. Available at www.pcaob.org/Rules/Rule
s_of_the_Board/Auditing_Standard_5.pdf.
64
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Source Excerpt from PCAOB AS No. 5. Public
Company Accounting Oversight Board (PCAOB). 2007.
Auditing Standard No. 5. An Audit of Internal
Control over Financial Reporting That is
Integrated with an Audit of Financial Statements
(May 24). Available at pcaobus.org/Rules/Rules_of
_the_Board/Auditing_Standard_5.pdf.
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Materiality and Risk