Audit Reports

Chapter 3

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3-1

 Parts of the Standard
Unqualified Audit Report
Q: Describe the parts of the standard unqualified audit
report.

1. Report title
Title should include the word independent (e.g., independent audit report)
2. Audit report address
Report is usually addressed to the company, its stockholders or board of directors.

3. Introductory paragraph
The intro paragraph does 3 things:
1. States the CPA firm has done an audit
2. It lists the financial statements that were audited
3. It defines responsibilities between management and the auditor
©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3-2
 Parts of the Standard
Unqualified Audit Report
4. Scope paragraph
The scope paragraph is a factual statement about what the auditor did
in the audit and sets the expectation about reasonable assurance.
5. Opinion paragraph
The opinion paragraph states the auditor’s conclusions.
6. Name of CPA firm
The name identifies the CPA firm who performed the audit.
7. Audit report date
The report date indicates the last day audit procedures were performed
in the field.
©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3-3
 Parts of the Standard
Unqualified Audit Report

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3-4

 Conditions for Standard
Unqualified Audit Report
Q2: Specify the conditions required to issue the standard unqualified audit report

1- All financial statements are included

Balance sheet, income statement, statement of changes in
stockholders’ equity and statement of cash flows,
comprehensive income statement, and changes in owners’
equity statement.
2- The three general standards have been followed in all
respects on the engagement

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3-5

 Conditions for Standard
Unqualified Audit Report
3- Sufficient evidence has been accumulated to conclude
that the three standards of field work have been met.

4. The financial statements had been prepared in accordanc

to the applicable accounting framework and adequate
Disclosures had been included in the footnotes.

5- There are no circumstances requiring the addition of

an explanatory paragraph or modification of the wording
of the report.
©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3-6
Four Categories of Audit Reports

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3-7

 Unqualified Report with
Explanatory Paragraph
Q3: Describe the five circumstances when an unqualified
report with an explanatory paragraph or modified
Wording is appropriate.

1. Lack of consistent application of generally accepted

accounting principles
2. Substantial doubt about going concern
3. Auditor agrees with a departure from promulgated
accounting principles
4. Emphasis of a matter
5. Reports involving other auditors
©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3-8
Lack of Consistent Application of
GAAP
Auditors must note circumstances in which
accounting principles are not consistently
applied

Auditor should modify the report when a

material change occurs by adding an
explanatory paragraph in the report

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3-9

The following are examples of changes
therefore require an explanatory paragraph
if they are material:
1. Changes in accounting principles, such as a
change from FIFO to average cost inventory
valuation
2. Changes in reporting entities, such as the
inclusion of an additional company in combined
financial statements
3. Corrections of errors involving principles, by
changing from an accounting principle that is not
generally acceptable to one that is generally
acceptable, including correction of the resulting
error

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 10

 Changes that need not be included in the audit
report include the following:
1. Changes in an estimate, such as a decrease in the
life of an asset for depreciation purposes
2. Error corrections not involving principles, such as
a previous year’s mathematical error
3. Variations in format and presentation of financial
information

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 11

 Substantial Doubt About
Going Concern

 Significant recurring operating

losses or working capital deficiencies.
 Inability of the company to pay its
obligations as they come due.
 Loss of major customers, the
occurrence of uninsured catastrophes.
 Legal proceedings, legislation that
might jeopardize the entity’s ability to operate.

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 12

 The auditor’s concern in such situations is the
possibility that the client may not be able to
continue its operations or meet its obligations for
a reasonable period.
For this purpose, a reasonable period is
considered not to exceed 1 year from the date of
the financial statements being audited.
When the auditor concludes that there is
substantial doubt about the entity’s ability to
continue as a going concern, an unqualified
opinion with an explanatory paragraph is
required, regardless of the disclosures in
the financial statements.

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 13

Example:
Independent Auditor’s Report
(Same introductory, management responsibility, auditor’s responsibility,
and opinion paragraph as the standard audit report
Emphasis of Matter [Emphasis of Matter Paragraph- Forth Paragraph]
The accompanying financial statements have been prepared assuming that Fairfax
Company will continue as a going concern. As discussed in Note 11 to the financial
statements, Fairfax Company has suffered recurring losses from operations and
has a net capital deficiency that raises substantial doubts about the company’s
ability to continue as a going concern. Management’s plans in regard to these
matters are also described in Note 11. The financial statements do not include
any adjustments that might result from the outcome of this uncertainty.

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 14

3-14
 Auditor Agrees with a Departure
from a Promulgated Principle
Departure may not require a qualified or
adverse opinion

The auditor must separately explain in the

audit report that adhering to the principle
would have produced a misleading result.

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 15

 Emphasis of a Matter

Under certain circumstances, the CPA may

want to emphasize specific matters regarding
the financial statements, even though the
CPA intends to express an unqualified opinion.

Related Party
Transactions
Subsequent
Events
Material
Uncertainties

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 16

 Reports Involving Other
Auditors
1. Make no reference in the audit report

2. Make reference in the report

(modified wording report)

3. Qualify the opinion

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 17

 Reports Involving Other
Auditors

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 18

 5
Identify the types of audit reports that
can be issued when an unqualified
opinion is not justified.

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 19

3-19
 1. The existence of material misstatements

2. Scope limitation

3-20 ©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 20

 1.The appropriateness of selected accounting policies (not
consistent with the applicable financial reporting framework or
the F/S do not represent the underlying transactions)

2. The application of selected accounting policies is not in

accordance with the applicable financial reporting framework.

3. The appropriateness or adequacy of disclosures in the financial

statements including sufficiency of disclosure is not in accordance
with the applicable financial reporting framework.

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 21

3-21
 1.Circumstances beyond the control of the entity (entity’s
records have been destroyed or the accounting records of a
significant component have been seized indefinitely by
government authorities)
2. Circumstances related to the timing and nature of the
auditor’s work (the timing of auditor’s appointment is such
that he is unable to observe the counting of the physical
inventories, the auditor determines that performing
substantive tests alone is not sufficient but the entity’s
controls are not effective)
3. Limitations imposed by management (management
prevents the auditor from counting of the physical inventory
or management prevents the auditor from requesting
confirmations of specific account balances.

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 22

3-22
 Materiality
Q5: Explain how materiality affects audit
reporting decisions.

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.

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 23

 Materiality Decisions

Failure to
follow GAAP

Audit report

Qualified
Unqualified Adverse
opinion only

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 24

 Relationship of Materiality to
Type of Opinion
Materiality Significance in Terms of Type of
Level Reasonable Users’ Decisions Opinion
Users’ decisions are unlikely
Immaterial to be affected. Unqualified

Users’ decisions are likely

Material to be affected. Qualified

Highly Users’ decisions are likely Disclaimer

material to be significantly affected. or adverse
©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 25
 Materiality Decisions

 Dollar amount compared with a base

 Measurability

Nature of the item

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 26

 Materiality Decisions

Scope
limitation

Audit report

Qualified scope
Unqualified Disclaimer
and opinion

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 27

 Amounts are immaterial (A misstatement in the F/S is unlikely to affect the
decisions of a reasonable user). Standard unqualified opinion is issued

Amounts are material but do not overshadow the financial statements as

a whole.(material but not pervasive) Auditor qualifies his opinion

Amounts are so material and pervasive that overall fairness of the

statements is in question (This is the highest level of materiality occurs when users
make Incorrect decisions if they rely on the overall F/S). Auditor issues
An adverse or disclaim his opinion according to the circumstances.

3-28 ©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 28

 When the auditor modifies his opinion, he should include
a paragraph in the auditor’s report that describes the matter
giving rise to the modification.
This paragraph shall be placed immediately before the opinion
paragraph in the auditor’s report and use the heading “Basis for
Qualified opinion” “Basis for adverse Opinion”
or “ Basis for Disclaimer of Opinion”
If there is a material misstatement in the F/S, the auditor shall
Include in the basis for modification paragraph a description
and quantification of the financial effects of the misstatements
unless impractical
If it is not practical to quantify the financial effects, the auditor
shall state so in the basis for modification paragraph

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 29

3-29
 In this case, the auditor modifies the audit
Opinion, and using the heading “ Qualified
Opinion,” “ Adverse Opinion” or “Disclaimer of
Opinion” for the opinion paragraph.

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 30

3-30
 Qualified opinion
The auditor shall express a qualified
opinion when:
(1)Auditor has obtained sufficient audit evidence and he
concluded that misstatements, individually or in aggregate,
are material but not pervasive, to the F/S or
(2)The auditor is unable to obtain sufficient appropriate audit
evidence on which to base the opinion (scope limitation),
but the auditor concluded that the possible effects on the f/S
of undetected misstatements, if any could be material but
not pervasive.

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 31

3-31
 Qualified opinion due to material
misstatement in the f/S

The auditor shall state in the opinion paragraph

that, in the auditor’s opinion, except for the effects
of the matter described in the “Basis for Qualified
Opinion” paragraph:
“The financial statements present fairly in all
material respects, …..in accordance with the
applicable financial reporting or compliance
framework”

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 32

3-32
3-33 ©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 33
 ©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 34
34
 Auditor shall express an adverse opinion when the auditor
having obtained sufficient appropriate evidence, concludes
that misstatements, individually or in the aggregate, are both
material and pervasive to the financial

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 35

3-35
 ©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 36
3-36
 Issued when the auditor is unable
obtain sufficient appropriate evidence
on which to base his opinion, and the
auditor concludes that the possible
effects on the F/S of undetected
misstatements, if any, could be material
or pervasive

3-37 ©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 37

 If the auditor concludes that the possible
effects of the undetected misstatements
could be material or pervasive so that
qualification of opinion is inadequate,
the auditor shall:
1. Withdraw from the audit if practical
or possible.
2. If withdrawal is not practical or possible,
he will disclaim an opinion on the
financial statements (scope paragraph is
ommitted)

3-38 ©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 38

 ©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 39
3-39
Problem (1) : Patel, CPA, has completed the audit of the financial statements of Bellamy Corporation as of and for
the year ended December 31, 2011. Patel also audited and reported on the Bellamy financial statements for the prior
year. Patel drafted the following report for 2011.
We have audited the balance sheet and statements of income and retained earnings of Bellamy Corporation as of
December 31, 2011. We conducted our audit in accordance with generally accepted accounting standards. Those
standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial
statements are free of misstatement.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly the financial position of Bellamy Corporation as
of December 31, 2011, and the results of its operations for the year then ended in conformity with generally accepted
auditing standards, applied on a basis consistent with those of the preceding year.
Patel, CPA
(Signed)

Other Information
• Bellamy is presenting comparative financial statements.
• Bellamy does not wish to present a statement of cash flows for either year.
• During 2011, Bellamy changed its method of accounting for long-term construction contracts and properly reflected
the effect of the change in the current year’s financial statements and restated the prior year’s statements. Patel is
satisfied with Bellamy’s justification for making the change. The change is discussed in footnote 12.
• Patel was unable to perform normal accounts receivable confirmation procedures, but alternative procedures were
used to satisfy Patel as to the existence of the receivables.
• Bellamy Corporation is the defendant in a litigation, the outcome of which is highly uncertain. If the case is settled in
favor of the plaintiff, Bellamy will be required to pay a substantial amount of cash, which might require the sale of
certain fixed assets. The litigation and the possible effects have been properly disclosed in footnote 11.
• Bellamy issued debentures on January 31, 2010, in the amount of $10 million. The funds obtained from the issuance
were used to finance the expansion of plant facilities.
The debenture agreement restricts the payment of future cash dividends to earnings after December 31, 2015.
Bellamy declined to disclose this essential data in the footnotes to the financial statements.
Required:
a. Identify and explain any items included in “Other Information” that need not be part of the auditor’s report.
b. Explain the deficiencies in Patel’s report as drafted.

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 40

Problem (2) : For the following independent situations, assume that you are the audit partner on the
engagement:

1. During your audit of Raceway.com, Inc., you conclude that there is a possibility that inventory is materially overstated.
The client refuses to allow you to expand the scope of your audit sufficiently to verify whether the balance is actually
misstated.
2. You complete the audit of Munich Department Store, and in your opinion, the financial statements are fairly presented.
On the last day of the audit, you discover that one of your supervisors assigned to the audit has a material investment
in Munich.
3. Auto Delivery Company has a fleet of several delivery trucks. In the past, Auto Delivery had followed the policy of
purchasing all equipment. In the current year, they decided to lease the trucks. The method of accounting for the
trucks is therefore changed to lease capitalization. This change in policy is fully disclosed in footnotes.
4. You are auditing Deep Clean Services for the first time. Deep Clean has been in business for several years but over
the last two years has struggled to stay afloat given the economic conditions. Based on your audit work, you have
substantial doubt that Deep Clean will be in business by the end of its next fiscal year.
5. One of your audit clients has a material investment in a privately-held biosciences company. Your audit firm engaged
a business valuation specialist to assist in evaluating the client’s estimation of the investment’s fair value.
You conclude that the valuation specialist’s work provides sufficient appropriate audit evidence.
6. Four weeks after the year-end date, a major customer of Prince Construction Co. declared bankruptcy. Because the
customer had confirmed the balance due to Prince at the balance sheet date, management refuses to charge off the
account or otherwise disclose the information. The receivable represents approximately 10% of accounts
receivable and 20% of net earnings before taxes.

For each situation, do the following:

a. Identify which of the conditions requiring a modification of or a deviation from an unqualified standard report is
applicable.
b. State the level of materiality as immaterial, material, or highly material. If you cannot decide the level of materiality,
state the additional information needed to make a decision.
c. Given your answers in parts a and b, state the type of audit report that should be issued. If you have not decided
on one level of materiality in part b, state the appropriate report for each alternative materiality level.

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 41

Problem (3) : For the following independent situations, assume that you are the audit
partner on the engagement:

1. In the last 3 months of the current year, Oil Refining Company decided to change direction and go
significantly into the oil drilling business. Management recognizes that this business is exceptionally
risky and could jeopardize the success of its existing refining business, but there are significant
potential rewards. During the short period of operation in drilling, the company has had three dry
wells and no successes. The facts are adequately disclosed in footnotes.
2. Your client, Harrison Automotive, has changed from straight-line to sum-of-theyears’ digits depreciation.
The effect on this year’s income is immaterial, but the effect in future years is likely to be material.
The facts are adequately disclosed in footnotes.
3. Toronto Technology Corporation has prepared financial statements but has decided to exclude the
statement of cash flows. Management explains to you that the users of their financial statements find
this statement confusing and prefer not to have it included.
4. Marseilles Fragrance, Inc. is based in New York but has operations throughout Europe. Because users
of the audited financial statement are international, your audit firm was engaged to conduct the audit
in accordance with U.S. auditing standards and International Standards on Auditing (ISAs).
5. The controller of Brentwood Industries, Inc. will not allow you to confirm the receivable balance from
two of its major customers. The amounts of the receivables are material in relation to Brentwood
Industries’ financial statements.
You are unable to satisfy yourself as to the receivable balances by alternative procedures.
6. Approximately 20% of the audit of Lumberton Farms, Inc. was performed by a different CPA firm,
selected by you.
You have reviewed their audit files and believe they did an excellent job on their portion of the audit.
Nevertheless, you are unwilling to take complete responsibility for their work.

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 42

Problem (3) : Cont.

For each situation, do the following:

a. Identify which of the conditions requiring a modification of or a deviation from an unqualified
standard report is applicable.
b. State the level of materiality as immaterial, material, or highly material. If you cannot decide the
level of materiality, state the additional information needed to make a decision.
c. Given your answers in parts a and b, state the appropriate audit report from the following alternatives
(if you have not decided on one level of materiality in part b, state the appropriate report for each
Alternative materiality level):
(1) Unqualified—standard wording (5) Qualified scope and opinion
(2) Unqualified—explanatory paragraph (6) Disclaimer
(3) Unqualified—modified wording (7) Adverse
(4) Qualified opinion only
d. Based on your answer to part c, indicate which paragraphs, if any, should be modified in the standard
audit report. Also indicate whether an additional paragraph is necessary and its location in the report.

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 43

Problem (4) : The following tentative auditor’s report was drafted by a staff accountant and submitted to
a partner in the accounting firm of Better & Best, CPAs:

AUDIT REPORT
To the Audit Committee of American Broadband, Inc.
We have examined the consolidated balance sheets of American Broadband, Inc. and subsidiaries as of December 31,
2011 and 2010, and the related consolidated statements of income, retained earnings, and cash flows for the years then
ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express
an opinion on these financial statements based on our audits.
Our audits were made in accordance with auditing standards generally accepted in the United States of America as we
considered necessary in the circumstances. Other auditors audited the financial statements of certain subsidiaries and
have furnished us with reports thereon containing no exceptions. Our opinion expressed herein, insofar as it relates to
the amounts included for those subsidiaries, is based solely upon the reports of the other auditors.
As fully discussed in Note 7 to the financial statements, in 2011, the company extended the use of the last-in, first-out
(LIFO) method of accounting to include all inventories. In examining inventories, we engaged Dr. Irwin Same
(Nobel Prize winner 2009) to test check the technical requirements and specifications of certain items of equipment
manufactured by the company.
In our opinion, the financial statements referred to above present fairly the financial position of American Broadband, Inc.
as of December 31, 2011, and the results of operations for the years then ended, in conformity with accounting principles
generally accepted in the United States of America.
To be signed by
Better & Best, CPAs
March 1, 2012

Required:
Identify deficiencies in the staff accountant’s tentative report that constitute departures from the generally accepted
standards of reporting.

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 44

Problem (5) : The following is an auditor’s report prepared in accordance with International Standards on
Auditing (ISAs) issued by the International Auditing and Assurance Standards Board (IAASB):

INDEPENDENT AUDITOR’S REPORT

To the Shareholders of Les Meridian, Inc.
We have audited the accompanying financial statements of Les Meridian, Inc., which comprise the statement of financial
position as of December 31, 2011, and the statement of comprehensive income, statement of changes in equity and
statement of cash flows for the year then ended, and a summary of significant accounting policies and other explanatory
notes.
Management’s Responsibility for the Financial Statements
Management is responsible for the preparation and fair presentation of these financial statements in accordance with
International Financial Reporting Standards, and for such internal control as management determines is necessary to
enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error.
Auditor’s Responsibility
Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in
accordance with International Standards on Auditing. Those standards require that we comply with ethical requirements
and plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from
material misstatement.
An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial
statements. The procedures selected depend on the auditor’s judgment, including the assessment of the risks of material
misstatement of the financial statements, whether due to fraud or error. In making those risk assessments, the auditor
considers internal control relevant to the entity’s preparation and fair presentation of the financial statements in order to
design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on
the effectiveness of the entity’s internal control. An audit also includes evaluating the appropriateness of accounting
policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall
presentation of the financial statements.
We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion.

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 45

Problem (5) : Cont.

Opinion
In our opinion, the financial statements give a true and fair view of the financial position of Les Meridian, Inc. as of
December 31, 2011, and of its financial performance and cash flows for the year then ended in accordance with
International Financial Reporting Standards.
Bergen and Bergen, CPAs
February 20, 2012
19 Rue de Bordeaux
Marseille, France

Required:
a. For each of the seven distinct parts of the standard unqualified report prepared in accordance with generally accepted
auditing standards in the United States, describe whether key elements of each of those seven parts are present in the
audit report based on International Standards on Auditing for Les Meridian’s financial statements.
b. Describe elements in the audit report based on International Standards on Auditing that are more extensive than an
audit report based on U.S. auditing standards.

©2012 Pearson Education, Auditing 14/e, Arens/Elder/Beasley 3 - 46