CHAPTER 18CHAPTER 18

AUDITORS’ REPORTSAUDITORS’ REPORTS

ASSOCIATION WITH ASSOCIATION WITH FINANCIAL STATEMENTSFINANCIAL STATEMENTS

• An accountant (auditor) is associated with the financial statements of an entity when he/she has:

– consented to the use of his/her name in a report, document, or written communication containing the financial statements, or

– submitted to his/her client or to others financial statements that he/she has prepared or assisted in preparing.

ASSOCIATION WITH ASSOCIATION WITH FINANCIAL STATEMENTSFINANCIAL STATEMENTS

• If the accountant (auditor) is associated with the financial statements of a public entity, but has not audited or reviewed such statements, the accountant should issue the following form of report:

Addressee:

The accompanying balance sheet of X Company as of December 31, 2004, and the related statements of income, retained earnings, and cash flows for the year then ended were not audited by us and, accordingly, we do not express an opinion on them.

SignatureDate

TYPES OF AUDITORS' AND TYPES OF AUDITORS' AND ACCOUNTANTS' ACCOUNTANTS'

REPORTS ON FINANCIAL STATEMENTSREPORTS ON FINANCIAL STATEMENTSA.A. Auditors' Reports ‑ Reports on audits of financial Auditors' Reports ‑ Reports on audits of financial

statement(s) that purport to be in conformity with GAAP.statement(s) that purport to be in conformity with GAAP.

B.B. Special ReportsSpecial Reports

C.C. Reports on Application of Accounting PrinciplesReports on Application of Accounting Principles

D.D. Letters for Underwriters:Letters for Underwriters:

E.E. Review of Interim Financial Information Review of Interim Financial Information

F.F. Compilation and Review of Financial Statements (AR 100-Compilation and Review of Financial Statements (AR 100-600)600)

G.G. Prospective Financial Statements (AT 200)Prospective Financial Statements (AT 200)

H.H. Pro Forma Financial Statements (AT 300) Pro Forma Financial Statements (AT 300)

TYPES OF AUDITORS' AND TYPES OF AUDITORS' AND ACCOUNTANTS' ACCOUNTANTS'

REPORTS ON FINANCIAL STATEMENTSREPORTS ON FINANCIAL STATEMENTS

I.I. Reports on the audit of a governmental entity’s Reports on the audit of a governmental entity’s financial statements performed in accordance with financial statements performed in accordance with one or moreone or more of the following: of the following:

Generally Accepted Auditing Standards (GAAS)Generally Accepted Auditing Standards (GAAS)

Governmental Auditing Standards (GAS)Governmental Auditing Standards (GAS)

Single Audit Act of 1984Single Audit Act of 1984

Types of Auditor Reports & Types of Auditor Reports & Opinions (see Table 1)Opinions (see Table 1)

• Unqualified Opinion

– Standard report

– Report with explanatory language added that does not affect the auditor’s unqualified opinion

• Qualified Opinion (sometimes called an Except for Qualified Opinion):

– Material departure from GAAP (including inadequate disclosure)

– Significant scope limitation.

• Adverse Opinion – Material departure from GAAP

• Disclaimer of Opinion Significant scope limitation

EXPLANATORY LANGUAGE ADDED EXPLANATORY LANGUAGE ADDED

TO THE AUDITOR'S REPORTTO THE AUDITOR'S REPORT1.1. The auditor's opinion is based in part on the report of another The auditor's opinion is based in part on the report of another

auditor.auditor.

2.2. To prevent the financial statements from being misleading due to To prevent the financial statements from being misleading due to unusual circumstances, the financial statements contain a unusual circumstances, the financial statements contain a departure from "promulgated" GAAP.departure from "promulgated" GAAP.

3.3. The financial statements are affected by significant uncertainties The financial statements are affected by significant uncertainties concerning future events, the outcome of which is not concerning future events, the outcome of which is not susceptible to reasonable estimation. (Eliminated by SAS #79).susceptible to reasonable estimation. (Eliminated by SAS #79).

4.4. There is substantial doubt about the entity's ability to continue as There is substantial doubt about the entity's ability to continue as a going concern.a going concern.

5.5. There has been a material change between periods in There has been a material change between periods in accounting principles or their method of application.accounting principles or their method of application.

6.6. The auditor wishes to add an explanatory paragraph to the audit The auditor wishes to add an explanatory paragraph to the audit report to emphasize a matter in the financial statements, but still report to emphasize a matter in the financial statements, but still express an unqualified opinion.express an unqualified opinion.

EXPLANATORY LANGUAGE ADDED EXPLANATORY LANGUAGE ADDED

TO THE AUDITOR'S REPORTTO THE AUDITOR'S REPORT7.7. Certain circumstances relating to reports on comparative financial Certain circumstances relating to reports on comparative financial

statements exist.statements exist.

8.8. Selected quarterly financial data required by SEC Regulation S-K Selected quarterly financial data required by SEC Regulation S-K have been omitted or have not been reviewed.have been omitted or have not been reviewed.

9.9. Supplementary information required by the FASB or the GASB:Supplementary information required by the FASB or the GASB:– Supplementary information has been omitted from the financial Supplementary information has been omitted from the financial

statements, orstatements, or– Presentation of such information departs materially from FASB or Presentation of such information departs materially from FASB or

GASB guidelines, or GASB guidelines, or – Auditor is unable to complete prescribed procedures with respect to Auditor is unable to complete prescribed procedures with respect to

such information, orsuch information, or– Auditor is unable to remove substantial doubts about whether the Auditor is unable to remove substantial doubts about whether the

supplementary information conforms to FASB or GASB guidelines, supplementary information conforms to FASB or GASB guidelines, oror

– Other information in a document containing audited financial Other information in a document containing audited financial statements is materially inconsistent with information appearing in statements is materially inconsistent with information appearing in the financial statements.the financial statements.

AUDITOR'S OPINION IS BASED IN AUDITOR'S OPINION IS BASED IN PART ON THE REPORT OF PART ON THE REPORT OF

ANOTHER AUDITORANOTHER AUDITOR

• When a principal auditor decides to make reference to the report of another auditor, he/she should:

– disclose this fact in the introductory paragraph of his or her report by indicating the dollar amounts, or the relative percentages, of assets and revenues examined by the other auditors,

– refer to the report of the other auditor in the scope paragraph by inserting after "We believe that our audit" the phrase "and the report of the other auditors,".

– refer to the report of the other auditor in the opinion paragraph by inserting after "In our opinion," the phrase "based on our audit(s) and the report of the other auditors,".

Example of a Report Indicating Example of a Report Indicating Division of ResponsibilityDivision of Responsibility

Report of Independent Registered Public Accounting FirmReport of Independent Registered Public Accounting Firm

To the Board of DirectorsTo the Board of Directorsof X Companyof X Company

Example of a Report Indicating Example of a Report Indicating Division of ResponsibilityDivision of Responsibility - Intro- Intro

We have audited the accompanying balance sheets of X We have audited the accompanying balance sheets of X Company as of December 31, 2004 and 2003, and the related Company as of December 31, 2004 and 2003, and the related statements of income, shareholders’ equity, and cash flows for statements of income, shareholders’ equity, and cash flows for each of the two years in the period ended December 31, 2004. each of the two years in the period ended December 31, 2004. These financial statements are the responsibility of the These financial statements are the responsibility of the Company's management. Our responsibility is to express an Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. opinion on these financial statements based on our audits. We We did not audit the financial statements of B Company, a did not audit the financial statements of B Company, a wholly owned subsidiary, which statements reflect total wholly owned subsidiary, which statements reflect total assets of $______ and $_______ as of December 31, 2004 assets of $______ and $_______ as of December 31, 2004 and 2003, respectively, and total revenues of $_______ and and 2003, respectively, and total revenues of $_______ and $_______ for the years then ended. Those statements were $_______ for the years then ended. Those statements were audited by other auditors whose report has been furnished audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts to us, and our opinion, insofar as it relates to the amounts included for B Company, is based solely on the reports of included for B Company, is based solely on the reports of the other auditors.the other auditors.

Example of a Report Indicating Example of a Report Indicating Division of ResponsibilityDivision of Responsibility - Scope- Scope

We conducted our audits in accordance with the standards We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform States). Those standards require that we plan and perform an audit to obtain reasonable assurance about whether the an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial supporting the amounts and disclosures in the financial statements. An audit also includes assessing the statements. An audit also includes assessing the accounting principles used and significant estimates made accounting principles used and significant estimates made by management, as well as evaluating the overall financial by management, as well as evaluating the overall financial statement presentation. We believe that our audits statement presentation. We believe that our audits and the and the reports of the other auditorreports of the other auditor provide a reasonable basis provide a reasonable basis for our opinion.for our opinion.

Example of a Report Indicating Example of a Report Indicating Division of ResponsibilityDivision of Responsibility - Opinion- Opinion

In our opinion, In our opinion, based on our audits and the based on our audits and the reports of the other auditors, reports of the other auditors, the financial the financial statements referred to above present fairly, in all statements referred to above present fairly, in all material respects, the financial position of X material respects, the financial position of X Company as of December 31, 2004 and 2003, and Company as of December 31, 2004 and 2003, and the results of operations and its cash flows for the results of operations and its cash flows for each of the two years in the period ended each of the two years in the period ended December 31, 2004, in conformity with U.S. December 31, 2004, in conformity with U.S. generally accepted accounting principles.generally accepted accounting principles.

SignatureSignatureCity and State or Country)City and State or Country)DateDate

TO PREVENT THE FINANCIAL STATEMENTS TO PREVENT THE FINANCIAL STATEMENTS FROM BEING MISLEADING DUE TO UNUSUAL FROM BEING MISLEADING DUE TO UNUSUAL

CIRCUMSTANCES, THE FINANCIAL CIRCUMSTANCES, THE FINANCIAL STATEMENTS CONTAIN A DEPARTURE FROM STATEMENTS CONTAIN A DEPARTURE FROM

"PROMULGATED" GAAP"PROMULGATED" GAAP

A.A. Management and the auditor must be able to Management and the auditor must be able to justify that, due to unusual circumstances, justify that, due to unusual circumstances, adherence to "promulgated" GAAP would be adherence to "promulgated" GAAP would be misleading.misleading.

B.B. Though the auditor's report contains a departure Though the auditor's report contains a departure from the standard report, the opinion expressed from the standard report, the opinion expressed by the auditor is an unqualified opinion.by the auditor is an unqualified opinion.

TO PREVENT THE FINANCIAL STATEMENTS TO PREVENT THE FINANCIAL STATEMENTS FROM BEING MISLEADING DUE TO UNUSUAL FROM BEING MISLEADING DUE TO UNUSUAL

CIRCUMSTANCES, THE FINANCIAL CIRCUMSTANCES, THE FINANCIAL STATEMENTS CONTAIN A DEPARTURE FROM STATEMENTS CONTAIN A DEPARTURE FROM

"PROMULGATED" GAAP"PROMULGATED" GAAP

C.C. The auditor's report should include, in a separate The auditor's report should include, in a separate explanatory paragraph, in which the auditor describes theexplanatory paragraph, in which the auditor describes the

1.1. departure,departure,

2.2. approximate effects, if practicable, andapproximate effects, if practicable, and

3.3. reasons why compliance with promulgated GAAP would reasons why compliance with promulgated GAAP would be misleading. be misleading.

D.D. The separate explanatory paragraph should The separate explanatory paragraph should precedeprecede the the opinion paragraph.opinion paragraph.

THERE IS SUBSTANTIAL DOUBT ABOUT THERE IS SUBSTANTIAL DOUBT ABOUT AN ENTITY'S ABILITY TO CONTINUE AS AN ENTITY'S ABILITY TO CONTINUE AS

A GOING CONCERNA GOING CONCERNA. The following are audit procedures that may identify a going

concern problem:

1. Analytical procedures.

2. Review of subsequent events.

3. Review of compliance with the terms of debt and loan agreements.

4. Reading minutes of meetings of stockholders, board of directors, and important committees of the board.

5. Inquiry of a client's legal counsel about litigation, claims, and assessments.

6. Confirmation with related and third parties of the details of arrangements to provide or maintain financial support.

B.B. Conditions or Events That Could Cast Substantial Conditions or Events That Could Cast Substantial Doubt on a Client's Ability to Continue as a Going Doubt on a Client's Ability to Continue as a Going Concern for a Reasonable Period of TimeConcern for a Reasonable Period of Time

1. Negative trends – such as operating losses, working capital deficiencies, negative cash flows, adverse key financial ratios

2. Other indications of possible financial difficulties – such as default on bonds or loans, denial of normal trade credit from suppliers, restructuring of debt, noncompliance with statutory capital requirements

3. Internal matters that have occurred such as work stoppages

4. External matters that have occurred such as litigations; loss of a key franchise, license or patent; loss of a principal customer; uninsured catastrophes such as drought, flood, or earthquake.

C.C. If the auditor concludes that there is substantial doubt If the auditor concludes that there is substantial doubt about the client's ability to continue as a going concern about the client's ability to continue as a going concern for a reasonable period of timefor a reasonable period of time, the auditor should , the auditor should evaluate management’s plans to mitigate the effects of evaluate management’s plans to mitigate the effects of the adverse conditions or events. The following are the adverse conditions or events. The following are examples of mitigating factors:examples of mitigating factors:

1.1. Sale of assetsSale of assets

2.2. Reduction or postponement of discretionary Reduction or postponement of discretionary expenditures, such as expenditures for research and expenditures, such as expenditures for research and developmentdevelopment

3.3. Restructuring of existing debtRestructuring of existing debt

4.4. Issuance of new debtIssuance of new debt

5.5. Issuance of capital stockIssuance of capital stock

6.6. Reduce or eliminate dividends on common or Reduce or eliminate dividends on common or preferred stockpreferred stock

D.D. If the auditor concludes that there is substantial doubt about If the auditor concludes that there is substantial doubt about the client's ability to continue as a going concern the client's ability to continue as a going concern for a for a reasonable period of timereasonable period of time and the mitigating factors are not and the mitigating factors are not sufficient to remedy the substantial doubt, the auditor sufficient to remedy the substantial doubt, the auditor should include an explanatory paragraph such as the should include an explanatory paragraph such as the following in the report.following in the report.

The accompanying financial statements have been The accompanying financial statements have been prepared assuming that the X Company will continue as a prepared assuming that the X Company will continue as a going concern. As discussed in Note X to the financial going concern. As discussed in Note X to the financial statements, the X Company has suffered recurring losses statements, the X Company has suffered recurring losses from operations and has a net capital deficiency that raise from operations and has a net capital deficiency that raise substantial doubts about its ability to continue as a going substantial doubts about its ability to continue as a going concern. Management's plans in regard to these matters concern. Management's plans in regard to these matters are also described in Note X. The financial statements do are also described in Note X. The financial statements do not include any adjustments that might result from the not include any adjustments that might result from the outcome of this uncertaintyoutcome of this uncertainty..

E.E. The explanatory paragraph should The explanatory paragraph should followfollow the opinion the opinion paragraph paragraph

There Has Been a Material Change Between There Has Been a Material Change Between Periods in Accounting Principles or in Their Periods in Accounting Principles or in Their

Method of ApplicationMethod of Application

A. The auditor's standard report implies that the auditor is satisfied that:

1. The comparability of financial statements between periods has not been materially affected by changes in accounting principles, and

2. Such principles have been consistently applied between or among periods.

B.B. If (a) there has been a change in accounting principles or in the If (a) there has been a change in accounting principles or in the method of their application that has a material affect on the method of their application that has a material affect on the comparability of the client's financial statements and (b) if comparability of the client's financial statements and (b) if management has provided proper justification for the change, then management has provided proper justification for the change, then the auditor would refer to the change in an explanatory paragraph in the auditor would refer to the change in an explanatory paragraph in his or her report.his or her report.

1.1. The explanatory paragraph should follow the opinion paragraph.The explanatory paragraph should follow the opinion paragraph.2.2. The explanatory paragraph should identify the nature of the The explanatory paragraph should identify the nature of the

change and refer the reader to the note in the financial change and refer the reader to the note in the financial statements that discusses the change in detail.statements that discusses the change in detail.

3.3. The auditor's concurrence with the change is implicit unless he The auditor's concurrence with the change is implicit unless he or she takes exception to the change in expressing his or her or she takes exception to the change in expressing his or her opinion as to fair presentation of the financial statements.opinion as to fair presentation of the financial statements.

4.4. The explanatory paragraph should be included in reports on the The explanatory paragraph should be included in reports on the financial statements of subsequent years as long as the financial financial statements of subsequent years as long as the financial statements for the year of the change is presented on a statements for the year of the change is presented on a comparative basis with the financial statements of subsequent comparative basis with the financial statements of subsequent years.years.

5.5. The only exception to Part 4 above is when the change is The only exception to Part 4 above is when the change is accounted for by retroactive restatement of the financial accounted for by retroactive restatement of the financial statements affected. In this case, the explanatory paragraph is statements affected. In this case, the explanatory paragraph is required only in the year of the change. required only in the year of the change.

C. The following is an example of an appropriate explanatory paragraph due to a change in accounting principles:

As discussed in Note 14 to the consolidated financial statements, in the first quarter of fiscal 2002, the Company changed its method of recognizing revenue for pharmacy automation equipment. In addition, as discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for purchased goodwill and other intangible assets in accordance with Statement of Financial Standards ("Statement") No. 142 during the first quarter of

fiscal 2002 .

D. The explanatory paragraph should follow the opinion paragraph.

E. If management is not able to provide reasonable justification for the change, then the auditor would not follow the guidance above. Instead, the auditor would issue a short-form report that contains either a qualified opinion or an adverse opinion.

Emphasis of a MatterEmphasis of a MatterA.A. In certain circumstances, an auditor may wish to add an In certain circumstances, an auditor may wish to add an

explanatory paragraph to the audit report to emphasize a matter explanatory paragraph to the audit report to emphasize a matter in the financial statements, but still express an unqualified in the financial statements, but still express an unqualified opinion.opinion.

B.B. For example, the auditor may wish to emphasize that: For example, the auditor may wish to emphasize that:

1.1. The client is a component of a larger business enterprise.The client is a component of a larger business enterprise.

2.2. The client has had significant transactions with related The client has had significant transactions with related parties.parties.

3.3. The financial statements disclose a highly material The financial statements disclose a highly material uncertainty.uncertainty.

4.4. An unusually important subsequent event or an accounting An unusually important subsequent event or an accounting matter affects the comparability of the financial statements matter affects the comparability of the financial statements with those of a preceding period.with those of a preceding period.

C.C. Phrases such as Phrases such as "with the foregoing explanation""with the foregoing explanation" should not should not be included in the opinion paragraph to refer to an explanatory be included in the opinion paragraph to refer to an explanatory paragraph that emphasizes a matter.paragraph that emphasizes a matter.

Qualified, Adverse, and DisclaimerQualified, Adverse, and DisclaimerA. Qualified Opinion:

1. An auditor may express a qualified opinion on audited financial statements either because of a departure from GAAP (including inadequate disclosure) or because of a significant scope limitation.

2. Key terminology is “except for.”3. Types of qualified opinions:

a) Material departure from GAAP or inadequate disclosure - States that, "except for the effects of the matter..." to which the qualification relates, the financial statements present fairly.

b) Significant scope limitation - States that "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 ..." to which the scope limitation relates, the financial statements present fairly.

Qualified, Adverse, and DisclaimerQualified, Adverse, and Disclaimer

B.B. Adverse Opinion:Adverse Opinion:

1.1. States that the financial statements "States that the financial statements "do not do not present fairly, in conformity with accounting present fairly, in conformity with accounting principles generally accepted in the United principles generally accepted in the United States of America, the financial position of X States of America, the financial position of X Company as of December 31, 19XX, or the Company as of December 31, 19XX, or the results of its operations or its cash flows for results of its operations or its cash flows for the year then ended.the year then ended.""

2.2. Key terminology is “do Key terminology is “do notnot present fairly.” present fairly.”

3.3. Results from the highly material affects of a Results from the highly material affects of a departure from GAAP or inadequate disclosure. departure from GAAP or inadequate disclosure. However, the omission of the statement of cash However, the omission of the statement of cash flows would result only in an "except for" flows would result only in an "except for" qualified opinion.qualified opinion.

Qualified, Adverse, and DisclaimerQualified, Adverse, and Disclaimer

C.C. Disclaimer of Opinion:Disclaimer of Opinion:

1.1. States that the auditor has not performed an States that the auditor has not performed an audit that was "audit that was "sufficient to enable us to sufficient to enable us to express, and we do not express, an express, and we do not express, an opinion on these financial statementsopinion on these financial statements."."

2.2. Key terminology is “does not express an Key terminology is “does not express an opinion.”opinion.”

3.3. Results from a significant scope limitation or Results from a significant scope limitation or lack of independence relative to a publicly-lack of independence relative to a publicly-held entityheld entity..