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CHAPTER

19
19-1.

WRITING THE AUDIT REPORT

The purposes of the scope paragraph in the auditors report are to inform the financial statement users that the audit was conducted in accordance with generally accepted auditing standards, in general terms what those standards mean, and whether the audit provides a reasonable basis for an opinion.

The information in the scope paragraph includes: 1. 2. 3. 4. 19-2. The auditor followed generally accepted auditing standards. The audit is designed to obtain reasonable assurance about whether the statements are free of material misstatement. Discussion of the audit evidence accumulated. Statement that the auditor believes the evidence accumulated was appropriate for the circumstances to express the opinion presented.

The purpose of the opinion paragraph is to state the auditors conclusions based upon the results of the audit evidence. The most important information in the opinion paragraph includes: 1. 2. 3. The words in our opinion which indicate that the conclusions are based on professional judgment. A restatement of the financial statements that have been examined and the dates thereof or a reference to the introductory paragraph. A statement about whether the financial statements were presented fairly and in accordance with generally accepted accounting principles.

19-3.

The common definition of materiality as it applies to accounting and, therefore, to audit reporting is:

A misstatement in the financial statements can be considered material if knowledge of the misstatement would affect a decision of a reasonable user of the statements. Auditors must have knowledge of the likely uses of their clients statements and the decisions that are being made. Materiality involves both quantitative and qualitative considerations. In assessing the quantitative importance of a misstatement, it is necessary to relate the peso amount of the

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Solutions Manual to Accompany Applied Auditing, 2010 Edition error to the financial statements under examination. Qualitative considerations, on the other hand, relate to the causes of the misstatement. An error that may not be material quantitatively, may be material qualitatively. This may occur, for instance, when the misstatement is attributed to an irregularity or an illegal act by the client.

19-4.

Materiality for lack of independence in audit reporting is easiest to define. If the auditor lacks independence as defined by the Code of Professional Ethics, it is always considered highly material and therefore a disclaimer of opinion is always necessary. For failure to follow GAAP, there are three levels of materiality: immaterial, material, and highly material. The auditors opinion may be qualified by scope limitations caused by client restrictions or by limitations resulting from conditions beyond the clients control. The former occurs when the client will not, for example, permit the auditor to confirm material receivables or physically observe inventories. The latter may occur when the engagement is not agreed upon until after the clients year end when it may not be possible to physically observe inventories or confirm receivables.

19-5.

A disclaimer of opinion is issued if the scope limitation is so material that the auditor cannot determine if the overall financial statements are fairly presented. If the scope limitation is caused by the clients restriction the auditor should be aware that the reason for the restriction may be to deceive the auditor. For that reason a disclaimer is more likely for client restrictions than for conditions beyond anyones control. When there is a scope restriction that results in the failure to verify material, but not pervasive accounts, a qualified opinion may be issued. This is more likely when the scope limitation is for conditions beyond the clients control than for restrictions by the client. 19-6. When another CPA has performed part of the audit, the primary auditor issues one of the following types of reports based on the circumstances. 1. No reference is made to the other auditor. This will occur if the other auditor examined an immaterial portion of the statement, the other auditor is known or closely supervised, or if the principal auditor has thoroughly reviewed the other auditors work. Issue a shared opinion in which reference is made to the other auditor. This type of report is issued when it is impractical to review the work of the other auditor or when a portion of the financial statements audited by the other CPA is material in relation to the total.

2.

Writing the Audit Report 3.

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The report may be qualified if the principal auditor is not willing to assume any responsibility for the work of the other auditor. A disclaimer may be issued if the segment audited by the other CPA is highly material.

19-7.

1) Disclaimer of opinion. Because the client refuses to allow the auditor to expand the scope of his examination, a disclaimer of opinion is appropriate rather than a qualified as to scope and opinion. 2) Disclaimer of opinion. The auditor cannot issue an unqualified opinion on the income statement or the statement of cash flows because a disclaimer of opinion is necessary for the beginning balance sheet. The auditor may issue an unqualified opinion on the ending balance sheet and a disclaimer of opinion on the income statement, statement of cash flows, and the beginning balance sheet. 3) Unqualified opinion. The auditor is able to satisfy him or herself that with the use of alternative procedures, a qualified opinion is not necessary. 4) Qualified opinion or adverse opinion for failure to follow generally accepted accounting principles. The materiality of twenty per cent of net earnings before taxes would be sufficient for many auditors to require an adverse opinion. That materiality question is a matter of auditor judgment. 5) Disclaimer of opinion. Lack of independence by audit personnel on the engagement mandates a disclaimer for lack of independence. 6) Unqualified opinion. The company has made a decision to follow a different financing method which is adequately disclosed. There is no change of accounting principle.

19-8. a. CONDITION 1. Failure to follow GAAP. b. TYPE OF REPORT (4) Qualified opinion only except for or (7) Adverse COMMENT Disclosure of this information is required in a footnote. Failure to do so is a violation of GAAP and is likely to be a qualified opinion, or it could be so important as to require an adverse.

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Solutions Manual to Accompany Applied Auditing, 2010 Edition 2. Scope of the auditors examination has been restricted. (1) Unqualified standard Because the auditor was able to obtain alternative evidence, no scope qualification is necessary. If there were such a qualification, it would be a qualified scope and opinion or a disclaimer, depending on materiality. Retail Auto Parts has used a replacement cost inventory rather than lower of cost or market. It is not sufficiently material to require an adverse opinion. FASB No. 2 requires the expending in the current period of all research and development costs regardless of the benefit in future years. Given the materiality of the amount, an adverse opinion would be required. Because the auditor was unable to satisfy himself about beginning inventories, it would be necessary to issue either a qualified or disclaimer of opinion on the income statement and statement of cash flows as well as the beginning balance sheet. The use of a qualified or disclaimer would depend upon the opinion given in the prior year. An unqualified opinion could be issued for the current period balance sheet.

3. Failure to follow GAAP.

(4) Qualified opinion only except for

4. Failure to follow GAAP.

(7) Adverse

5. Scope of the auditors examination has been restricted.

(5) Qualified scope and opinion

Writing the Audit Report 6. Scope of the auditors examination has been restricted. (6) Disclaimer

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Failure of the client to allow the auditor to inspect the minutes book would be a material client-imposed restriction. Due to the importance of the minutes book, a disclaimer would be necessary. The certified copy of all resolutions and actions would not be a satisfactory alternative procedure. The change of estimated life is a change of condition and not a change in accounting principles. Therefore, an unqualified opinion is appropriate since there is adequate disclosure.

7. Accounting principles used in the financial statements have not been consistently applied.

(1) Unqualified standard wording

19-9.

Young Manufacturing Corporation

The auditors report on his examination of the financial statements of the Young Manufacturing Corporation includes the following deficiencies: 1. 2. 3. 4. 5. The audit report has no title. It should include a phrase such as independent auditors report. The audit report is addressed to the president. It is usually more appropriate to address it to the stockholders or board of directors. The date of the auditors report should be the date of the completion of the auditors field work, not the balance sheet date. The report includes only two paragraphs. It should be three paragraphs if it is standard wording, or more if there is a violation of GAAP, which there is. There must be reference to both the 2011 and 2010 financial statements in the scope and opinion paragraphs, including a statement about the degree of responsibility the auditor is taking for each years statements. The auditors report is deficient because the dates of the balance sheet and the period covered by the income statement are not given. These dates should be given so that the reader will clearly understand that the opinion is limited to specific financial statements. Clarification as to the statements

6.

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Solutions Manual to Accompany Applied Auditing, 2010 Edition covered by the opinion is imperative because comparative financial statements are presented. 7. The title Balance Sheet is used in the report, but statements of condition is employed as the title of the financial statement. Different titles should not be used because a criterion of professional work is that uniform and accurate terminology be used. Although the auditors report states that he or she examined the Statement of Income and Retained Earnings, the attached financial statements do not include the Retained Earnings statement. All financial statements referred to in the auditors report should be appended to the report. The difference of P66,481 between the opening and closing balances of the Retained Earnings account is not reconcilable to the reported net income for the year of P52,924. Because an amount of P13,557 in the Retained Earnings account is not accounted for, the auditors report should contain at least a qualification on the grounds of inadequate disclosure. If the auditors examination disclosed that the P13,557 is a net amount of charges and credits to the Retained Earnings account, some of which bear directly upon the current years income statement, the auditor may be compelled to render an adverse opinion. 9. There is no reference in the introductory paragraph to the responsibilities of the auditor and management.

8.

10. The mandatory standard scope paragraph is excluded. 11. Two items in the Statements of Condition, Accounts receivable and Inventories, are listed as pledged, but no footnotes or comments disclose the nature or extent of the commitments. The item other liabilities probably represents the liability for which the assets serve as security; its nature should be appropriately disclosed in the statements. Also, the terms of the long-term mortgage should be disclosed. Therefore, the auditor should disclose this information in a separate paragraph in the report and his or her opinion should be appropriately qualified. 12. The auditors report is written in the first person apparently because the auditor is an individual practitioner. Although some CPAs contend that it is inappropriate for an individual to practice under a style that denotes a partnership, individual practitioners generally use we rather than I in writing their reports. The we used in the report is the so-called editorial we and it is used because it is more formal, impersonal, and carries more dignity. As used in auditors reports we is not to be taken in its literal (plural) sense. 13. The opinion paragraph should contain the phrase in our opinion to clearly disclose that the statement as to fair presentation is a professional opinion, not a statement of fact.

Writing the Audit Report

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14. A statement of cash flows is not included in the financial statements of the audit reports introductory paragraphs. A qualified opinion is required when no statement of cash flows is included. 15. There is not inclusion of the phrase in all material respects in the opinion. 16. There should be no reference to consistency in the opinion paragraph. 17. The opinion paragraph should include no reference to what is done on the audit. That should be in the scope paragraph. 18. As stated above, the opinion paragraph should not be unqualified, because of the missing statements or retained earnings and cash flow and the omitted footnotes. 19-10. Star Corporation The auditors' report contains the following deficiencies: Introductory paragraph Not all the financial statements audited are identified. The second sentence on auditors responsibility must be stated after the paragraph on managements responsibility for the financial statements.

Managements responsibility for the financial statements The paragraph on management's responsibility for the financial statements is omitted.

Auditors responsibility/ Scope paragraph Reference to "Philippine Standards on Auditing" is omitted. An auditor obtains reasonable assurance about whether the financial statements are "free of material misstatement," not "in conformity with generally accepted accounting principles." The statement that an audit includes "evaluating the overall financial statement presentation" is omitted. The statement that the auditors "believe that the audit provides a reasonable basis for our opinion" is omitted.

Explanatory paragraph/Other reporting responsibilities The explanatory paragraph should follow the opinion paragraph. The auditors should not give an opinion concerning the entity's survival "beyond a reasonable period of time."

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Solutions Manual to Accompany Applied Auditing, 2010 Edition Opinion paragraph A qualified ("subject to") opinion is inappropriate. The date of the financial statements audited is omitted. There should be no reference to consistency unless the accounting principles have not been applied consistently. There is no reference to Philippine Financial Reporting Standards.

19-11.

Carmel Industries, Inc. Deficiencies in the audit assistant's draft include the following: (1) (2) (3) There is no heading such as "Independent Auditors' Report." The report is improperly addressed to the president. Reference to "Note K" pertaining to a subsequent event is inappropriate in the introductory paragraph. If the auditor wishes to emphasize this matter, such explanatory information should be presented in a separate paragraph of the auditors' report. There is no reference to the predecessor auditors in the introductory paragraph as required when the statements are in comparative form. There is no indication that an adverse opinion was expressed by the predecessor auditors. The separate explanatory paragraph does not make reference to the requirements of generally accepted accounting principles, i.e., property and equipment should be stated at an amount not in excess of cost and deferred income taxes should be provided. Therefore, all of the substantive reasons for the qualified opinion have not been disclosed. Also, this paragraph should precede the opinion paragraph. The separate explanatory paragraph does not disclose either the monetary effects of the violations of generally accepted accounting principles or that the effects are not reasonably determinable. The opinion paragraph does not include a direct reference to the separate explanatory paragraph that discloses the basis for the adverse opinion. No reference to consistency in the application of accounting principles should be made. The auditors' report is not properly dual dated.

(4) (5) (6)

(7)

(8) (9) (10)

Writing the Audit Report 19-12. Kristina Company Note 6

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Indentures relating to the long-term debt require that the company (1) will maintain working capital at not less than P4,500,000, and (2) will not pay cash dividends or purchase its common stock except to the extent of 70 percent of net earnings since January 1, 2010, plus P250,000, or if working capital would be reduced by such action to less than P5,000,000. At December 31, 2011, P2,441,291 of retained earnings was not restricted under the indentures.