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 client’s or the auditor’s 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. Not material Somewhat material Very material Standard Opinion Qualified Opinion Adverse Opinion

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 Opinion—Scope Limitations Examples of scope limitations include: Failure to observe client’s ending inventories, because of client’s requests or a late appointment of the auditor by the client. Failure to confirm accounts receivable, because of client’s requests or missing or incomplete customer records. Other situations where inadequate accounting records exist.

8. Qualified Opinion—Scope Limitations Scope Limitation Yes Perform procedures and issue standard report* Are alternative procedures available? No Is the restriction a significant limitation? Yes Issue a disclaimer ofopinion 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

14. Comparison of Compilation, Review, and Audit Engagements

15. Comparison of Compilation, Review, and Audit Engagements

16. Comparison of Compilation, Review, and Audit Engagements

17. Comparison of Audits, Reviews and Compilations of Financial Statements

18. Comparison of Audits, Reviews and Compilations of Financial Statements

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. Management’s 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. Management’s 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 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 Section 404 of the Act requires the management of a public company to (1) assess the effectiveness of the company’s internal control over financial reporting; and (2) include in the annual report management’s assessment about whether the internal control is effective. Section 404 also requires (1) auditors to attest to and report on management’s assessment of internal controls; and (2) the PCAOB establish professional standards governing the auditor’s 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 Responsibilities—Internal Control over Financial Reporting Management: Designs and implements the system of internal control over financial reporting; evaluates the effectiveness of the company’s 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 company’s financial reporting process. Independent Auditor: Performs an audit of internal control over financial reporting and issues a report on management’s assessment of internal control over financial reporting and on the effectiveness of internal control over financial reporting; also performs an audit of the company’s financial statements.

32. What Management’s Report Will Include Under the SEC rules, management’s report on internal control over financial reporting should include the following information: Statement of management’s 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. Management’s assessment of the effectiveness of the company’s internal control over financial reporting as of the end of the company’s 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 management’s internal control assessment.

33. PCAOB Auditing Standard No. 2:An 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. Management’s 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 auditor’s attestation of internal control. AS No. 2 was effective beginning June 17, 2004.

34. The Independent Auditor’s Opinion The content of the auditor’s 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 auditor’s work prevent the auditor from expressing an opinion on the company’s 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 auditor’s 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 A—Illustrative Reports, available at pcaobus.org.

37. Source: Release No. 2004-001, pages 116−137, Appendix A—Illustrative Reports, available at pcaobus.org.

38. Source: Release No. 2004-001, pages 116−137, Appendix A—Illustrative 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) Integrated financial and internal control reporting (IFICR) Demanded by the capital markets (investors) Required by policymakers (SOX), regulators (SEC), standard setters (PCAOB) Overseen by the board of directors (the audit committee) Prepared by management (executive certifications) Audited by the independent auditors Submitted to shareholders and filed with the SEC in the form of: Executive certifications of financial statements and internal controls Management’s assessment of internal control over financial reporting (ICFR) Audit report on financial statements (Form 10-K) Audit report on ICFR

41. Integrated Financial and Internal Control Reporting (IFICR)

42. Integrated Financial and Internal Control Reporting (IFICR) (cont.)

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 Results in a global crisis that will take time Encourages regulatory reforms Creates significant risk to GDP growth Causes a global economic meltdown Increases likelihood of bankruptcy Causes unemployment http://www.youtube.com/watch?v=SwRFoxgEcHc&feature=related (VIDEO)

45. Practice Opinions

46. 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. Assume the following facts about the auditor:

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.