Chapter 3: Audit Reports

Standard Unqualified Audit Report (For Non-Public Entities) (AICPA Auditing standards)
- The most common audit opinion
- Standard unqualified audit report is referred to a clean opinion, because there are no circumstances
requiring a qualification or modification of the auditors opinion
- Note - if a report is on comparative financial statements, a report on both years statements is
needed
- Eight distinct parts
o 1- Report Title: Report should be titled and title should include the word Independent, simply to
indicate the audit was unbiased (e.g. independent auditors report)
o 2- Audit Report Address: Report is usually addressed to the company, its stockholders or board
of directors (Sometimes does not include the company to make sure no bias)
o 3- Introductory Paragraph: Intro paragraph does 3 things
1- States that the CPA firm has performed an audit (which distinguishes the report from a
compilation or review report)
2- First paragraph should list the financial statements that were audited (including the notes
to the financial statements, as well as the balance sheet dates, and the accounting periods
for the income statement and statement of cash flows)
3- The wording of the financial statements in the report should be identical to those used by
management on the financial statements (It defines responsibilities between management
and the auditor)
o 4- Managements Responsibility: This heading and paragraph state that the statements are the
responsibility of management
This responsibility includes selecting the appropriate accounting principles and maintaining
internal control over financial reporting sufficient for preparation of financial statements
that are free of material misstatements brought on by either fraud or error
o 5- Auditors Responsibility: Contains three paragraphs
1- First paragraph states that the audit was conducted in accordance with auditing standards
generally accepted in USA. This paragraph also notes that the audit is designed to obtain
reasonable assurance about whether the financial statements are free of material
misstatement.
Material = auditors look for huge misstatements, not minor ones with no effect on user
Reasonable assurance = an audit does not guarantee no material misstatements
2- Scope paragraph - Second paragraph describes the scope of the audit and the evidence
accumulated.
The scope paragraph is a factual statement about what the auditor did in the audit and
sets the expectation about reasonable assurance
This paragraph indicates that the procedures depend on the auditors judgment and
include an assessment of the risk of material misstatements in the financial statements.
It also indicates that the auditor considers internal control relevant to the preparation
and fair presentation of the financial statements in designing the audit procedures
performed, but this assessment of internal control is not for the purpose and is not
sufficient to express an opinion on the effectiveness of the entitys internal control.
The last sentence of this paragraph indicates that the audit includes evaluating the
accounting policies selected, the reasonableness of accounting estimates, and the
overall financial statement presentation.
3- Third paragraph indicates the auditor believes that sufficient appropriate evidence has
been obtained to support the auditors opinion
o 6- Opinion Paragraph: states the auditors conclusions based on the results of the audit
Very important part-- it is why entire report is referred to auditors opinion
Conclusions are based on professional judgment-- It is stated as an opinion rather than as a
statement of absolute fact or guarantee --- In our Opinion indicates that even though an
audit was done, there may still be some information risk associated with the financial
statements
Note - financial statements are presented fairly when they are in accordance with GAAP;
also, it is necessary to examine the substance of transactions and balances for possible
misinformation
o 7- Name and Address of CPA Firm: The name identifies the CPA firm or practitioner who
performed the audit
Typically, the firms name is used because the entire CPA firm has the legal and professional
responsibility to ensure that the quality of the audit meets professional standards
City and state of the audit firm should also be indicated
o 8- Audit Report Date: The appropriate date for the report is the one on which audit field work is
completed)
This date is important to users because it indicates the last day of the auditors responsibility
for the review of significant events that occurred after the date of the financial statements
Ex. B/S is dated 12/31/13 and audit report is dated 2/15/14. This indicates that the auditor
had searched for material unrecorded transactions and events that occurred up to February
15, 2014
- Conditions for a Standard Unqualified Audit Report to be issued:
o 1- All statements (B/S, I/S, Statement of changes in equity, statement of cash flows) are included
in the financial statement. Anything missing is considered a lack of disclosure (a departure from
GAAP)
o 2- Sufficient appropriate evidence has been accumulated, and auditor conducted engagement
that enables them to conclude audit was performed in accordance with auditing standards
o 3- Financial statements are presented in accordance with U.S. GAAP (or other appropriate
framework). This also means that adequate disclosures have been included in the footnotes and
other parts of the financial statements.
o 4- There are no circumstances that require the addition of an explanatory paragraph or
modification of the wording of the report
- If any of the requirements for the standard unqualified audit report are not met, the standard
unqualified report cannot be issued.
- Categories of audit reports that can be issued by an auditor
o Standard unqualified - the four conditions stated above have been met
o Unqualified with Emphasis-of-matter Explanatory Paragraph or Modified Wording - a complete
audit took place with satisfactory results and financial statements that are fairly presented, but
the auditor believes that it is important or is required to provide additional information
o Qualified - the auditor concludes that the overall financial statements are fairly presented, but
the scope of the audit has been materially restricted or applicable accounting standards were not
followed in preparing the financial statements (Auditor has not performed a satisfactory audit)
o Adverse or Disclaimer - The auditor concludes that the financial statements are not fairly
presented (ADVERSE), he or she is unable to form an opinion as to whether the financial
statements are fairly presented (DISCLAIMER), or he or she is not independent (DISCLAIMER)

Unqualified Audit Report AND Report on Internal Control over Financial Reporting Under PCAOB
Auditing Standards (FOR PUBLIC ENTITIES) (PCAOB Auditing Standards)
- 2 main audit reporting differences for public companies
o 1- standard unqualified audit report is different when auditing public companies statements
o 2- auditors of larger public companies must also issue an opinion on internal control over
financial reporting
- Overall, the report is quite similar to the audit report for non-public entities, but there are some
differences in wording
- Parts to the standard unqualified audit report for public companies
o Report Title
o Audit Report Address
o Introductory paragraph - indicates that an audit was performed and that the financial systems
were audited. It also indicates that the financial statements are the responsibility of
management and that the auditors responsibility is to express an opinion on the financial
statements.
Pretty similar to the first three paragraphs in the standard unqualified report for non-public
companies
o Scope Paragraph - Indicates that an audit is designed to provide reasonable assurance that the
financial statements are free of material misstatement. Scope paragraph also notes that auditing
is done on a test basis
Pretty similar to the scope paragraph of report for private
o Opinion Paragraph - states the auditors conclusions based on the results of the audit
Pretty similar to the opinion paragraph of report for private
o (OPTIONAL) - If auditor also issues a separate report on internal control over financial reporting,
a fourth paragraph follows the opinion paragraph referencing the audit report on internal
control
o CPA Firm name
o Audit Report Date

- Reporting on Internal Control over Financial Reporting
o Auditors of public companies subject to Section 404(b) of the Sarbanes-Oxley Act must attest to
managements report on the effectiveness of internal control over financial reporting
o Since 2004, larger public companies (known as accelerated filers) have been required by the SEC
to annually obtain an auditors report on internal controls over financial reporting

o PCAOB Auditing Standard 5 requires the audit of internal control to be integrated with the audit
of the financial statements.
However, the auditor may choose to issue separate reports or in a combined report
Separate report is more common
o Combined Report on financial statements and internal control over financial reporting (PUBLIC)
- addresses both the financial statements and managements report on internal control over
financial reporting
o Sarbanes-Oxley Act: Separate Report on Internal Control over financial reporting (PUBLIC
COMPANY): INCLUDES THESE ELEMENTS
The introductory, scope, and opinion paragraphs describe that the scope of the auditors
work and opinion is on internal control over financial reporting, and the introductory
paragraph highlights managements responsibility for and its separate assessment of internal
control over financial reporting
The introductory and opinion paragraphs also refer to the framework used to evaluate
internal control
Definition paragraph - a paragraph after the scope that defines internal control over
financial reporting
Inherent limitations paragraph - an additional paragraph before the opinion that addresses
the inherent limitations of internal control
Opinion paragraph - Multiple reporting periods are addressed in audit opinion, but the
opinion about the effectiveness of internal control is as of the end of the most recent fiscal
year
Cross-Reference Paragraph - last paragraph that includes a cross-reference to the auditors
separate report on the financial statements.
o An auditor can issue the following opinions on the separate report on the operating effectiveness
of internal control over financial reporting
Unqualified opinion
Qualified opinion
Adverse opinion
Disclaimer of opinion

Unqualified Audit Report with Emphasis-of-matter Explanatory Paragraph or Modified Wording
- This report meets the criteria of a complete audit with satisfactory results and financial statements
that are fairly presented, but the auditor believes that it is important or is required to provide
additional information
- Causes of the addition of an explanatory paragraph or modification in the wording of the standard
unqualified report under both PCAOB and AICPA audit standards
o Lack of consistent application of generally accepted accounting principles
Requires an explanatory paragraph following the opinion paragraph
o Substantial doubt about going concern
Requires an explanatory paragraph following the opinion paragraph
o Auditor agrees with a departure from promulgated accounting principles
Requires an explanatory paragraph following the opinion paragraph
o Emphasis of a matter
Requires an explanatory paragraph following the opinion paragraph
o Reports involving other auditors
If other auditors are involved in the report, reports use modified wording
- NOTE -
o Under PCAOB auditing standards, explanatory paragraphs are referred to as explanatory
paragraphs
o Under AICPA auditing standards, explanatory paragraphs were replaced with emphasis-of-
matter or other-matter paragraphs. Thus, if reporting on a non-public entity under AICPA
auditing standards, the explanatory paragraph should be preceded by the header Emphasis of a
Matter
- Lack of Consistent application of GAAP
o Auditors must note circumstances in which accounting principles are not consistently applied
(Auditors are required to adequately disclose circumstances in which accounting principles have
not been consistently observed in the current period in relation to the preceding period.)
o When a material change occurs, the auditor should modify the report by adding an explanatory
paragraph after the opinion paragraph that discusses the nature of the change and points the
reader to the footnote that discussed the change.
Materiality of the change is evaluated based on the current year effect of the change
Explanatory paragraph is required for both voluntary changes and required changes due to a
new accounting pronouncement
o NOTE - if report includes explanatory paragraph, its implicit that auditor agrees with the
appropriateness of the change in accounting principles. If it doesnt, the auditor believes the
change is a violation of GAAP and the auditors opinion must be qualified.
o Consistency versus Comparability
Changes that affect consistency (and therefore requires an explanatory paragraph if
changes are material):
1- changes in accounting principles, such as a change from FIFO to LIFO 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
Changes that affect comparability (but not consistency) (and therefore need not be
included in the audit report):
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 years mathematical
error
3- Variations in format and presentation of financial information
4- Changes because of substantially different transactions or events, such as new
endeavors in R&D or the sale of a subsidiary
o Items that materially affect comparability of financial statements generally require disclosure
in the footnotes
o If client refuses to properly disclose the items, a qualified audit report for inadequate disclosure
may be required
- Substantial Doubt about Going Concern
o Auditor has a responsibility under auditing standards to evaluate whether the company is likely
to continue as a going concern
o The existence of one or more of the following factors causes uncertainty about the companys
ability to continue as a going concern:
1- significant recurring operating losses or working capital deficiencies.
2- Inability of the company to pay its obligations as they come due.
3- Loss of major customers, the occurrence of uninsured catastrophes (ex. flood), or unusual
labor difficulties
4- Legal proceedings, legislation, or similar matters that might jeopardize the entitys ability
to operate.
o Auditors concern in such situations is likelihood client cannot continue its operations or meet its
obligation for a reasonable period
A reasonable period is considered not to exceed 1 year from the date of the financial
statements being audited
o If auditor concludes there is substantial doubt about the entitys ability to continue as a going
concern, an unqualified opinion with an explanatory paragraph is required, regardless of the
disclosures in the financial statements
o A disclaimer can also be issued, but its not required by Auditing standards. In fact, disclaimers
are rarely issued in practice
- Auditor Agrees with a Departure from a Promulgated Principle
o Departure from GAAP may not require a qualified or adverse opinion (AICPA Code of
Professional Conduct Rule 203)
o However, to justify an unqualified opinion, the auditor must be satisfied and must state and
explain, in a separate paragraph or paragraphs in the audit report, that adhering to the principle
would produce a misleading result in that situation
o Usually happens with unusual circumstances
- Emphasis of a Matter
o 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
o Normally, such explanatory information should be included in a separate paragraph in the report
o Examples of explanatory information the auditor may report as an emphasis of a matter include:
The existence of material related party transactions
Important events occurring subsequent to the balance sheet date
Accounting matters affecting comparability of the financial statements with those of the
preceding year
Material uncertainties disclosed in the footnotes
- Reports Involving other Auditors
o If client has widespread operations, CPAs often rely on other CPA firms to perform part of the
audit
o Primary auditor issuing the opinion on the financial statements = referred to as principal auditor
under PCAOB auditing standards and as group engagement partner under AICPA auditing
standards
o Other auditors who perform work on the financial information of a component is called the
component auditor under AICPA auditing standards
o When the CPA relies on a different CPA firm to perform part of the audit, the principle CPA has
three alternatives.
1- Make no reference in the audit report
If no reference is made to the other auditor, a standard unqualified opinion is given,
that is unless other circumstances require a departure
This approach is usually followed when the other auditor audits an immaterial portion
of the statements, the other auditor is well known or closely supervised by the principal
auditor, or the principal auditor has thoroughly reviewed the other auditors work
2- Make reference in the report (Unqualified report with modified wording)
This report is called a shared opinion or report
A shared unqualified report is appropriate when it is impractical to review the work of
the other auditor or when the portion of the financial statements audited by the other
CPA is material in relation to the whole
The report does not include a separate paragraph that discusses the shared
responsibility -- but does so in the auditors responsibility and opinion paragraphs
The portion of the statements audited by the other auditor can be stated as
percentages or absolute amounts
3- Qualify the opinion
A qualified opinion or disclaimer, depending on materiality, is required if the principal
auditor is not willing to assume any responsibility for the work of the other auditor
Principal auditor may also decide that a qualification is required in the overall report if
the other auditor qualified his or her portion of the audit

Departures from an Unqualified Opinion -- three conditions
- 1- Scope limitation - (The scope of the audit has been restricted)
o When the auditor has not accumulated sufficient appropriate evidence to conclude whether the
financial statements are stated in accordance with GAAP
o Two causes of scope restrictions
Restrictions imposed by the client
Ex. managements refusal to permit auditor to confirm material receivables
Ex. managements refusal to permit auditor to physically examine inventory
Restrictions caused by circumstances beyond either the clients or auditors control
Ex. auditor is not appointed until after the clients year-end --- this may make it
impossible to physically observe inventories, confirm receivables, etc. after the balance
sheet date
- 2- GAAP departure - F/S not prepared in accordance with GAAP
o Client insists on using a method that is not consistent with GAAP
o Ex. Client insists on using replacement costs for fixed assets
o Ex. Client values inventory at selling price rather than historical cost
- 3- Auditor is not independent
o Independence ordinarily is determined by Rule 101 of the rules of the Code of Professional
Conduct
- If any of the three conditions exists and is material, a report other than an unqualified report must
be issued

Qualified Opinion
- Can result from a limitation on the scope of the audit or failure to follow generally accepted
accounting principles
o Qualified opinion report can be used ONLY when auditor concludes that the overall financial
statements are fairly stated
o Disclaimer or adverse report must be used if auditor believes the condition being reported is
highly material
- Qualified report can take the form of a qualification of both the scope and the opinion or of the
opinion alone.
o Scope and opinion qualification can be issued ONLY when the auditor has been unable to
accumulate all of the evidence required by auditing standards (either because of client
restrictions or when circumstances exist that prevent auditor from conducting a complete audit)
o The use of a qualification of the opinion alone is restricted to situations in which financial
statements are not stated in accordance with GAAP
- When qualified report is issued, auditor must use the term EXCEPT FOR. - This implies that the
auditor is satisfied that the overall financial statements are correctly stated, except for a specific
aspect of them

Adverse Opinion
- Used only when the auditor believes that the overall financial statements are so materially misstated
or misleading that they do not present fairly the financial position or results of operations and cash
flows in conformity with GAAP
- Adverse opinion can arise only when the auditor has knowledge, after an adequate investigation, of
the absence of conformity
- This is uncommon and thus, the adverse opinion is rarely used

Disclaimer of Opinion
- Issued when the auditor is unable to be satisfied that the overall financial statements are fairly
presented
o Disclaimer is different from an adverse in that it arises ONLY from a lack of knowledge by the
auditor (whereas adverse opinions arise when auditor has knowledge that the financial
statements are not fairly stated)
o Both disclaimers and adverse are used ONLY when condition is highly material
- The necessity for disclaiming an opinion may arise because of a severe limitation on the scope of the
audit or a non-independent relationship under the Code of Professional Conduct between the auditor
and the client
- The auditor can also issue a disclaimer of opinion for a going concern problem

Materiality
- 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
- Materiality is an essential consideration in determining the appropriate type of report
o Ex. if misstatement is immaterial relative to the F/S of the entity for the current period, it is
appropriate to issue an unqualified report
- 3 Levels of Materiality
o 1- Amounts are immaterial
Management may fail to follow GAAP, but if amounts are small, the misstatement is
immaterial and is unlikely to affect the decisions of a reasonable user.
Thus, a standard unqualified audit report is still appropriate
Ex. Management recorded prepaid insurance as an asset in one year, but in the next,
expensed it to reduce record-keeping costs
o 2- Amounts are material but do not overshadow the financial statements as a whole
Misstatement in financial statements would affect a users decision, but the overall
statements are still fairly stated and therefore useful
Ex. A misstatement of inventory does not mean that cash, A/R, and other elements of the
financial statements, are materially incorrect
A Qualified Opinion is appropriate
o 3- Amounts are so material or so pervasive that overall fairness of the statements is in question
Highest level of materially exists when users are likely to make incorrect decisions if they rely
on the overall financial statements
Ex. If inventory is misstated, but its a big deal because inventory is the largest balance on
the financial statements. Thus, auditor would indicate that financial statements taken as a
whole cannot be considered fairly stated
Auditor must issue a disclaimer of opinion or an adverse opinion
Pervasiveness: when determining whether an exception is highly material, the extent to
which the exception affects different parts of the F/S must be considered
o Misclassification between cash and A/R affects only those two accounts and is
therefore not pervasive
o However, failing to record a material sale is highly pervasive, because it affects
sales, A/R, income tax expense, accrued income taxes, and retained earnings == all
together, this affects total assets, current liabilities, total liabilities, owners equity,
gross margin, and operating income
As misstatements become more pervasive, the likelihood of issuing an adverse
opinion (Rather than a qualified opinion) increases
A disclaimer must be issued if the auditor is determined to lack independence -- any
deviation from independence rule is considered highly material
- Materiality Decisions
o There are no simple, well-defined guidelines that enable auditors to decide when something is
immaterial material, or highly material
o Materiality Decisions - Non-GAAP Conditions - When client fails to follow GAAP, the audit
report will be either unqualified, qualified opinion only, or adverse --- depending on the
materially of the departure
o Several aspects of materiality must be considered when client fails to follow GAAP
Dollar amount compared with a base
Any misstatements must be compared with some measurement base before a decision
can be made about materiality of the failure to follow GAAP
Common bases include net income, total assets, current assets, and working capital.
And when comparing potential misstatements with a base, the auditor must carefully
consider all accounts affected by a misstatement (pervasiveness)
Measurability
Some misstatements cannot be accurately measured (e.g., existing lawsuit, acquisition
of a new company subsequent to the balance sheet date)
To determine if material, auditor must evaluate the effect on statement users the failure
to make the disclosure of such things
Nature of the item
The decision of a user (and therefore the auditors opinion) may also be affected by the
kind of misstatement:
1- Illegal or fraudulent transaction
2- an item that may be material in some future period but immaterial in the current
period
3- An item changing a small loss to a small profit
4- An item that may be important in terms of possible consequences arising from
contractual obligations
o Materiality Decisions - Scope Limitations Condition
If scope limitation exists in an audit, the audit report can be either unqualified, qualified
scope and opinion, or disclaimer, depending on the materiality of the scope limitation
It is more difficult to evaluate the materiality of potential misstatements resulting form a
scope limitation than for a failure to follow GAAP
WHY? Because misstatements resulting from failure to follow GAAP are known. Those
resulting from scope limitations must be subjectively measured in terms of potential or
likely misstatements
Ex. a recorded AP of 400K might be understated by more than $1 million, which may
affect several totals, including gross margin, net earnings, and total assets
Auditor will consider measurability, the nature of the item, and the dollar amount compared
with a base, just like as auditor would do with non-GAAP conditions
The size of the potential misstatements is more important here as well

- Discussion of Conditions Requiring a Departure
o If departure from an unqualified report is required, the wording and nature of the paragraph
explaining the reason is similar under both AICPA and PCAOB standards
o 1- Auditors Scope has been restricted
Categories of scope restriction
Restricted by client
o Auditor should be concerned about the possibility that management is trying to
prevent discovery of misstated information
o In such cases, auditing standards encourage a disclaimer of opinion when
materiality is in question
o When disclaimer needed, the first (introductory) paragraph is modified slightly to
say We were engaged to audit. The first paragraph of the auditors
responsibility is modified to indicate that the auditor was not able to obtain
sufficient appropriate evidence to express an audit opinion. The last two
paragraphs under auditors responsibility included in the unqualified audit report
are eliminated to avoid stating anything that might lead readers to believe that
other parts of the financial statements were audited and therefore might be fairly
stated
Restricted by conditions beyond the control of either the client or the auditor
o Qualification of scope and opinion is more likely
o When restricted, auditor must include a qualifying paragraph preceding the opinion
to describe the restriction
When scope restriction exists, appropriate response is to issue an unqualified report, a
qualification of scope and opinion, or a disclaimer of opinion, depending on materiality
o 2- Statements are not in conformity with GAAP
If auditor realized statements are non-GAAP, and client is unable or unwilling to correct the
misstatement, he or she must issue a qualified or an adverse opinion
The opinion must clearly state the nature of the departure from accepted principles and the
amount of the misstatement, if known
If adverse opinion required (Because amounts are so material or pervasive), the scope is still
unqualified, and the qualifying paragraph can stay the same, but opinion paragraph must be
changed to an adverse opinion.
When client fails to include information necessary for fair presentation of statements (either
in the body of statements or in footnotes), auditor must present the information in the audit
report and issue a qualified or adverse opinion. This information must be put in an added
paragraph preceding the opinion (and it must be referred to in the opinion paragraph.)
Rule 203 - when auditor allows departure from GAAP because adherence would lead to
misleading financial statements. If this is the case, there should be a complete explanation of
the departure and why GAAP would be misleading in an added paragraph. (Opinion
paragraph should then be unqualified, except for the reference to the added explanatory
paragraph)
o 3- Auditor is not independent
Disclaimer of opinion is required -- even if all audit procedures considered necessary were
performed
Lack of independence overrides any other scope limitations -- therefore, no other reason
for disclaiming an opinion should be cited. There should be no mention in the report of any
performance of audit procedures. Its a simple one-paragraph audit report.

- Auditors decision process for audit reports
o 1- Determine whether any condition exists requiring a departure from a standard unqualified
report.
If no conditions exist, which is the case in most audits, the auditor issues a standard
unqualified audit report
o 2- Auditor should then decide materiality for each condition (and how they affect financial
statements)
o 3- Decide the appropriate type of report for the condition, given the materiality level
o 4- Write the audit report



- More than one condition requiring a departure or modification (From an unqualified report or
modification of the standard unqualified report)
o In such a situation, auditor should modify his or her opinion for each condition unless one has
the effect of neutralizing the others
o Ex. if there is scope limitation and a situation in which auditor is not independence, the scope
limitation should not be revealed
o Examples of when more than one modification should be included in the report
The auditor is not independent and the auditor knows that the company has not followed
GAAP
There is a scope limitation and there is substantial doubt about the companys ability to
continue as a going concern
There is substantial doubt about the companys ability to continue as a going concern and
information about the causes of the uncertainties is not adequately disclosed in a footnote
There is a deviation in the statements preparation in accordance with GAAP and another
accounting principle was applied on a basis that was not consistent with that of the
preceding year

- Proposed Use of International Accounting and Auditing Standards by U.S. companies
o
o Globalization of worlds capital markets are leading to calls for a single set of accounting
standards to be used around the world. (When the auditor reports on financial statements
prepared in conformity with IFRS, the auditor refers to those standards rather than U.S. GAAP.)