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AUDITED FINANCIAL STATEMENTS—THE BASICS

Company's Management: Financial Statements


Auditors: Expression of Opinion (on financial statements and if publicly traded, management's assertion on internal
control)
Primary assertion: whether statements are "presented fairly" in accordance with GAAP.
PROFESSIONAL STANDARDS
Auditing Standards:
GAAS: Generally Accepted Auditing Standards
GAGAS: Generally Accepted Government Auditing Standards
PCAOB: The Public Company Accounting Oversight Board
Auditing Guidance: The GAAS Hierarchy
1. Statements on Auditing Standards (SASs)
2. Interpretive Publications
3. Other Auditing Publications (i.e. journals, textbooks)
GAAS
General Standards
T - Training
I - Independence (in appearance and fact)
P - Professional Care
Standards of Fieldwork
P - Planning and Supervision
I - Internal Control, Entity, and Environment
E - Evidence
Standards of Reporting
A - Accounting = GAAP -- Must State (Explicit)
C - Consistency -- Silence is OK (Implicit)
D - Disclosure -- Silence is OK (Implicit)
O - Express Opinion -- Must State (Explicit)
Weak internal control does NOT equal adverse opinion
Taken as a whole applies equally to a complete set of financial statements, and to an individual financial statement, such

as a balance sheet.
- Different opinions are okay
- One statement opinions are okay
REPORTS ON AUDITED FINANCIAL STATEMENTS
Auditor's Standard Report (Unqualified Opinion)
A. Title ("Independent" auditor's report)
B. Addressee (To company, stockholders, board of directors, generally not addressed to management.)
C. Introductory Paragraph
1. Statement that the financial statements were audited
2. RR - Responsibility of management is financial statements and Responsibility of auditor is
to express an opinion.
D. Scope Paragraph
1. AA - Audit was conducted in Accordance with US GAAS
2. PP - audit was Planned and Performed to obtain reasonable assurance
MM - that the financial statements are free from Material Misstatement
3. EE - audit included Examining Evidence on test basis
AA - Assessing the Accounting Principles used
MM - significant estimates Made by Management
4. Statement that audit provides reasonable basis for opinion.
E. Opinion Paragraph
1. Statement referring to financial statements identified in intro paragraph
2. Opinion to fair representation of financial statements (ACDO)
3. Statement regarding conformity with US GAAP (ACDO)
F. Firm Name (signed or printed)
G. Report Date (on or after the date when audit evidence was obtained.)
RR - Responsibility of management = financial statements, Responsibility of auditor = express opinion.
AA - Audit was conducted in Accordance with US GAAS
PP - audit was Planned and Performed to obtain reasonable assurance
MM - that the financial statements are free from Material Misstatement
EE - audit included Examining Evidence on test basis
AA - Assessing the Accounting Principles used
MM - significant estimates Made by Management
GAAS --- Scope Paragraph
GAAP---Opinion Paragraph
Types of Opinions:
1. Unqualified (Clean) Opinion

a. Explanatory Language (Modified Unqualified Opinion)

2. Qualified Opinion (Except For)----- Material GAAP or GAAS Problem

3. Adverse Opinion----- Very material GAAP Problem

4. Disclaimer of Opinion----- Significant GAAS Problem

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Unqualified Opinion
Uncertainty and GAAP requires:

Management`s Responsibility:

a. Probable and reasonably estimable = record

b. Only probable, andnot estimable = disclose



Auditor`s Responsibility
a. If supported and properly recorded or disclosed, then issue unqualified opinion with no reference to
uncertainty.
b. If unable to obtain sufficient evidence, then scope limitation = GAAS problem. Issue qualified or disclaim
opinion.
c. If financial statement is materially misstated due to a departure from GAAP = GAAP problem. Issue
qualified or adverse opinion.
Modified Unqualified Opinion
1. Modified Wording:
a. Division of responsibility (opinion based in part on another auditor`s report.)
2. Explanatory Paragraph:
a. Necessary and justified departure from GAAP
b. Going concern

c. To emphasize a matter

d. A justified lack of consistency

e. Required SEC regulation S-K quarterly financial data has been omitted or not reviewed
f. Supplementary information required by GAAP has been omitted

g. Other information in a document containing audited financial statements is materially inconsistent with
information appearing in the financial statements.
General Rule on Position of Explanatory Paragraph:
1. Unqualified Opinion:
a. Explanatory paragraph generally would follow the opinion paragraph
2. Qualified, adverse, and disclaimer of opinion:
a. Explanatory paragraph generally would precede the opinion paragraph
3. Exceptions:

a. The explanatory paragraphs can be either before or after the opinion paragraph, if:

i. Justified GAAP departure

ii. Emphasis of a matter


1.Division of responsibility (modified unqualified): opinion based in part on another auditor`s report.
a. The principal auditor will mention this division in all three paragraphs.
i. Name of the other auditor is not mentioned unless that auditor gives express permission and
the report of the other auditor is presented.
ii. The work done by other auditor is expressed in terms of percentage, total assets, or other
appropriate criteria in the introduction paragraph.

b. Assumption of responsibility (no reference of other CPA)

i. The principal auditor should:

1. Visit the other auditor and discuss the procedure.

2. Review the audit program, audit documentation, and evaluation of internal control
performed by the other auditor.
c. Treat the other CPA just like your staff:
R – Reputation
I – Independent
P – Professional Competency
P – Program Steps
2.Necessary or Justified Departure from GAAP (modified unqualified):
a. Explanatory paragraph should contain a description of the departure, its approximate effects, and the
reasons why adherence to GAAP would make financial statements misleading.
b. Unjustified departures = Qualified ``Except for`` or Adverse opinion

3.Going Concern (modified unqualified):

a. The going concern period should not exceed one year from date of statements being audited

b. The procedures to follow that is contrary to the basic principle of going concern:

A – Analytical procedures

D – Debt compliance: auditor should review terms of debt and loan agreements

M – Minutes: auditor should review minutes from stockholder and board of director meetings
I – Inquiry of client`s legal counsel
T – Third parties: the auditor should confirm the details of financial support arrangements
S – Subsequent events review
c. Conditions and Events that may be indicative of substantial doubt:
F – Financial difficulties: loan defaults, dividend arrearages, debt restructuring
I – Internal Matters: work stoppages, labor difficulties, significant revision of operations
N – Negative Trends: recurrent losses, working capital deficiencies, negative cash flows
E – External Matters: Legal proceedings, new legislation, loss of a franchise, license, or patent
d. Mitigating Factors:
i. Plans to borrow money, restructure debt, to sell assets, delay or reduce expenditures, to
increase ownership equity.
e. Alleviation of Doubt

i. If going concern is alleviated, auditor should still consider the need for disclosure of the
conditions and events that initially gave rise to the doubt.
f. Modified Unqualified vs. Disclaimer
i. The auditor can still choose to disclaim an opinion in cases involving uncertainties.
g. Sample report – Explanatory Paragraph AFTER Opinion Paragraph
i. Wording of explanatory paragraph must include the terms `Substantial Doubt`` and ``Going
Concern``
If, in the auditor`s judgement, the entity’s disclosures are inadequate, a departure from GAAP exists. This may
result in either a qualified or adverse opinion.
4.Emphasis of a Matter (modified unqualified): Professional Judgement
a. Items of emphasize:

i. Related party transaction

ii. A significant subsequent event

iii. The entity is a component of a larger business enterprise

iv. Accounting matters affect the comparability of the statements

v. Always emphasize when the company is a ``RECC``


b. Not required, and can be put either before or after the opinion paragraph
5.Lack of Consistency (modified unqualified): Justified changes in accounting principle: ACDO

a. The auditor would consider whether:

i. The change is to an acceptable principle

ii. The method of accounting for the change is acceptable

iii. Management is justified in the change

b. If any of the 3 conditions is not met, the auditor would generally express a qualified opinion

c. If the change in GAAP is material, then the explanatory paragraph comes AFTER the opinion paragraph

d. No revision to the report if:


i. Effect of a change in GAAP is immaterial
ii. Changes in accounting estimates or corrections of errors do not affect the consistency standard
e. Modification required if:
i. Corrections of an error in principle do affect consistency and would require a consistency
modification.
ii. If the year in which the change occurred is presented, the explanatory paragraph is required in
subsequent years`reports.
iii. Changes in deprecation method, not change in estimate, require addition of an explanatory
paragraphThe Qualified Opinion – GAAP Problems
Qualified ``Except For`` GAAP
1. Non-GAAP Change
2. Inadequate Disclosure
3. Unjustified Departure from GAAP
4. Unreasonable Accounting Estimat

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1. Non-GAAP Change in Accounting Principle (GAAP ISSUE: Qualified or Adverse):
a. Issue is consistency (ACDO)

b. The auditor would consider whether:

i. The change is to an acceptable principle

ii. The method of accounting for the change is acceptable

iii. Management is justified in the change


c. If any one of the 3 conditions is not met, the auditor would express a qualified or adverse opinion
d. An explanatory paragraph should appear before the opinion paragraph to describe the non-GAAP
accounting change and financial impact (is possible).
e. In short, this all takes place if the auditor disagrees with the GAAP change.

GAAP = acceptable justified = Modified Unqualified

Not GAAP = unacceptable unjustified = Qualified ``except for`` or Adverse
2.Inadequate Disclosure (GAAP Issue: Qualified or Adverse)
a. For statements to be in conformity with GAAP, they must include adequate disclosure of all material
matters (i.e. form, content, notes).

b. Failure to disclose:

i. Qualified or Adverse opinion

ii. If missing pertinent info, include in auditor`s report BEFORE the opinion paragraph = Middle
Paragraph
c. Reason for omission:

i. When the auditor believes the omitted items cause the statements to be deceptive, misleading,

or fraudulent, the auditor must insist that management correct the defect. If management

refuses, auditor should withdraw from engagement.


d. Special situation – No Statement of Cash Flows
i. The explanatory paragraph should disclose the fact that management has not presented a

statement of cash flows

1. Intro Paragraph: No mention

2. Scope Paragraph: No mention

3. Middle Paragraph: When practical, the auditor is required to disclose the missing

information and related financial effects in the explanatory paragraph. However, the

auditor is not required to prepare a statement of cash flows in the event the client

chooses not to present one.


4. Opinion Paragraph: The ``except for`` terminology
ii. Make sure the omission was not: false, fraudulent, deceptive, or misleading
3.Unnecessary Departure from GAAP (GAAP Issue: Qualified or Adverse)

GAAP = acceptable justified = Modified Unqualified

Not GAAP = unacceptable unjustified = Qualified ``except for`` or Adverse
a. Auditor would include an explanatory paragraph describing the departure from GAAP and if practical,
the financial impact of the departure. This will be BEFORE the opinion paragraph = Middle paragraph
4.Unreasonable Accounting Estimates (GAAP Issue: Qualified or Adverse)
a. For example, no account for ``allowance of doubtful account``, because this makes their income look

b. Depending on materiality, qualified or adverse opinion


The Adverse Opinion – GAAP Problems
1. Non-GAAP Change in Accounting Principle (GAAP ISSUE: Qualified or Adverse):
a. If any one of the 3 conditions are not met:

i. The change is to an acceptable principle

ii. The method of accounting for the change is acceptable

iii. Management is justified in the change


b. An explanatory paragraph should appear BEFORE the opinion paragraph to describe the non-GAAP
accounting change and financial impact (is possible).
c. Depending on materiality, qualified or adverse.
2.Inadequate Disclosure (GAAP Issue: Qualified or Adverse)
a. For statements to be in conformity with GAAP, they must include adequate disclosure of all material
matters (i.e. form, content, notes).

b. Failure to disclose:

i. Qualified or Adverse opinion

ii. If missing pertinent info, include in auditor`s report BEFORE the opinion paragraph = Middle
Paragraph
3.Unnecessary Departure from GAAP (GAAP Issue: Qualified or Adverse)
a. Auditor would include an explanatory paragraph describing the departure from GAAP and if practical,
the financial impact of the departure. This will be BEFORE the opinion paragraph = Middle paragraph
b. Depending on materiality, qualified or adverse.
4.Unreasonable Accounting Estimates (GAAP Issue: Qualified or Adverse)
a. Depending on materiality, qualified or adverse opinion

Format of the report: When the auditor expresses an adverse opinion, all reasons and financial impact should be

set forth in explanatory paragraph BEFORE the opinion paragraph. If financial impact is not determinable, the

auditor should state in report.



Not ``except for`` in opinion paragraph, but instead it is ``because of the effects of the matters discussed in
preceding paragraphs``
Adverse GAAP
1. Non-GAAP Change
2. Inadequate Disclosure
3. Unjustified Departure from GAAP
4. Unreasonable Accounting Estimate

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