Module 5 Flashcards
(39 cards)
Auditing Opinions on Financial Statements
- Unqualified/Unmodified (clean or standard opinion
- Unqualified/Unmodified with explanatory
- Qualified
- Adverse
- Disclaimer
In Looking at external auditor’s responsibilities for fraud detections let us first look at what the auditors say about fraud detection in their report.
The AICPA and the PCAOB have very similar reports and report opinions, but use slightly different terminology AICPA now uses the terms Unmodified and modified (qualified, adverse, disclaimer) for categories of audit opinions.
Unqualified/Unmodified
Financial statements present fairly the financial position or results of operations and cash flows in accordance with GAAP or other financial reporting framework (e.g., IFRS).
Unqualified/Unmodified with Explanatory Paragraph
F.S. users need added information to better understand the F.S. or the audit.
- Shared audit responsibilities
- Going concern – Substantial doubt client will not survive for next 12 months.
- Client changed 1 or more accounting practices from prior period.
- Emphasis of a Matter (e.g., significant uncertainties).
For these circumstances, the auditor generally adds an explanatory paragraph AFTER their opinion paragraph for highlighting the items listed above. For sharing responsibilities, the auditor modifies other paragraphs of the report to say that the opinion is based on their audit and the REPORT of another audit firm. So, they are sharing both responsibilities and liability
Qualified
Financial Statements have 1 or 2 material noncompliances with GAAP or a material shortcoming in audit scope – generally caused by circumstance (hired too late) or client refused to allow auditor to perform certain audit procedures the auditor considered necessary.
Adverse
Financial Statements do NOT fairly present the financial position or results of operations and cash flows in accordance with GAAP or other financial reporting framework (e.g., IFRS).
Disclaimer
Auditor does not have sufficient evidence to give any opinion (because of material and pervasive audit scope limitations.
Contents of the Audit Report (AICPA)
- Introductory Paragraph
- Management Responsibility Paragraph
- Auditor Responsibility Paragraph
- Opinion Paragraph
The standard audit report has these 4 paragraphs or sections. One or more explanatory paragraph(s) would be added to provide additional information that we discussed earlier or to explain a modified opinion.
We will now look at the latest audit report wording from the AICPA standards that went into effect for audits of calendar year 2012 and later.
Introductory Paragraph
Introductory Paragraph
We have audited the accompanying consolidated balance sheets of ABC Company and its subsidiaries, as of December 31, 20X1 and 20X0, and the related consolidated statements of income, retained earnings, and cash flows for the years then ended.
Management’s Responsibility Paragraph
Management’s Responsibility Paragraph
Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with accounting principles generally accepted in the United States of America; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of consolidated financial statements that are free from material misstatement, whether due to fraud or error.
- According to the auditor, client management, and frequently their accountants, are responsible for internal controls to prevent or detect fraud that would impact the financial statements. This is consistent with what Sarbanes-Oxley Act says for issuers or public companies and the COSO integrated framework for internal controls.
Auditor’s Responsibility Paragraph
Auditor’s Responsibility Paragraph
Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement.
An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditor’s judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity’s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but NOT for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements.
We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion.
- The auditor is only providing “reasonable assurance” of detecting material misstatement in the financial statements – whether caused by error/mistakes, (unintentional), fraud (intentional) or noncompliances with laws (illegal acts) or regulations.
- The middle paragraph vaguely describes what the auditor does on a financial statement audit. “Materiality” means that auditors do NOT look for immaterial or insignificant errors or fraud.
Opinion Paragraph
Opinion Paragraph
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of ABC Company and its subsidiaries as of December 31, 20X1 and 20X0, and the results of their operations and their cash flows for the years then ended in accordance with accounting principles generally accepted in the United States of America.
- The auditor is only providing “reasonable assurance” of detecting material misstatement in the financial statements – whether caused by error/mistakes, (unintentional), fraud (intentional) or noncompliances with laws (illegal acts) or regulations.
- Materiality is reiterated in the audit opinion.
Management Assertions
Every financial statement has embedded assertions or statements that the client is making to financial statement reader about their company’s financial position or the financial results of operations or cash flows.
Sometimes these assertions or statements are mis-stated, which can mislead financial statement users and they may make financial decisions that they would not make if the financial statements were more reliable
Mgmt assertions embedded in F.S. (A/C level and F.S. level)
Now categorized for consistency with International Auditing Standards:
(1) Account Balances
(2) Transactions/Events
(3) Presentation & Disclosures in F.S.
- Existence - Balance sheet, Occurrence - Income Statement
- Existence means valid.
- Completeness = All transactions and balances that should be are reflected in F.S.
- Rights = Bal Sheet (assumed no restriction to rights unless disclosed in F.S.)
- Valuation = GAAP Allocation = What period
- Accuracy = of the data/info supporting recorded transactions
- Presentation & Disclosure = GAAP, esp. pronounced GAAP from the FASB. Described = account title; Classified = where on F.S (such as current vs noncurrent).
- Which ones are most important to auditor? - Generally ones which overstate financial position or results of operations
Three Categories of GAAS/PCAOB
- General Standards-for the individuals=
- Standards of Field Work-conducting the audit
- Standards of Reporting-what is in the report
Recently, the AICPA has rewritten its overall GAAS, into premises, but still has basically these 3 categories still in the PCAOB GAAS.
What does a financial statment offer?
- Only reasonable assurance, not an absolute guarantee of F.S. fairness.
- Only search for material misstatements.
- GAAS requires sufficient appropriate (relevant & reliable) evidence.
- Due professional care must be exercised.
- Audit firm must be independent of the client
Remember from the AICPA Code of Professional Conduct we covered in module 4 that the external auditors must respect the public trust.
What is reasonable assurance?
- High level of assurance, but not absolute
- Audit evidence more likely persuasive rather than convincing or conclusive:
- Nature of audit testing-not 100% and involves use of professional judgment
- Nature of audit evidence (e.g., accounting estimates)
- Characteristics of fraud, including concealment
Reasonable assurance is similar to what is required as proof of guilt in a civil court case as compared to a criminal trial what the proof of guilt must be beyond a reasonable doubt.
Materiality
Materiality
“The magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.”
Source: FASB’s Financial Accounting Concepts No. 2
According to the AICPA, the “reasonable person” is one who has some financial statement analysis skills
Error versus Fraud
Errors = Unintentional F.S. Misstatements or omissions of amounts or disclosures
Fraud = Intentional acts that cause a F.S. misstatement
According to the AICPA, there are two types of financial statement fraud
- Fraudulent financial reporting or
- Theft of assets (also called defalcation)
The only real difference between errors and fraud is the reason the resulting misstatements occurs – accidentally or on purpose. Fraudulent financial reporting is generally more likely to be material as they are done to purposely misstatement the financial statements to gain a financial advantage over others.
Theft of asset fraud is usually done for personal gain.
Why is F.S. fraud so hard to detect?
- There is usually significant effort to conceal material fraud
- Senior management frequently leading material fraud.
- Based on a COSO 2010 study of SEC investigations:
- 72% of cases: CEO involved.
- 65% of cases: CFO involved.
- 89% of cases: CEO and/or CFO involved.
- Revenue/Sales misstatements largest in amount and number. GAAP very flexible in this area and there are usually related misstatements to accounts receivables.
Auditor’s Responsibility for Fraud Detection
Risk
- Assess the risk of errors and fraud that may cause the financial statements to contain a material misstatement.
- Obtain information to assess the inherent risks and fraud risks:
- Information about the company and its environment
- Discussion among audit team members
- Inquiries of management and others
- Planning analytical procedures, including those involving revenue
Fraud used to be called Irregularities. Assessing the risk of fraud having occurred is necessary to be able to have an increased probability of finding it. Prevention: Auditor has no direct responsibilities to prevent client fraud. But, we are to discuss fraud risks and approached to preventing & detecting with client management and our assessments with those charged with governance.
Auditor’s Responsibility for Fraud Detection
(Professional Skepticism)
- Based on that assessment, plan and perform the audit to obtain reasonable assurance that material misstatements, whether caused by errors or fraud, will be detected (including specific steps required by SAS 99
- Exercise due care in planning, performing and evaluating the results of audit procedures, and the proper degree of professional skepticism to achieve reasonable assurance that material misstatements due to error or fraud will be detected.
We must be Professionally Skeptical, otherwise we are less likely to detect the concealment of fraud. And, we must exercise due professional care in interpreting the audit evidence we obtain.
Professional Skepticism
- Toughest attribute for some auditors.
- Basically means that we must have support for our conclusions that is:
- Convincing (consider competency/reliability)
- Corroborated (consistent evidence)
- Verified or Tested by the auditor
Since senior client management is frequently involved in major financial statement fraud, the support documentation and explanations provided to the auditor may have been manipulated to conceal the fraud. Most fraud detected by auditors start with identifying inconsistencies between the audit evidence.
Detection of Noncompliances w/Laws & Regulations
(Direct and Material Effect on F.S)
For those laws & regulations that are generally recognized as having a direct and material effect on financial statement amounts & disclosures–same as for errors & fraud:
- Assess the risk
- Plan and perform the audit to obtain reasonable assurance
- Exercise professional skepticism and due care
Examples: Laws & regs related to taxes, pensions, form or content of F.S. (SEC), industry-specific reporting, contracts/grants with the government that could affect revenue or expense recognition. Reference is AU-C 250. These are Laws & Regs that generally have a direct effect on determining material amounts or disclosures in the F.S.
Detection of Noncompliances w/Laws & Regulations
(NOT Direct and Material Effect on F.S)
For those laws & regulations that are NOT generally recognized as having a direct effect, but could still have a material effect, on financial statements (generally disclosures):
- Inquire of management and, when appropriate, those charged with governance about whether the entity is in compliance with such laws and regulations.
- Inspect correspondence, if any, with the relevant licensing or regulatory authorities.
Examples: Related solely to operations (anti-trust) or fines/penalties that could be levied, terms of a license, regulatory solvency requirements, workplace or environmental regs.
