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in a misleading statement.10

Statement of the Accounting Principles Board No. 4, “Basic Concepts and Accounting Principles Un-
derlying Financial Statements of Business Enterprises” (New York: AICPA, 1970), pars. 137“138.
AICPA Professional Standards, U.S. Auditing Standards/Attestation Standards, Vol. 1, AU Sec.
See the bodies designated by Council to promulgate technical standards in the Code of Professional
Conduct at www.aicpa.org.
AICPA, Rules of Conduct of the Code of Professional Conduct Visit www.aicpa.org.
Integration of Auditing and Related Accounting Standards 185

Thus the auditors may express an unqualified opinion; however, their audit re-
port should be modified to describe the circumstances.

With respect to the third standard of reporting, the auditors are
not required to state in their report whether the accounting principles have been
consistently applied in the current and preceding periods. However, as previously
mentioned, consistency in the application of accounting principles and adequate
informative disclosure in the financial statements can be assumed by the users un-
less the auditors take exception in their audit report. As the APB pointed out:

Consistency is an important factor in comparability within a single enterprise. Al-
though financial accounting practices and procedures are largely conventional, con-
sistency in their use permits comparison over time.11

The FASB reaffirmed its predecessor™s position in SFAC No. 2, which states:

Information about a particular enterprise gains greatly in usefulness if it can be com-
pared with similar information about other enterprises and with similar information
about the same enterprise for some other period or some other point in time. Com-
parability between enterprises and consistency in the application of methods over
time increases the informational value of comparisons of relative economic oppor-
tunities or performance. The significance of information, especially quantitative in-
formation, depends to a great extent on the user™s ability to relate it to some

Such a requirement is necessary because management has flexibility in the se-
lection of accounting methods or procedures. In the practice of accounting, several
alternative accounting methods are available to management for financial report-
ing. For example, the annual depreciation charges on the entity™s plant and equip-
ment may be computed on the basis of several acceptable depreciation methods.
As a result, the auditors must satisfy themselves that management has applied the
alternative accounting methods on a consistent basis from period to period in order
to enhance the comparability of the financial statements. The comparability of fi-
nancial statements is essential since the users of the statements make economic de-
cisions and thus need financial accounting information that is meaningful.
However, management can make changes in the application of alternative ac-
counting methods. Changes in the economic conditions that affect a particular en-
terprise may require a change in the application of an accounting method. For
example, a corporation may change its method of pricing inventory items because
of the inflationary conditions in the economy and the effects on the financial state-
ments. It is incumbent upon management to justify the change in the accounting
methods whereby a particular change enhances a fairer presentation in the finan-
cial statements. Such an accounting change should be disclosed in the financial

Statement of the Accounting Principles Board, No. 4, par. 98.
Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 2, “Quali-
tative Characteristics of Accounting Information” (Stamford, CT: FASB, May 1980), p. 2. See paras.
120“122 for additional emphasis.
186 Rules of the Road”Auditing and Related Accounting Standards

statements in order to indicate the effects of the change on the statements.13 More-
over, the auditors are required to point out the change in the application of the ac-
counting methods by modifying their report with an additional paragraph
following the opinion paragraph.14 (See Chapter 10.)

The third reporting standard regarding informative disclosures implies
that the information in the financial statements should be relevant to the users of ac-
counting information. The information in the body of the statements, footnotes, and
supplementary materials should be pertinent to the informational needs of the users.
The accounting principle related to this particular auditing standard is known as the
full disclosure principle. Under this principle, management has a reporting responsi-
bility to its constituencies to disclose financial information that is necessary for a
proper understanding of the financial statements. Such disclosure of information is
based on management™s judgment. Furthermore, the auditors have a professional
obligation to ensure reasonably adequate informative disclosures in the statements.
The fundamental recognition criteria are set forth by the FASB:

An item and information about it should meet four fundamental recognition criteria
to be recognized and should be recognized when the criteria are met, subject to a
cost-benefit constraint and a materiality threshold. Those criteria are:
Definitions”The item meets the definition of an element of financial statements.
Measurability”It has a relevant attribute measurable with sufficient reliability.
Relevance”The information about it is capable of making a difference in user
Reliability”The information is representationally faithful, verifiable, and neutral.
All four criteria are subject to a pervasive cost-benefit constraint: the expected ben-
efits from recognizing a particular item should justify perceived costs of providing
and using the information. Recognition is also subject to a materiality threshold: an
item and information about it need not be recognized in a set of financial statements
if the item is not large enough to be material and the aggregate of individually im-
material items is not large enough to be material to those financial statements.15

However, management may not disclose certain information because such dis-
closure may injure the entity™s competitive position.

With respect to materiality, the FASB indicates:

Individual judgments are required to assess materiality in the absence of authorita-
tive criteria or to decide that minimum quantitative criteria are not appropriate in

Opinions of the Accounting Principles Board No. 20, “Accounting Changes” (New York: AICPA,
1971), par. 17.
AICPA, Professional Standards, U.S. Auditing Standards/Attestation Standards, Vol. 1, AU Sec.
Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 5, “Recog-
nition and Measurement in Financial Statements of Business Enterprises” (Stamford, CT: FASB,
1984), par. 63.
Integration of Auditing and Related Accounting Standards 187

particular situations. The essence of the materiality concept is clear. The omission or
misstatement of an item in a financial report is material if, in the light of surround-
ing circumstances, the magnitude of the item is such that it is probable that the judg-
ment of a reasonable person relying upon the report would have been changed or
influenced by the inclusion or correction of the item.16

The Auditing Standards Board has reaffirmed the FASB position on materiality as
mentioned in SAS No. 47, “Audit Risk and Materiality in Conducting an Audit.”
Implicit in the preceding narrative is the pervasive influence of the materiality
principle on the financial statements. Although the materiality of a particular fi-
nancial fact is a matter of professional judgment, consideration should be given to
the significance of the information in relationship to the users™ information needs.
Such consideration may include the effect of the financial item on the entity™s net
income or financial condition. For example, an inventory loss of $10,000 would be
a material item in the financial statements of a small trading or manufacturing con-
cern because such a loss may represent 5 to 10 percent of the company™s assets.
However, in a large conglomerate enterprise with billions of dollars in assets, in-
ventory loss of $10,000 would be an immaterial item in the financial statements.
Thus the nature and size of the financial item and its relative importance to the fi-
nancial statements determine the materiality of the item. In short, no definitive
rules or criteria are used to judge materiality since the circumstances regarding
each audit examination vary.
In 1999, Arthur Levitt, former SEC chairman, reported that: “Staff Accounting
Bulletin 99 reemphasizes that the exclusive reliance on any percentage or numer-
ical threshold in assessing materiality for financial reporting has no basis in the ac-
counting literature or in the law.”17 As a result, independent auditors are required
to assess both quantitative and qualitative factors in their determination of whether
an item is material. Likewise, independent auditors are required to obtain an ac-
knowledgment from management of uncorrected misstatements and discuss these
misstatements with the audit committee.
To enhance the usefulness of the financial statements, the APB has adopted a
rule with respect to the disclosure of accounting policies. In particular, “the Board
believes that the disclosure is particularly useful if given in a separate ˜Summary of
Significant Accounting Policies™ preceding the notes to the financial statements or
as the initial note.”18 For example, the disclosures would include, among others, the
basis of consolidation, depreciation methods, inventory pricing methods, account-
ing for research and development costs, and translation of foreign currencies.19

Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 2, par. 132.
Securities and Exchange Commission, 1999 Annual Report (Washington, DC: U.S. Government
Printing Office), p. 84. For examples of qualitative factors, see SEC Staff Accounting Bulletin No. 99,
“Materiality” (August 12, 1999). Also see Statement on Auditing Standards No. 89, “Audit Adjust-
ments,” and Statement on Auditing Standards No. 90, “Audit Committee Communications” (New
York: AICPA, 1999).
Opinions of the Accounting Principles Board No. 22, “Disclosure of Accounting Policies” (New
York: AICPA, 1972), par. 15.
Ibid., par. 13.
188 Rules of the Road”Auditing and Related Accounting Standards

The disclosure principle is particularly important because if the auditors do not
concur with the adequacy of management™s disclosures, then they cannot express
an unqualified opinion. Such inadequate disclosures should be stated in their audit
report. For further information or additional disclosure matters, see Chapter 10.

The fourth auditing standard of reporting requires that the indepen-
dent auditors express their opinion on the fairness of the financial presentation in
the financial statements. However, if the auditors cannot express an opinion, then
they are required to acknowledge this fact and the related reasons. Moreover, the
auditors are required to disclose the nature of their association and responsibility
with the financial statements when their names are associated with the statements.
Their professional opinion is based on their informed judgment as a result of the
audit. Their opinion should not be construed as an absolute guarantee regarding
the accuracy of the financial statements. Furthermore, the Auditing Standards
Board points out the following with respect to the term fairness:

The independent auditor™s judgment concerning the “fairness” of the overall presen-
tation of financial statements should be applied within the framework of generally
accepted accounting principles. Without that framework the auditor would have no
uniform standard for judging the presentation of financial position, results of opera-
tions, and cash flows in financial statements.20

In summary, the auditors should base their judgment on matters such as:

• Whether the accounting principles selected and applied have general acceptance
• Whether the accounting principles are appropriate in the circumstances
• Whether the financial statements, including the related notes, are informative
of matters that may affect their use, understanding, and interpretation
• Whether the information presented in the financial statements is classified and
summarized in a reasonable manner
• Whether the financial statements reflect the underlying events and transac-
tions in a manner that presents the statements within limits that are reasonable
and practicable to attain in financial statements21

The preceding discussions of an overview of auditing standards and their inte-
gration with related accounting standards indicate the need for a framework of ac-
ceptable guidelines in order to meet the demand for financial accounting
information. Particularly important is the judgment and discretion of management

Statement on Auditing Standards No. 69, par. 3.
Ibid., par. 4. With respect to current Securities and Exchange initiatives dealing with such matters as
materiality, revenue recognition, in-process research and development, reserves, and audit adjust-
ments, the reader should visit Arthur Levitt™s speech, www.sec.gov/news/speeches/spch220.txt. For ad-
ditional information regarding the guidance on the criteria necessary to recognize restructuring
liabilities and asset impairments and the criteria to recognizing revenue, see Staff Accounting Bulletin
No. 100, “Restructuring Charges and Asset Impairment” (November 24, 1999) and Staff Accounting
Bulletin No. 101 “Revenue Recognition” (December 3, 1999) (Washington, DC: SEC, 1999).
International Auditing Standards 189

and the independent auditors. Management™s involvement in the application of ac-
ceptable accounting standards and the auditors™ attestation of their financial judg-
ments enhances the usefulness of the financial statements. More important, it is
incumbent on the audit committee to understand the causes or reasons for the au-
ditors™ inability to express an unqualified opinion on the financial statements.
Whereas the preceding discussion focuses on the basic framework of auditing
standards and the relationship to accounting standards, Exhibit 5.3 is a summary
of the more significant auditing standards and related topical areas of interest to
audit committees.

In addition to the generally accepted auditing standards associated with the annual
audit of financial statements, the Auditing Standards Board and the Accounting
and Review Services Committee have issued a codification of four statements on
Standards for Attestation Engagements (SSAEs) and two SSAEs in response to the
banking reform legislation (FDICIA). The basic framework for these standards is
shown in Exhibit 5.4. The auditor™s responsibility for attestation engagements
with respect to special reports, reviews, and agreed-upon procedures is discussed
in Chapter 13.
Exhibit 5.5 lists the attestation standards and related topical areas of concern
to audit committees. The reader may wish to consult other AICPA statements such
as Statements on Standards for Accounting and Review Services, Statements on
Standards for Management Consulting Services, Statements on Quality Control
Standards, Standards for Performing and Reporting on Quality Reviews, State-
ments on Responsibilities in Tax Practices, and Statements on Standards for Ac-
countants™ Services on Prospective Financial Information.

Recognizing that there is a movement toward the “globalization” of the world™s se-
curities markets, the International Organization of Securities Commission
(IOSCO)22 has been working with the International Accounting Standards Com-
mittee (IASC) (renamed International Auditing and Assurance Standards Board


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