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whether the financial statements are free of material misstatement. An audit includes ex-
amining, on a test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and signifi-
cant estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion.
We were unable to obtain audited financial statements supporting the Company™s in-
vestment in a foreign affiliate stated at $______ and $______ at December 31, 20X2 and
20X1, respectively, or its equity in earnings of that affiliate of $______ and $______, which
is included in net income for the years then ended as described in Note X to the financial
statements; nor were we able to satisfy ourselves as to the carrying value of the investment
in the foreign affiliate or the equity in its earnings by other auditing procedures. In our opin-
ion, except for the effects of such adjustments, if any, as might have been determined to be
necessary had we been able to examine evidence regarding the foreign affiliate investment
and earnings, the financial statements referred to in the first paragraph above present fairly,
in all material respects, the financial position of X Company as of December 31, 20X2 and
20X1, and the results of its operations and its cash flows for the years then ended in con-
formity with accounting principles generally accepted in the United States of America.a
Departure from a Generally Accepted Accounting Principle
[Same first and second paragraphs as the standard report]
The Company has excluded, from property and debt in the accompanying balance sheets,
certain lease obligations that, in our opinion, should be capitalized in order to conform
with generally accepted accounting principles. If these lease obligations were capitalized,
property would be increased by $______ and $______, long-term debt by $______ and
$______, and retained earnings by $______ and $______ as of December 31, 20X2 and
20X1, respectively. Additionally, net income would be increased (decreased) by $______
and $______ and earnings per share would be increased (decreased) by $______ and
$______, respectively, for the years then ended.
In our opinion, except for the effects of not capitalizing certain lease obligations as dis-
cussed in the preceding paragraph, the financial statements referred to above present fairly, in
all material respects, the financial position of X Company as of December 31, 20X2 and
20X1, and the results of its operations and its cash flows for the years then ended in confor-
mity with accounting principles generally accepted in the United States of America.b
Inadequate Disclosure
[Same first and second paragraphs as the standard report]
The Company™s financial statements do not disclose [describe the nature of the omitted
disclosures]. In our opinion, disclosure of this information is required by generally
accepted accounting principles.
In our opinion, except for the omission of the information discussed in the preceding
paragraph, . . .c

a
Professional Standards, U.S. Auditing Standards/Attestation Standards, Vol. 1, AU Sec. 26 (New
York: AICPA, 2003).
b
Ibid., AU Sec. 39.
c
Ibid., AU Sec. 42. For further reference, see Jack C. Robertson, “Analysts™ Reactions to Auditors™
Messages in Qualified Reports,” Accounting Horizons 2, No. 2 (June 1988), pp. 82“89.
380 Independent Auditors™ Reports


The Adverse Opinion
The adverse opinion is expressed by the auditors when, in their judgment, “the fi-
nancial statements taken as a whole are not presented fairly in conformity with gen-
erally accepted accounting principles.”12 The adverse opinion is appropriate where
the auditors™ exceptions are so material that the statements as a whole are not fairly
presented. Thus the distinction between the adverse opinion and qualified opinion
is predicated on the concept of materiality discussed in Chapter 5. When the audi-
tors express an adverse opinion, their audit report should disclose “all the substan-
tive reasons” for the opinion as well as “the principal effects of the subject matter”
on the financial statements, “if reasonably determinable.”13 “If the effects are not
reasonably determinable, the report should so state.”14 If management applies ac-
counting principles that are not in conformity with acceptable principles (discussed
in Chapter 5), then the auditors are required to render an adverse opinion. For ex-
ample, if management refuses to disclose material information in the notes to the
statements, such inaction constitutes a violation of the disclosure principle. Thus an
adverse opinion is appropriate. Such a violation of the disclosure principle would
materially distort the financial statements taken as a whole. However, the expres-
sion of an adverse opinion is infrequent in practice because management opts for
an unqualified opinion and as a result makes the necessary adjustments.
An example of an adverse opinion is shown in Exhibit 13.3.

Disclaimer of Opinion
When the auditors lack sufficient information to form an opinion regarding the fi-
nancial statements, their report should indicate that they are unable to express an
opinion. For example, it is appropriate to express a disclaimer of opinion when the
auditors have not conducted “an examination sufficient in scope” to warrant the
expression of an opinion on the statements taken as a whole.15 In contrast to the
qualified opinion, the disclaimer of opinion means that the auditors do not have
sufficient knowledge about the fairness of management™s representations in the fi-
nancial statements. Furthermore, the auditors should indicate the reason for the
disclaimer of opinion in their report. Thus, although the circumstances regarding
the issuance of the qualified opinion may be the same for a disclaimer of opinion,
the distinction between the former and the latter is based on the degree of materi-
ality with respect to each circumstance. Such a distinction is contingent on the au-
ditors™ professional judgment. Accordingly, the audit committee should inquire
about the public accounting firm™s criteria for judging materiality as it relates to
the financial statements.
An example of a disclaimer of opinion is shown in Exhibit 13.4.


12
Ibid., AU Sec. 58.
13
Ibid., AU Sec. 59.
14
Ibid.
15
Ibid., AU Sec. 62.
Other Reports of the Auditors 381



Exhibit 13.3 Independent Auditor™s Report: Example 3

Adverse Opinion
[Same first and second paragraphs as the standard report]
As discussed in Note X to the financial statements, the Company carries its property,
plant, and equipment accounts at appraisal values, and provides depreciation on the basis
of such values. Further, the Company does not provide for income taxes with respect to dif-
ferences between financial income and taxable income arising because of the use, for in-
come tax purposes, of the installment method of reporting gross profit from certain types
of sales. Generally accepted accounting principles require that property, plant, and equip-
ment be stated at an amount not in excess of cost, reduced by depreciation based on such
amount, and that deferred income taxes be provided.
Because of the departures from generally accepted accounting principles identified
above, as of December 31, 20X2 and 20X1, inventories have been increased $______ and
$______ by inclusion in manufacturing overhead of depreciation in excess of that based on
cost; property, plant, and equipment, less accumulated depreciation, is carried at $______
and $______ in excess of an amount based on the cost to the Company; and deferred in-
come taxes of $______ and $______ have not been recorded; resulting in an increase of
$______ and $______ in retained earnings and in appraisal surplus of $______ and
$______, respectively. For the years ended December 31, 20X2 and 20X1, cost of goods
sold has been increased $______ and $______, respectively, because of the effects of the
depreciation accounting referred to above and deferred income taxes of $______ and
$______ have not been provided, resulting in an increase in net income of $______ and
$______, respectively.
In our opinion, because of the effects of the matters discussed in the preceding para-
graphs, the financial statements referred to above do not present fairly, in conformity with
accounting principles generally accepted in the United States of America, the financial po-
sition of X Company as of December 31, 20X2 and 20X1, or the results of its operations
or its cash flows for the years then ended.

Source: Professional Standards, U.S. Auditing Standards/Attestation Standards, Vol. 1 (New York:
AICPA, 2003), AU Sec. 60.




OTHER REPORTS OF THE AUDITORS
Report on Interim Financial Statements
In addition to the auditors™ opinion on the annual financial statements, the Audit-
ing Standards Board states:

The Securities and Exchange Commission (SEC) requiresa a registrant to engage an
independent accountant to review the registrant™s interim financial information, in
accordance with this Statement, before the registrant files its quarterly report on
Form 10-Q or Form 10-QSB. Although this Statement does not require an accoun-
tant to issue a written report on a review of interim financial information, the SEC
382 Independent Auditors™ Reports



Exhibit 13.4 Independent Auditor™s Report: Example 4

Disclaimer of Opinion
We were engaged to audit the accompanying balance sheets of X Company as of Decem-
ber 31, 20X2 and 20X1, and the related statements of income, retained earnings, and cash
flows for the years then ended. These financial statements are the responsibility of the
Company™s management.

[Second paragraph of standard report should be omitted]
The Company did not make a count of its physical inventory in 20X2 or 20X1, stated in
the accompanying financial statements at $______ as of December 31, 20X2, and at
$______ as of December 31, 20X1. Further, evidence supporting the cost of property and
equipment acquired prior to December 31, 20X1, is no longer available. The Company™s
records do not permit the application of other auditing procedures to inventories or prop-
erty and equipment.
Since the Company did not take physical inventories and we were not able to apply
other auditing procedures to satisfy ourselves as to inventory quantities and the cost of
property and equipment, the scope of our work was not sufficient to enable us to express,
and we do not express, an opinion on these financial statements.

Source: Professional Standards, U.S. Auditing Standards and Attestation Standards, Vol. 1 (New
York: AICPA, 2003), AU Sec. 63.




requires that an accountant™s review report be filed with the interim financial infor-
mation if, in any filing, the entity states that the interim financial information has
been reviewed by an independent public accountant.
SAS No. 84, Communications Between Predecessor and Successor Auditors (AICPA,
Professional Standards, vol. 1, AU sec. 315), requires a successor auditor to contact
the entity™s predecessor auditor and make inquiries of the predecessor auditor in de-
ciding whether to accept appointment as an entity™s independent auditor. Such in-
quiries should be completed before accepting an engagement to perform an initial
review of an entity™s interim financial information.16

a
The Securities and Exchange Commission (SEC) requirement is set forth in Rule 10-01(d) of
Regulation S-X for Form 10-Q and item 310(b) of Regulation S-B for Form 10-QSB.

With respect to the independent auditors™ objective of a review of interim fi-
nancial statements, the Auditing Standards Board points out:

The objective of a review of interim financial information pursuant to this Statement
is to provide the accountant with a basis for communicating whether he or she is
aware of any material modifications that should be made to the interim financial in-

16
Statement on Auditing Standards No. 100, “Interim Financial Information” (New York: AICPA,
2002), pars. 3 and 4. SAS No. 100 was issued to improve the guidance on performing reviews of in-
terim financial information of public companies. The SEC requires that the registrant submit timely
filings of interim financial information. For further information, see the AICPA™s Professional Issues
Task Force Practice Alert 2000-4, “Quarterly Review Procedures for Public Companies” (New York:
AICPA, 2000).
Other Reports of the Auditors 383


formation for it to conform with generally accepted accounting principles. The ob-
jective of a review of interim financial information differs significantly from that of
an audit conducted in accordance with generally accepted auditing standards. A re-
view of interim financial information does not provide a basis for expressing an opin-
ion about whether the financial statements are presented fairly, in all material respects,
in conformity with generally accepted accounting principles. A review consists prin-
cipally of performing analytical procedures and making inquiries of persons respon-
sible for financial and accounting matters, and does not contemplate (a) tests of
accounting records through inspection, observation, or confirmation; (b) tests of con-
trols to evaluate their effectiveness; (c) obtaining corroborating evidence in response
to inquiries; or (d) performing certain other procedures ordinarily performed in an
audit. A review may bring to the accountant™s attention significant matters affecting
the interim financial information, but it does not provide assurance that the accountant
will become aware of all significant matters that would be identified in an audit. Para-
graph 22 of this Statement provides guidance to the accountant if he or she becomes
aware of information that leads him or her to believe that the interim financial infor-
mation may not be in conformity with generally accepted accounting principles.17

To achieve their review objective, The independent auditors should apply these
topical procedures:

• Establishing an understanding with client regarding the services to be per-
formed in an engagement to review interim financial information (pars. 8“9)
• Obtaining knowledge of the entity™s business and its internal control (pars.
10“14)
• Requiring analytical procedures, inquiries, and other review procedures (em-
phasis added”comparing disaggregated revenue data by month and by prod-
uct line or operating segment during the current interim period with that of
comparable prior periods (pars. 15“23)
• Obtaining written representation from management concerning such matters as
management™s responsibility for the financial statements (par. 24)
• Evaluating the results of interim review procedures (pars. 25“28)
• Communicating to the management, the Audit Committee, and others (pars.
29“36)
• Reporting on a review of interim financial information (pars. 37“46)
• Obtaining the client™s representation concerning the review engagement (pars.
47“50)
• Preparing documentation for the review of interim financial information (pars.
51“52).18

The audit committee™s review of the reports of the independent auditors™ lim-
ited reviews of the interim financial statements is an important task, because it can

17
Ibid., par. 7.
18
Ibid. See paragraphs parenthetically noted above. Also, see the appendices on this book™s website for
examples of analytical procedures, unusual or complex situations, and illustration representation letters.
384 Independent Auditors™ Reports


alert the board of directors to possible changes in accounting policies in a timely
manner and thus minimize unanticipated financial reporting implications at the
end of the year.19
With respect to communication with audit committees, the Auditing Standards
Board requires the following procedures:

As a result of conducting a review of interim financial information, the accountant
may become aware of matters that cause him or her to believe that (a) material mod-
ification should be made to the interim financial information for it to conform with

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