Week 2 - Lecturer 2 - Audit Reports and Ethics PDF

AUDIT PRACTICE AND PROCEDURES II Audit Reports and Ethics Week Two  First Class Recap 1. Brief History of Auditing 2. What is an Audit 3. Functions of Audit 4. Difference between Internal & External Auditing 5. Dynamics of Auditing/Und...

AUDIT PRACTICE AND PROCEDURES II Audit Reports and Ethics Week Two  First Class Recap 1. Brief History of Auditing 2. What is an Audit 3. Functions of Audit 4. Difference between Internal & External Auditing 5. Dynamics of Auditing/Understanding the Dynamics  What is an Audit Report? An audit report is a public document that expresses an auditor's educated opinion on the financial status of a company. Depending on the financial status of a company and its financial practices, an audit can yield four types of results. An audit report is a document prepared by an auditor that serves as a summary of a company's financial status. This document lists a company's assets and liabilities, as well as the auditor's educated opinion on the business's finances. Auditors then release this document to the public for consumers and investors to see. While audits may be mandatory, companies also request them. Companies seeking to find fiscal areas that could improve or those hoping to find investors may be interested in having an audit performed for their business.  Audit Report Cont’d The audit report is generally accompanied by the company’s annual report. The audit report is required by banks, financial institutions, investors, creditors, and regulators. When the auditor issues a clean report, it means that the company’s financial statements have been found to be fully compliant with accounting standards. An unqualified report will tell you that the financial statement could have some errors. Audit reports are very important to a company. Investors rely on the audit report to assess the financial health of the company and they base many important decisions on the audit report. Regulatory bodies also read the audit report as it tells them how accurate the financial information reported is. When an audit report is adverse it can seriously affect the company’s status and reputation. It is essential to have good accounting practices so that the audit of accounts goes well.  Types of Audit Reports The following are types of reports that are issued by external auditors: 1. Standard Unqualified Audit Report 2. Unqualified Report with Explanatory Paragraph or Modified Wording 3. Qualified Audit Report 4. Adverse or Disclaimer Audit Report  The Standard Unqualified Audit Report Otherwise called a Clean Report This is the kind of report that most companies expect to receive after an Audit is conducted. This report doesn’t have any kind of adverse comments and it doesn’t include any disclaimers about any clauses are the audit process. This type of report indicate that the auditors are satisfied with the organization’s financial reporting. The auditor believes that the company’s operations are in compliance with governance principles and applicable laws. The company, the auditors, the investors, and the public perceive such a report to be free from material misstatements. The auditor’s standard unqualified audit report contains eight distinct parts 1. Report title - Auditing standards require that the report be titled and that the title include the word independent. For example, appropriate titles include “independent auditor’s report,” “report of independent auditor,” or “independent accountant’s opinion.” The requirement that the title include the word independent conveys to users that the audit was unbiased in all aspects. 2. Audit report address - The report is usually addressed to the company, its stockholders, or the board of directors. In recent years, it has become customary to address the report to the board of directors and stockholders to indicate that the auditor is independent of the company. 3. Introductory paragraph - The first paragraph of the report indicates that the CPA firm has performed an audit, which distinguishes the report from a compilation or review report. The first paragraph also lists 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. The wording of the financial statements in the report should be identical to those used by management on the financial statements. 4. Management’s 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 due to fraud or error. 5. Auditor’s responsibility - The section on the auditor’s responsibility contains three paragraphs. The first paragraph states that the audit was conducted in accordance with auditing standards generally accepted in the United States of America. This paragraph also notes that the audit is designed to obtain reasonable assurance about whether the financial statements are free of material misstatement. The inclusion of the word material conveys that auditors are only responsible to search for significant misstatements, not minor misstatements that do not affect users’ decisions. The use of the term reasonable assurance is intended to indicate that an audit cannot be expected to completely eliminate the possibility that a material misstatement will exist in the financial statements. In other words, an audit provides a high level of assurance, but it is not a guarantee.  Auditor’s responsibility Cont’d - The second paragraph describes the scope of the audit and the evidence accumulated. This paragraph indicates that the procedures depend on the auditor’s 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 entity’s 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. The third paragraph indicates the auditor believes that sufficient appropriate evidence has been obtained to support the auditor’s opinion. 6. Opinion paragraph - The final paragraph in the standard report states the auditor’s conclusions based on the results of the audit. This part of the report is so important that often the entire audit report is referred to simply as the auditor’s opinion. The opinion paragraph is stated as an opinion rather than as a statement of absolute fact or a guarantee. The intent is to indicate that the conclusions are based on professional judgment. The phrase in our opinion indicates that there may be some information risk associated with the financial statements, even though the statements have been audited. A controversial part of the auditor’s report is the meaning of the term present fairly. Does this mean that if generally accepted accounting principles are followed, the financial statements are presented fairly, or something more? Occasionally, the courts have concluded that auditors are responsible for looking beyond generally accepted accounting principles to determine whether users might be misled, even if those principles are followed. Most auditors believe that financial statements are “presented fairly” when the statements are in accordance with generally accepted accounting principles, but that it is also necessary to examine the substance of transactions and balances for possible misinformation. 7. Name and address of Certified Public Accountant (CPA ) firm - The name identifies the CPA firm or practitioner who performed the audit. Typically, the firm’s 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. The city and state of the audit firm should also be indicated. 8. Audit report date - The appropriate date for the report is the one on which the auditor completed the auditing procedures in the field. This date is important to users because it indicates the last day of the auditor’s responsibility for the review of significant events that occurred after the date of the financial statements. In the auditor report for example, the balance sheet is dated February 15th, 2014. This indicates that the auditor has searched for material unrecorded transactions and events that occurred up to February 15th, 2014.  When is a standard unqualified audit report issued? The standard unqualified audit report is issued when the following conditions have been met: 1. All statements—balance sheet, income statement, statement of changes in stockholders’ equity, and statement of cash flows—are included in the financial statements. 2. Sufficient appropriate evidence has been accumulated, and the auditor has conducted the engagement in a manner that enables him or her to conclude that the audit was performed in accordance with auditing standards. 3. The financial statements are presented in accordance with U.S. generally accepted accounting principles or other appropriate accounting framework. This also means that adequate disclosures have been included in the footnotes and other parts of the financial statements. 4. There are no circumstances requiring the addition of an explanatory paragraph or modification of the wording of the report.  When is a standard unqualified audit report issued? The standard unqualified audit report is sometimes called a clean opinion because there are no circumstances requiring a qualification or modification of the auditor’s opinion. If any of the four requirements for the standard unqualified audit report are not met, the standard unqualified report cannot be issued.  The standard unqualified audit report The standard unqualified audit report for public companies includes three paragraphs 1. The first paragraph is the introductory paragraph and indicates that an audit was performed and the financial statements that were audited. The introductory paragraph also indicates that the financial statements are the responsibility of management, and that the auditor’s responsibility is to express an opinion on the financial statements. Note that this information is similar to the first three paragraphs in the standard unqualified report for non-public entities 2. The scope paragraph is similar to the second paragraph under the auditor’s responsibilities in the standard qualified audit report and indicates that an audit is designed to provide reasonable assurance that the financial statements are free of material misstatement. The scope paragraph notes that auditing is done on a test basis.  The standard unqualified audit report 3. The third paragraph is the opinion paragraph and is similar to the opinion paragraph included in Figure 3-1. If the auditor also issues a separate report on internal control over financial reporting, a fourth paragraph would follow the opinion paragraph referencing the audit report on internal control. The Public Company Accounting Oversight Board (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, such as the separate report on internal control over financial reporting or in a combined report. The combined report on financial statements and internal control over financial reporting addresses both the financial statements and management’s report on internal control over financial reporting. While the combined report is permitted, the separate report on internal control over financial reporting is more common and includes these elements: The introductory, scope, and opinion paragraphs describe that the scope of the auditor’s work and opinion is on internal control over financial reporting, and the introductory paragraph highlights management’s 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. The report includes a paragraph after the scope paragraph defining internal control over financial reporting. The report also includes an additional paragraph before the opinion that addresses the inherent limitations of internal control. Although the audit opinion on the financial statements addresses multiple reporting periods, the auditor’s opinion about the effectiveness of internal control is as of the end of the most recent fiscal year. The last paragraph of the report includes a cross-reference to the auditor’s separate report on the financial statements.  Disclaimer of Opinion-Disclaimer Report When an auditor issues a disclaimer of opinion report, it means that they are distancing themselves from providing any opinion at all related to the financial statements. Some of the reasons that auditors may issue a disclaimer of opinion are because they felt like the company limited their ability to conduct a thorough audit or they couldn’t get satisfactory explanations for their questions. They may not have been able to decipher the correct nature of some transactions or to secure enough evidence to support good financial reporting. Auditors that aren’t allowed an opportunity to observe operational procedures or to review particular procedures may feel like they’re not able to express a definite opinion, so they feel a disclaimer is necessary and in order. The general consensus is that a disclaimer of opinion constitutes a very harsh stance. As a result, it creates an adverse image of the company.  Adverse Opinion-Adverse Audit Report The final type of audit opinion is an adverse opinion. Auditors who aren’t at all satisfied with the financial statements or who discover a high level of material misstatements or irregularities know that this creates a situation in which investors and the government will mistrust the company’s financial reports. An auditor’s adverse opinion is a big red flag. An adverse audit report usually indicates that financial reports contain gross misstatements and have the potential for fraud. Adverse opinions send out a high alert that the company’s records haven’t been prepared according to GAAP. Financial institutions and investors take this opinion seriously and will reject doing any kind of business with the company.  A Qualified Opinion A qualified opinion report can result from a limitation on the scope of the audit or failure to follow generally accepted accounting principles. A qualified opinion report can be used only when the auditor concludes that the overall financial statements are fairly stated. A disclaimer or an adverse report must be used if the auditor believes that the condition being reported on is highly material. Therefore, the qualified opinion is considered the least severe type of departure from an unqualified report. A qualified report can take the form of a qualification of both the scope and the opinion or of the opinion alone. A scope and opinion qualification can be issued only when the auditor has been unable to accumulate all of the evidence required by auditing standards. Therefore, this type of qualification is used when the auditor’s scope has been restricted by the client or when circumstances exist that prevent the auditor from conducting a complete audit. The use of a qualification of the opinion alone is restricted to situations in which the financial statements are not stated in accordance with GAAP  A Qualified Opinion When an auditor issues a qualified report, he or she must use the term except for in the opinion paragraph. The implication is that the auditor is satisfied that the overall financial statements are correctly stated “except for” a specific aspect of them. Examples of this qualification are given later in this chapter. It is unacceptable to use the phrase except for with any other type of audit opinion.  An Adverse Opinion An adverse opinion is 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. The adverse opinion report 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  A Disclaimer of Opinion A disclaimer of opinion is issued when the auditor has been unable to satisfy himself or herself that the overall financial statements are fairly presented. 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. Either of these situations prevents the auditor from expressing an opinion on the financial statements as a whole. The auditor also has the option to issue a disclaimer of opinion for a going concern problem  The difference between Disclaimer and Adverse Opinon The disclaimer is distinguished from an adverse opinion in that it can arise only from a lack of knowledge by the auditor, whereas to express an adverse opinion, the auditor must have knowledge that the financial statements are not fairly stated. Both disclaimers and adverse opinions are used only when the condition is highly material.  What are Ethics Ethics can be defined broadly as a set of moral principles or values. Philosophers, religious organizations, and other groups have defined in various ways ideal sets of moral principles or values. Examples of prescribed sets of moral principles or values include laws and regulations, church doctrine, codes of business ethics for professional groups such as CPAs, and codes of conduct within organizations. It is common for people to differ in their moral principles and values and the relative importance they attach to these principles. These differences reflect life experiences, successes and failures, as well as the influences of parents, teachers, and friends.  What are Ethics Ethical behavior is necessary for a society to function in an orderly manner. It can be argued that ethics is the glue that holds a society together. Imagine, for example, what would happen if we couldn’t depend on the people we deal with to be honest. If parents, teachers, employers, siblings, coworkers, and friends all consistently lied, it would be almost impossible to have effective communication. The need for ethics in society is sufficiently important that many commonly held ethical values are incorporated into laws.  Why People Act Unethically Most people define unethical behavior as conduct that differs from what they believe is appropriate given the circumstances. Each of us decides for ourselves what we consider unethical behavior, both for ourselves and others. It is important to understand what causes people to act in a manner that we decide is unethical. There are two primary reasons why people act unethically: The person’s ethical standards are different from those of society as a whole, or the person chooses to act selfishly. Frequently, both reasons exist. 1. Person’s Ethical Standards Differ from General Society. 2. The Person Chooses to Act Selfishly.  What is an Ethical Dilemma? An ethical dilemma is a situation a person faces in which a decision must be made about the appropriate behavior. A simple example of an ethical dilemma is finding a diamond ring, which necessitates deciding whether to attempt to find the owner or to keep it. A far more difficult ethical dilemma to resolve is the following example. It is the type of case that might be used in an ethics course. Class Discussion Auditors, accountants, and other businesspeople face many ethical dilemmas in their business careers. Dealing with a client who threatens to seek a new auditor unless an unqualified opinion is issued presents an ethical dilemma if an unqualified opinion is inappropriate. Deciding whether to confront a supervisor who has materially overstated departmental revenues as a means of receiving a larger bonus is an ethical dilemma. Continuing to be a part of the management of a company that harasses and mistreats employees or treats customers dishonestly is an ethical dilemma, especially if the person has a family to support and the job market is tight.  Resolving Ethical Dilemmas Formal frameworks have been developed to help people resolve ethical dilemmas. The purpose of such a framework is to help identify the ethical issues and decide an appropriate course of action using the person’s own values. The six-step approach that follows is intended to be a relatively simple approach to resolving ethical dilemmas:  Difference Between CPA Firms and Other Professionals CPA firms have a different relationship with users of financial statements than most other professionals have with their customers. Attorneys, for example, are typically engaged and paid by a client and have primary responsibility to be an advocate for that client. CPA firms are usually engaged by management for private companies and the audit committee for public companies and are paid by the company issuing the financial statements, but the primary beneficiaries of the audit are financial statement users. Often, the auditor does not know or have contact with the financial statement users but has frequent meetings and ongoing relationships with client personnel. It is essential that users regard CPA firms as competent and unbiased. If users believe that CPA firms do not perform a valuable service (reduce information risk), the value of CPA firms’ audit and other attestation reports is reduced and the demand for these services will thereby also be reduced. Therefore, there is considerable incentive for CPA firms to conduct themselves at a high professional level.  Code of Professional Conduct The American Institute of Certified Public Accountants (AICPA) Code of Professional Conduct provides both general standards of ideal conduct and specific enforceable rules of conduct. There are four parts to the code: principles, rules of conduct, interpretations of the rules of conduct, and ethical rulings. The parts are listed in order of increasing specificity; the principles provide ideal standards of conduct, whereas ethical rulings are highly specific.  Rules of Conduct When it comes to rules of conduct, they are enforceable and stand as the ideal standards of ethical conduct – stated as specific rules. As far as Interpretations of the rules go, they are not enforceable, however should departure take place, such an act would have to be justified.  Interpretations of the rules of conduct As far as Interpretations of the rules go, they are not enforceable, however should departure take place, such an act would have to be justified. The need for published interpretations of the rules of conduct arises when there are frequent questions from practitioners about a specific rule. The Professional Ethics Executive Committee of the AICPA prepares each interpretation based on a consensus of a committee made up principally of public accounting practitioners. Before interpretations are finalized, they are issued as exposure drafts to the profession and others for comment. Interpretations are not officially enforceable, but a departure from the interpretations is difficult if not impossible for a practitioner to justify in a disciplinary hearing. The most important interpretations are discussed as a part of each section of the rules  Ethical Rulings Ethical rulings deal with published explanations and answers to questions about the rules of conduct. Generally, these are submitted to the AICPA by professionals interested in ethical requirements. Rulings are explanations by the executive committee of the professional ethics division of specific factual circumstances. A large number of ethical rulings are published in the expanded version of the AICPA Code of Professional Conduct. The following is an example (Rule 101—Independence; Ruling No. 14): Question—A member serves as a director or officer of a United Way or similar federated fund-raising organization (the organization). Certain local charities receive funds from the organization. Would independence be considered to be impaired with respect to such charities? Answer—Independence would be considered to be impaired if any partner or professional employee of the firm served as a director or officer of the organization and the organization exercised managerial control over the local charities.  References https://www.indeed.com/career-advice/career-development/audit-report-types https://tallysolutions.com/accounting/audit-report/#gref https://www.diligent.com/resources/blog/understanding-four-types-audit-reports Chapter Three of the Textbook