Accounting Chapter 15 Homework One Difference Might The Lack Internal Control

15-15

3. (a) Unqualified, standard wording

The research related to the development of a specific product is adequately described in

4. (c) Qualified, 2 GAAP violations

The auditor has substantial doubt about the ability of the company to remain a going

concern. Although management has confidence that an alternative source may be found,

5. (c) Qualified, GAAP violation

The financial statements contain a material departure from GAAP, but the departure is

6. (a) Unqualified, standard wording

15-62

List A

Type of

Opinion

List B

Report

Modification

Explanation

1

b

r

Standard audit report and wording is appropriate.

2

a

l

This is a scope limitation requiring a qualified opinion.

3

b or d

chosen

required to add an explanatory paragraph when there is

substantial doubt about the going concern assumption.

i, if b is

An unqualified opinion is usually given. The auditor is

15-16

List A

Type of

Opinion

List B

Report

Modification

Explanation

However, the auditor has the option to disclaim an opinion

if it is believed this is more appropriate.

4

b

q

paragraphs are modified to indicate that the opinion is

based on both the audit done by the principal auditor and

the report furnished by the other auditor.

This is a shared report with the magnitude of the work

done by the other auditor stated in the introductory

paragraph, and the wording of the scope and opinion

5

a

j

This is a GAAP violation. A cash flow statement is

required whenever income statements are provided. This

should be explained in a paragraph preceding the opinion

paragraph that should be qualified.

b

i

This is a lack of consistency requiring an explanatory

paragraph.

8

e

j

This is a GAAP violation requiring either a qualified or

adverse opinion depending on the materiality and

pervasiveness of the effects of the violation.

15-63

2. D

4. A

15-64

1. Identify the ethical issue(s). The ethical issue for the auditor revolves around

2. Determine who are the affected parties and identify their rights. Affected parties

include shareholders (right to receive accurate information), the audit committee

3. Determine the most important rights. Shareholders of the company because they

are the most numerous and stand to lose most directly from the problems. Further,

4. Develop alternative courses of action. One course of action is to issue a going

5. Determine the likely consequences of each proposed course of action. If the

auditor issues a going concern opinion it is likely, although not guaranteed, that

he company will become bankrupt because of the difficulties of getting additional

sources of cash, financing, etc. If the auditor does not issue a going concern

6. Assess the possible consequences, including an estimation of the greatest good for

7. Decide on the appropriate course of action. If the auditor is not convinced that

15-65

The auditor of a public company must issue an adverse opinion on the client’s internal

control over financial reporting if there is a material weakness in the controls.

15-18

15-66

PCAOB AS 5 identifies five situations in which the auditor will modify the audit report

on ICFR effectiveness. These situations include the following:

• Elements of management’s annual report on internal control are incomplete or

improperly presented.

Fraud Focus: Contemporary and Historical Cases

15-67

a. Among other things, by participating in both the preparation (compilation) and

audit of these financial statements, Johnson and Johnson & Co. failed to maintain its

independence from Winners. With this set of circumstances, the audit opinion should

have been a disclaimer. However, more troubling is the fact that the AAER notes that the

auditor either prepared or was aware of fraudulent representations in the financial

statements. Thus, it appears that even the compilation performed by the auditor was in

violation of professional standards.

b. In Step One, the auditor structures the problem, considering the relevant parties to

involve in the decision process, identifying various feasible alternatives, considering how

to evaluate the alternatives, identifying uncertainties or risks, and determining how to

structure the problem. To illustrate these tasks, the auditor, in deciding on the appropriate

15-19

Note that the auditor has already concluded that a going concern modification was

appropriate for two years – accordingly, it appears as if the auditor is able to

appropriately complete the decision process related to issuing an audit opinion at least on

some dimensions.

The second alternative is to do exactly what Johnson did – and that is to issue an opinion

indicating he was independent when in fact he was not. The consequences associated

with that action could be no adverse consequences – it is never discovered that he is not

independent, and the client was able to file the financial statements with the SEC.

Application Activities

15-68

Following is an excerpt from Note 1:

The Company has incurred losses for its last seven fiscal years and negative cash

flows from operating activities for its last six fiscal years. As of June 30, 2012, the

Company had an accumulated deficit of $112.7 million. During fiscal 2012, the

Company incurred a net loss of $16.2 million. Through calendar 2012, the

15-20

Company expects to incur a net loss as it continues to change its business model

and improve operational efficiencies.

The Company has projected that cash on hand, combined with available

borrowings under its credit facility, will be sufficient to allow the Company to

continue operations for the next 12 months. Significant changes from the

Company’s current forecast, including but not limited to: (i) shortfalls from

This footnote should cause the student to recognize that a going concern explanatory

paragraph would likely be added to the auditor’s unqualified opinion. Page F-1 of the

Company’s annual report includes the auditor’s opinion, which does include the

following explanatory paragraph:

The accompanying consolidated financial statements have been prepared

assuming that the Company will continue as a going concern. As discussed in

Note 1 to the consolidated financial statements, the Company’s recurring losses

15-69

a. Differences include:

• financial reporting standards referred to in the report (U.S. generally accepted

accounting principles, International Financial Reporting Standards (IFRSs) as

adopted by the European Union)

contain this requirement because in the United States, auditors must comply

with the ethical standards contained in their Code of Professional Conduct.

Accordingly, the title indicating that it is the report of an independent auditor

b. The reports differ very little in terms of their relative informativeness for users.

One difference might be the lack of an internal control report in international contexts,

which leaves the user unaware of any such problems, should they exist.

c. Knowing the identity of the engagement partner responsible for the audit may be

helpful in terms of reputation and accountability assurances. Given the litigious nature of

the audit services market in the U.S., engagement partners may feel more exposed in

15-22

15-70

a. Audit reports are designed to promote clear communication between the auditor

and the financial statement reader by delineating:

• What was audited and the relative responsibilities of the client and the

auditor (introductory paragraph)

For large U.S. public companies, the auditor’s report will also refer to the audit of ICFR.

The auditor may issue a separate report on ICFR or may issue a combined report on both

the financial statements and ICFR. If a separate report is issued, the report on the

financial statements will include a paragraph after the scope paragraph (before the

opinion paragraph) indicating that an audit of ICFR was performed and providing an

opinion. If a combined report on both the financial statements and ICFR is issued, it will

include two additional paragraphs:

• Definition paragraph (after the scope paragraph) that defines what is

Other important components of an audit report include:

• A title that includes the word “independent”

• An addressee, which for public companies would be the board of directors

b. Following are the three key changes to the auditor’s report that the PCAOB is

proposing:

1. Requiring the auditor to communicate in the auditor’s report critical audit

matters that were addressed during the current-period audit, or stating that no

15-23

2. Adding information to the auditor’s report relating to auditor independence,

audit firm tenure on the engagement, and the auditor’s responsibility for and

evaluation of other information in annual reports (that is, information other

15-71

15-72

The relevant standard in AU-C 600 and the relevant information is provided in paragraph

25 of the standard.

Academic Research Cases

15-73

a. The authors examine the value of a going concern audit opinion modification in

capital markets. Specifically, the authors examine whether and how the market reacts to a

first-time going concern modification. The authors note this is important because the

audit opinion is the only public communication mechanism available to auditors. When a

firm’s performance and/or financial condition deteriorate to the point that financial

b. The authors find that the market places increased value relevance on the book

value of equity for firms receiving a first time going concern opinion, compared to

market valuations for the same firm in earlier years and financially distressed firms not

receiving a going concern modification in the same year. Namely, the valuation of these

15-24

c. This study indicates that market participants value the information provided by

auditors through going concern modifications. This is important for auditors because

significant judgment is required in decisions on whether or not to issue going concern

modified audit opinions. These results imply that auditors need to make careful,

d. The authors search all publicly traded durable manufacturing firms using

Compustat and EDGAR for firms receiving a first-time going concern audit report

modification between 1989 and 2006. The authors then search all publicly traded durable

manufacturing firms for all companies that meet one of the following criteria for financial

distress in the past three years: 1) operating loss, 2) bottom line loss, 3) negative working

capital, or 4) negative retained earnings. The authors find 431 durable manufacturing

15-25

e. Although the authors do not self-identify any limitations in this study, there are

several potentially limiting methodological and theoretical issues; two potential issues are

discussed below. First, the authors examine only publicly traded durable manufacturing

firms. There are differences between these firms and other firms that may limit the

15-74

a. The accounting scandal of Enron in December of 2001 led to legal issues for its

auditor, Arthur Andersen. On January 10, 2002, Arthur Andersen admitted to shredding

documents related to the Enron audit which eventually led to an indictment against the

audit firm on March 14, 2002. Andersen was found guilty of wrong-doing on June 15,

b. The results of the research indicated that large ex-Arthur Andersen clients were

treated more conservatively than large non-Andersen clients in the issuance of a going-

concern opinion by the auditor. The interpretation is that audit firms viewed large ex-

Andersen clients as posing a higher litigation risk. However, small ex-Andersen clients

c. Practicing auditors who are auditing former Arthur Andersen clients may want to

review their audit opinions more closely to confirm that they are making an independent

and objective decision based on the results of the audit. The concern would be that they

15-26

d. Data was gathered from sample companies that were selected from Compact

Disclosure. The authors identified 2,636 companies with going-concern modified

opinions during the fiscal years or 2002 and 2003. The control sample was derived from

5,993 companies with non-going-concern modified opinions that reported negative net

income or negative cash flows from operations. The analysis of former Andersen clients

was restricted to companies that became clients of one of the Big 4 firms. This removed

15-27

Andersen clients have higher probability of receiving a going concern opinion than non-

Andersen clients. The results were the opposite for large clients.

The authors also reviewed relevant literature to gain insights on issues related to audit

market changes and what happened to former Andersen clients.

Ford and Toyota

15-75

Note to instructor: The solutions based upon the FYE 2012 annual reports for Ford and