LECTURE 3 Audit Reports financial reporting analysis

Audit Reports

1. Auditor’s Report Lecture 03

2. 2 An auditor is an individual who is responsible to evaluate the validity and reliability of a limited firm’s financial statements in conformity with the domicile GAAP rules. Auditor ensure that an organization’s financial records are fair and accurate in all respects. There are two types of auditors; Internal and external auditors. That are appointed by the Board of Directors and report back to the same. Internal auditors are employees of the firm being audited while external auditors usually work in collaboration with the state. Also auditors may be nominated public personals in some cases. It is the prime responsibility of an auditor to approve and issue a report at the end of the audit that conclude the accuracy and transparency of financial statements prepared by an organization. Who is an Auditor?

3. Audit Report Providing an independent and expert opinion on the fairness of financial statements through an audit is the most frequent attestation service. An audit provides users of financial statements reasonable assurance that the statements are in conformity with GAAP. Audit report is a formal document of auditor’s opinion about the FS of the firm after conducting the audit. Auditors write this report in three steps. In first step they define that it’s the management responsibility to maintain fair and accurate financial statement as per local GAAP with strict internal control. In second step Auditors elaborates the nature of the audit and state the auditors only review the internal control and FS on sample basis. In third step they auditors give the opinion on the FS. 3

4. Types of Reports Reports on the financial statements ordinarily include: The financial statements themselves: Balance sheet Income statement Statement of cash flows Statement of retained earnings (equity) Financial Statement Disclosures The notes to the financial statements are considered an integral part of the financial statements 4

5. Auditors’ Standard Report – Nonpublic Clients Details Title includes word independent Addressed to person or audit committee who retained the auditors Signed with name of CPA firm not individual partner unless sole practitioner Dated last day of fieldwork or date on which the auditors obtained sufficient appropriate audit evidence to support their opinion 5

6. We have audited the accompanying balance sheet of XYZ Company as of December 31, 20XX, and the related statements of income, retained earnings, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. The AICPA Standard Auditors’ Report--Introductory Paragraph 6

7. We conducted our audit 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 financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. The AICPA Standard Auditors’ Report--Scope Paragraph 7

8. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of XYZ Company as of December 31, 20XX, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. The AICPA Standard Auditors’ Report--Opinion Paragraph 8

9. 9 Types of Auditor’s Opinion Auditor’s opinion are classified as under: Unqualified opinion Qualified opinion Adverse opinion Disclaimer of opinion

10. Types of Auditor’s Opinion Unqualified opinion is given when the financial statements of an organization are found accurate, fair and in accordance with the local GAAP. An unqualified opinion is considered the best possible audit outcome, and it is the most frequently reported opinion. This report assures the stakeholders that the auditor has thoroughly examined the organization’s financial reports and is of the opinion that the financial information is presented accurately and is in conformance with GAAP. 10

11. Conditions Required for Issuance of an Unqualified Report Two conditions are required to be met for issuance of an Unqualified Report: The financial statements are presented in conformity with GAAP, including adequate disclosure. The audit was performed in accordance with GAAS (Generally accepted auditing standards), and there were no significant scope limitations. 11

12. 12 An unqualified opinion—standard report . This report expresses a “clean opinion” and may be issued only when the two conditions listed in the preceding section have been met, and when no conditions requiring explanatory language exist. An unqualified opinion—with explanatory language. In certain circumstances explanatory language is added to the auditors’ report with no effect on the auditors’ opinion.

13. 13 For example an unqualified opinion by an external auditor ABC for a company XYZ would be written as under. In our opinion, all the financial statements reviewed, fairly represent the financial position of the XYZ corporation as of December 31, 199x and the results of its annual operation and cash flows for the year ended on December 31, 199x in accordance with the Generally accepted accounting practices. ABC & Co. Date

14. Modifications of the Auditors’ Report--Unqualified Opinions Type of Report Introductory or Scope paragraph Explanatory Paragraph Opinion Paragraph Shared responsibility Describe work of other auditors None "…based on our audit and the report of other auditors" Going concern uncertainty None Describe uncertainty None GAAP not consistent None Describe change in principle None Emphasis of a matter None Describe matter None Justified departure from GAAP None Describe departure None

15. 15 A qualified opinion states that the financial statements are presented fairly in conformity with generally accepted accounting principles “except for” the effects of some matter. A qualified opinion is the one in which the auditor concludes that most matters of financial statements are accurate and in concurrence with GAAP except for some areas for which justification is liable. A qualified opinion, contradictory to its connotation, is not a good report in terms of accounting. 2. Qualified Opinion

16. 16 It indicates a limited scope for auditors and advises the public that the audit is incomplete or the company is not maintaining the GAAP in some matters. But these matters must not be influencing the factual financial position of the firm. For example a publically trading company hires an external auditor at the year ended December 31 st 20XX to conduct an audit of accounts and financial control for its firms. Auditors find out that the firm is not properly maintain its adjusting entries record, also the cash accounts does not have relevant receipts. Hence they will give a Qualified opinion for this firm for limitation of scope and nonoccurrence with GAAP. 2. Qualified Opinion

17. Modifications of Auditors’ Report—Qualified Opinions Type of Report Introductory or Scope Paragraph Explanatory Paragraph Opinion Paragraph Qualified—GAAP Departure None Describe departure and effects “except for the effects of the departure the financial statements…” Qualified—Scope Limitation “Except as explained in the following paragraph…” Describe scope limitation “except for the effects of such adjustments, if any, as might have been determined to be necessary had we been able to…” 17

18. 18 An adverse opinion is generally considered a bad sign for public, management and stake holders of the company. This opinion indicates that the financial statement are not fair and accurate representation of financial position resulting from the organization’s annual operations and cash flows or not in concurrence with the GAAP. Adverse opinion is an official written statement of an internal auditor about the firm’s true financial position and the issuance of an adverse opinion may have noticeable effect of company stock value and business. 3. Adverse Opinion

19. 19 For example during audit it is disclosed that financial statements are materially misreported and no GAAP is followed while the preparation of the financial statements. Adverse Opinion: Auditor will issue an adverse opinion as FS are not the true presentation of the firm’s accurate financial position. A disclaimer of opinion is the one in which auditor does not express any opinion on the financial statements as the audit is not performed due to insufficient data or the data is inadequate in scope to form an opinion. For example during an audit FS were found incomplete or supporting documents of most of the financial transactions were not presented to the internal auditor or the audit was not conducted completely due to some unavoidable reasons than a disclaimer of auditor’s opinion will be issued.

20. Modifications of Auditors’ Report—Adverse Opinions and Disclaimers Type of Report Introductory or Scope Paragraph Explanatory Paragraph Opinion Paragraph Adverse None Describe reason for opinion "The financial statements do not present fairly" Disclaimer of Opinion--Scope Limitation "We were engaged"; Omit responsibility. Omit scope paragraph Describe scope restriction and any reservations "we do not express an opinion on the financial statements."

21. Auditors’ Standard Report – Public Clients Differences from nonpublic Includes the words “Registered” and “Independent” in the title. References standards of the PCAOB ( Public Company Accounting Oversight Board  ) rather than generally accepted auditing standards. Includes the city and state—or city and country in the case of non–U.S. auditors—where the auditors’ report has been issued. (Historically, auditors have included this information, although it was not required.) Includes an additional paragraph indicating that the auditors have also issued a report on the client’s internal control over financial reporting. The report on internal control may either be presented separately or combined with the report on the financial statements into one overall report 21

22. Accounting Income and Assets: Accrual Concept

23. What does Accrual means? Accrual  (accumulation) of something is, in finance, the adding together of interest or different investments over a period of time. It holds specific meanings in a ccounting , where it can refer to accounts on a balance sheet that represent liabilities and non-cash-based assets used in accrual -based accounting. Accrual Accounting is an accounting method that measures the performance and position of a company by recognizing economic events regardless of when cash transactions occur. The general idea is that economic events are recognized by matching revenues to expenses (the matching principle) at the time in which the transaction occurs rather than when payment is made (or received). This method allows the current cash inflows/outflows to be combined with future expected cash inflows/outflows to give a more accurate picture of a company's current financial condition. 23

24. What does Accrual means? Revenues are recognized when they are EARNED. Expenses are recognized when they are incurred. e.g. If you have to pay the rent of a shop at the end of the month, however for some reason you are unable to clear the liability and decides to pay next month, in this case you will have to record the expense that has incurred however not yet paid. i.e. Rent Expense for Jul-24 A/C……….Dr. Landlord A/C (A/P)……Cr Similarly when a revenue is earned, it has to be recorded as when earned regardless when cash is received by the landlord. Hence landlord will record accrued revenue as A/R (Rent from abc )………………Dr. Rent Revenue for Jul-24…….Cr. An Adjusting entry will be passed as the cash is received i.e. Cash (Rent received for Jul-24)…….Dr. A/R (Rent from abc )…………..Cr. 24

25. Income, Cash Flow, and Assets :Definition And Relationship In a world of certainty, the interrelationship among income, cash flow, and assets is captured by the concept of economic earnings . “Economic Earning, defined as net cash flow plus the change in market value of the firm’s net assets.” The market value of the firm’s assets in this certain world is equal to the present value of their future cash flows discounted at the (risk free) rate . In this world of uncertainty, income (however measured) is, at best, only a proxy for economic income. 25

26. Distributable Earning is the amount of earnings that can be paid out a dividends without changing the value of the firms. Sustainable Income , refers to the level of income that can be maintained in the future given the firm’s stock of capital investment (e.g., fixed assets & inventory) Permanent Earnings , used by analysts for valuation purposes, is the amount that can be normally earned given the firm’s assets and equals the market value of those assets times the firm’s required rate of return. Income, Cash Flow, and Assets: Definition And Relationship 26

27. As a result of these difficulties, the financial reporting concept of income- accounting income – is often quite different. The analyst, therefore, needs to relate accounting income to the economic income. Accounting Income , is measured using the accruals concept and provides information about the ability of the enterprise to generate future cash flows. Income, Cash Flow, and Assets: Definition And Relationship 27

28. The Accrual Concept of Income Accounting and economic income both define income as the sum of cash flows and changes in net assets. However, in financial reporting, the determinants of Which cash flows are included in income and when Which changes in asset and liability values are included in income How and when the selected changes in assets and liability values are measured Are based on accounting rules and principles – (GAAP) 28

29. The Matching Principle Revenue and expense recognition are also governed by the Matching Principle, which states that operating performance can be measured only if related revenues and expenses are accounted for during the same accounting time period. Revenue earned should be matched with the expenses incurred in earning it and should be reported is the same accounting period. It is the matching principle that requires the expense (cost of goods sold) of inventory to be recognized in the same period in which the sale of that inventory is recorded . Matching principal is applied in Income statement which helps in helps in calculation of profit of a particular period. Matching concept helps to reporting correct profit of the accounting period rather than under or over reporting. 29

30. Angle Machining, Inc. buys a new piece of equipment for $100,000 in 2015. This machine has a useful life of 10 years. This means that the machine will produce products for at least 10 years into the future. According to the matching principle, the machine cost should be matched with the revenues it creates. Thus, the machine is depreciated over its 10-year useful life instead of being fully expensed in 2015. 30 The Matching Principle

31. The Matching Principle For example if a shoe manufacturer incurred a cost of $10,000 on manufacturing of 100 shoes and earned a revenues of $12,000 by selling 80 shoes at $ 150 each. Where his other admin expenses are $1,000 then his profit according to matching principle will be calculated as under. Sales………………$12,000 less: CGS…………$ 8,000 Gross Profit………$ 4,000 Less: Admin Expenses…….$1,000 Net Profit……………………… $ 3,000 31

32. Income Statement Format & Classification IS formats vary, especially in the reporting of the gain or loss on sale of assets, equity in earnings of partners and other non-operating income and expense. In some cases, income statement detail appears in financial statement footnotes . IAS (International Accounting Standards) Presentation Requirements : IAS 1 specifically allows for presentation of the income statement in either of two formats: Classification of expenses by function. Classification of expenses based on their nature. Under this alternative, the company reports expenditures using categories such as raw materials, employees, and changes in inventories. 32

33. General Format of I/S Revenues from sale of Goods & services (+) Other income & Revenues (-) Operating Expenses (-) Finance cost (+/-) Unusual or infrequent items = Pretax earnings from continuing operations (-) Income tax expense = Net income from continuing operations (+/-) Income from discontinued operations ( net of tax) (+/-) Extraordinary items ( net of tax) (+/-) Cumulative effect of accounting changes (net of tax) = Net income 33

34. 34 A single-step income statement gives a simple accounting of a business’s net income, whereas a multi-step income statement follows a three-step process to calculate net income, separating operational from non-operational revenues and expenses.

35. Components of Net Income The format typically found in actual statement may not be the most useful for analytical purposes. It is important for the analyst to be aware of the various categories or groupings into which the income statement components can be combined. These grouping do not necessarily coincide with the classifications presented in actual financial statements. We shall follow the suggested grouping presentation. These grouping provide information about different aspects of a firm’s operations: 35

36. Suggested Format I/S Revenues from sale of Goods & services (-) Operating Expenses = Operating income from continuing operations (+) Other income & Revenues = Recurring income before interest and taxes from continuing operations (-) Finance cost = Recurring (pretax) income from continuing operations (+/-) Unusual or infrequent items = Pretax earnings from continuing operations (-) Income tax expense = Net income from continuing operations 36

37. Suggested Format, cont, = Net income from continuing operations (+/-) Income from discontinued operations ( net of tax) (+/-) Extraordinary items ( net of tax) (+/-) Cumulative effect of accounting changes (net of tax) = Net income 37

38. 38 A multi-step income statement reports much of the same general information included in a single-step income statement, but it uses multiple equations to determine the net income, or profit, of the company. The multi-step income statement breaks down operating revenues and operating expenses versus non-operating revenues and non-operating expenses. This separates revenues and expenses that are directly related to the business’s operations from those that are not directly tied to its operations. The multi-step income statement uses three different accounting formulas to arrive at the net income: Step 1: Calculate Gross Profit Cost of goods sold is subtracted from net sales. This gives the gross profit: Gross Profit = Net Sales – Cost of Goods Sold Step 2: Calculate Operating Income Operating expenses are subtracted from gross profit. This gives you the operating income: Operating Income = Gross Profit – Operating Expenses Step 3: Calculate Net Income Operating income is added to the net non-operating revenues, gains, expenses, and losses. This final figure gives the net income or net loss of the business for the reporting period: Net Income = Operating Income + Non-operating Items

39. Recurring Versus Nonrecurring Items Income from a firm’s recurring operating activities is considered the best indicator of future income. The predictive ability of reported income is enhanced if it excludes the impact of transitory or random components, which are not directly related to operating activities and are generally more volatile. Being a financial analyst separation of the results of normal, recurring operations from the effects of nonrecurring items facilitates the forecasting of future earnings and cash flows, Financial reporting defines nonrecurring by the type of transaction or event . 39

40. Recurring Revenue/Income The portion of a company's revenue that is highly likely to continue in the future. This is revenue that is predictable, stable and can be counted on in the future with a high degree of certainty. For example, a telephone company that has millions of customers paying monthly could consider a large portion of its monthly revenues to be recurring in nature. 40

41. Nonrecurring Items Events or transactions that infrequently happens. These items should be separately reported, because it will not occur in every period . Types of Nonrecurring Items : The income statement contains four categories of nonrecurring income : Unusual or infrequent items Extraordinary items Discontinued operations Accounting changes 41

42. Unusual or Infrequent Items: Transaction or events that are either unusual in nature or infrequent in occurrence but not both may be disclosed separately (as a single–line item) as a component of income from continuing operations. These items must be reported pretax in the income statement: the tax impact ( or the net – of – tax amount ) may be disclosed separately. Common Examples are: Gains or losses from disposal of a portion of a business segment Gains or losses from sales of assets or investments in affiliates or subsidiaries Provisions for environmental remediation Impairments, write-offs, write downs , and restructuring costs Expenses related to the integration of acquired companies Nonrecurring Items 42

43. 2. Extraordinary Items: Extraordinary items as transactions and events that are unusual in nature and infrequent in occurrence and are material in amount . Extraordinary items must be reported separately, net of income tax. Firms are also required to report per – share amounts for these items and encouraged to provide additional footnote disclosures . GAAP specifically stated that write-offs, write-downs, gains, or losses on the following items were not to be treated as extraordinary items: Abandonment of property, Accruals on long-term contracts, Disposal of a component of an entity, Effects of a strike , Equipment leased to others, Foreign currency exchange, Foreign currency translation, Intangible assets, Inventories, Receivables, Sale of property Nonrecurring Items 43

44. 3. Discontinued Operations : The discontinuation or sale of a business may indicate that it: Has inadequate or uncertain markets or prospects Has an unsatisfactory contribution to earnings and cash flows Is no longer considered by management to be a strategic fit Can be sold at a significant profit Operating income from discontinued operations and any gains or losses (net of taxes) from their sale are isolated in the income statement , since these activities will not contribute to future income and cash flows. Nonrecurring Items, cont. 44

45. 4. Accounting Changes: Accounting changes fall into two general categories : Those undertaken voluntarily by the firms and those mandated by new accounting standards. Generally, accounting changes do not have direct cash flow consequences . The changes from one acceptable accounting method to another acceptable method is reported net of tax after extraordinary items and discontinued operations on the income statement. Nonrecurring Items 45

46. Accounting Income Revenue & Expenses Recognition When accrual accounting is used to prepare financial statements, two revenue and expense recognition issues must be addressed: TIMING: When should revenue and expense be recognized ? MEASUREMENT : How much revenue and expense should be recognized? 46

47. Statement of Financial Accounting Concepts (SFAC) 5 , recognition and measurement in Financial Statements of Business Enterprises, specifies two conditions that must be met for revenue recognition to take place. These conditions are: Completion of the earning process Assurance of payment To satisfy the first condition, the firm must have provided all or virtually all the goods or services for which it is to be paid., and it must be possible to measure the total expected cost of providing the goods and services; that is, the seller must have no remaining significant contingent obligation. Revenue recognition also requires a second condition: the quantification of cash or assets expected to be received for the goods and services provided. 47

48. Current Environment Guidelines for revenue recognition Departures from sale basis Revenue Recognition at the Point of Sale Revenue Recognition before Delivery Revenue Recognition after Delivery Sales with discounts Sales with right of return Sales with buybacks Bill and hold sales Principal-agent relationships Trade loading and channel stuffing Multiple-deliverable arrangements Installment-sales method Cost-recovery method Deposit method Summary of bases Percentage-of-completion method Completed-contract method Long-term contract losses Disclosures Completion-of-production basis Revenue Recognition 48

49. Departures from the sales basis of Revenue Recognition Revenue may be recognized prior to sale or delivery when the earnings process is substantially complete and the proceeds of sale can be reasonably measured. For example revenue is recognized at the completion of production in the case of commodities, such as oil and agricultural products. Alternatively, revenues may not be recognized even at the time of sale if there is significant uncertainty regarding the seller’s ability to collect the sales price or to estimate remaining costs. 49

50. Revenue Recognition before Delivery You may have a contract of constructing a building. As a contractor . You will construct the building. During the construct period cost will incur, as well as some cash will be required. How to recognized these revenue and cost. Should these be shown at the time of construction or at the end of completion . Two method can be followed- Percentage-of-completion method Completed contract method 50

51. Percentage – of – Completion Methods The percentage of completion method recognizes revenues and costs in proportion to and as work is completed: production activity is considered the critical event in signaling the completion of the earning process rather than delivery of cash collections. This method is used when: There is a long-term contract, and If production activities, revenue and expenses can be reasonably estimated. Measurement of progress towards completion can be estimated by using either- (1) Engineering estimation; or (2) Ratio of cost incurred to total cost. 51

52. 2. Completed Contract Methods; contt .. The completed contract method recognizes revenues and expenses only at the end of the contract It must be used when any of the conditions required for the use of the percentage-of-completion method is not met. Generally when no contract exists or estimates of the selling price or collectability are not reliable. It must be used for short – term contracts. 52

53. Installment Method of Revenue Recognition Revenues should not be recognized at the time of sale or delivery when there is no reasonable basis to estimate collectability of the sales proceeds. The Installment method recognizes gross profit in proportion to cash collections, resulting in delayed recognition of revenues and expenses as compared with full recognition at the time of sale . This method is sometimes used to report income from sales of noncurrent assets and real estate transactions. Revenue Recognition After Delivery 53

54. 2. Cost Recovery Method Revenue recognition on sale or delivery is also excluded when the costs to provide goods or services cannot be reasonably determined. In many cases, there is also substantial uncertainty about revenue realization since only small down payments may be required with nonrecourse financing provided by the seller. With both future costs and collection uncertain, the cost recovery method requires that all cash receipts be first accounted for as a recovery of costs. 54