AU 410: Adherence to GAAP

AU-C 700: Forming an Opinion and Reporting on Financial Statements

EFFECTIVE DATE AND APPLICABILITY

Original Pronouncements Section 410: Statements on Auditing Standards (SASs) 1 and 62.
Effective Date These statements currently are effective.
Applicability Audits of generally accepted accounting principles (GAAP) financial statements in accordance with generally accepted auditing standards (GAAS).

EFFECTIVE DATE AND SUMMARY OF CHANGES

SAS No. 122, Codification of Auditing Standards and Procedures, is effective for audits of financial statements with periods ending on or after December 15, 2012.

AU-C Sections 700, 705, and 706 include auditor report changes and include close integration with AU-C Sections 210, Terms of Engagement, and 580.

AU-C Sections 700, 705, and 706 supersede:

  • AU Section 410,
  • AU Section 530, Dating of the Independent Auditor’s Report, (as amended) paragraphs .01–.02,
  • AU Section 508, Reports on Audited Financial Statements, supersedes paragraphs .01–.11, .14–.15, .19–.32, .35–.52, .58–.70, and .74–.76

Paragraph .08 of AU Section 508 requires a statement in the auditor’s report that the financial statements are the responsibility of the company’s management. Paragraph 25 of the clarified SAS proposes a requirement to describe management’s responsibility for the preparation and fair presentation of the financial statements in more detail than what was required in AU Section 508. The description includes an explanation that management is responsible for the preparation and fair presentation of the financial statements in accordance with the applicable financial reporting framework, and that this responsibility includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error.

The clarified SAS proposes the use of headings throughout the auditor’s report to clearly distinguish each section of the report.

This chapter includes information on AU-C 700. Consult the chapters on AU 508 and AU 530 for additional information on the auditor’s reports.

AU DEFINITIONS OF TERMS

Generally accepted accounting principles (GAAP). A technical accounting term that encompasses all the conventions, rules, and procedures necessary to define accepted accounting practice at a particular time. (As used in the reporting standards, GAAP includes accounting principles and practices as well as the methods of applying them.)

GAAP recognizes the importance of reporting transactions and events in accordance with their substance.

AU-C DEFINITIONS OF TERMS

Source: AU-C 700.11

Comparative financial statements. A complete set of financial statements for one or more prior periods included for comparison with the financial statements of the current period.

Comparative information. Prior period information presented for purposes of comparison with current period amounts or disclosures that is not in the form of a complete set of financial statements. Comparative information includes prior period information presented as condensed financial statements or summarized financial information.

Condensed financial statements. Historical financial information that is presented in less detail than a complete set of financial statements, in accordance with an appropriate financial reporting framework. Condensed financial statements may be separately presented as unaudited financial information or may be presented as comparative information.

General purpose financial statements. Financial statements prepared in accordance with a general purpose framework.

General purpose framework. A financial reporting framework designed to meet the common financial information needs of a wide range of users.

Unmodified opinion. The opinion expressed by the auditor when the auditor concludes that the financial statements are presented fairly, in all material respects, in accordance with the applicable financial reporting framework.

OBJECTIVES OF AU SECTION 410

To express an opinion on the “fairness” of financial statements, the independent auditor requires a standard to determine whether those financial statements are, in fact, presented fairly. That standard or framework is GAAP. Without that framework, the auditor would have no uniform standard for judging the presentation of financial position, results of operations, and cash flows in financial statements.

OBJECTIVES OF AU-C SECTION 700

AU-C 700 states that:

the objectives of the auditor are to

a. form an opinion on the financial statements based on an evaluation of the audit evidence obtained, including evidence obtained about comparative financial statements or comparative financial information, and
b. express clearly that opinion on the financial statements through a written report that also describes the basis for that opinion.

FUNDAMENTAL REQUIREMENTS

Framework for Opinion

The independent auditor’s judgment about whether the financial statements are fairly presented should be applied within the framework of GAAP. The auditor should evaluate whether the substance of a transaction or event differs materially from its form.

Reporting Standard

The first standard of reporting is: “The report shall state whether the financial statements are presented in accordance with generally accepted accounting principles.” AU 410.02 states that this standard is construed not to require a statement of fact by the auditor but an opinion.

Basis for Auditor’s Opinion

AU 410.02 states that “the term generally accepted accounting principles as used in reporting standards is construed to include not only accounting principles and practices but also the methods of applying them.”

Rule 203 Pronouncements

An auditor should not express an unqualified opinion on financial statements that contain a material departure from a pronouncement covered by Rule 203 of the American Institute of Certified Public Accountants (AICPA) Code of Professional Conduct (category 1 under both the nongovernmental and the governmental hierarchies).

Rule 203 pronouncements: Exception. An auditor should express an unqualified opinion on financial statements that contain a material departure from a pronouncement covered by Rule 203 of the AICPA Code of Professional Conduct in those unusual circumstances where literal application of that pronouncement might result in misleading financial statements. In those unusual circumstances, the auditor should:

1. Add a separate paragraph to the report that describes the departure, its approximate effects, if practicable, and the reasons why the departure is necessary to prevent the financial statements from being misleading
2. Express an unqualified opinion on conformity with GAAP
NOTE: Circumstances that would cause adherence to a Rule 203 pronouncement to result in misleading financial statements are likely to be exceedingly rare in practice. According to an interpretation of Rule 203, examples of circumstances that may justify a departure from GAAP are new legislation or the evolution of a new form of business transaction. An unusual degree of materiality or the existence of conflicting industry practices are examples of circumstances that would not ordinarily be regarded as unusual in the context of Rule 203. Only a handful of such reports have ever been issued. (See the “AU Illustrations” section. Also see Section 508, Reports on Audited Financial Statements.)

Securities and Exchange Commission (Sec)

Rules and interpretive releases of the SEC have a level of authority equal to that of category 1 pronouncements for SEC registrants.

INTERPRETATIONS

The Impact on the Auditor’s Report of Accounting Guidance Prior to Its Effective Date (Issued October 1979; Revised December 1992, June 1993, and February 1997; Revised June 2009)

The auditor should not qualify his or her opinion if an entity does not adopt accounting guidance prior to its effective date as long as the accounting principles being followed are currently acceptable.

For financial statements that are prepared on the basis of accounting principles that are acceptable at the financial statement date but that will not be acceptable in the future, the auditor should consider whether disclosure of the impending change in principle and resulting restatement are essential. In cases where the estimated impact of the impending changes is unusually material, disclosure is best made by supplementing the historical financial statements with pro forma financial data that give effect to the future adjustment as if it had occurred on the date of the balance sheet. The auditor may also decide to include an explanatory paragraph that highlights the changes. If essential information is not disclosed, the auditor should express a qualified or adverse opinion.

TECHNIQUES FOR APPLICATION

Auditor Awareness

The auditor should be aware of the content of the GAAP pronouncements. The auditor may obtain this awareness by subscribing to the various services published by the FASB, GASB, and AICPA.

Methods of Application

The auditor should also be aware of the different methods of applying accounting principles. For example, inventory cost may be computed under the FIFO, LIFO, or average cost method.

AU ILLUSTRATION

The following is illustrated:

1. Auditor’s report and explanatory note to the financial statements when adherence to an authoritative pronouncement would, in a very rare circumstance, make the financial statements misleading.
Illustration 1. Auditor’s Report and Note to Financial Statements for Rule 203 Departure1
To the Stockholders and Board of Directors of ABC Company.
We have examined the consolidated balance sheets of ABC Company and consolidated subsidiaries as of December 31, 20X8 and 20X7, and the related consolidated statements of income, additional capital, and changes in financial position for the years then ended. Our examinations were made in accordance with generally accepted auditing standards and, accordingly, included such tests of the accounting records and such other auditing procedures as we considered necessary in the circumstances. We did not examine the financial statements of the Corporation’s health spa subsidiaries for the years ended December 31, 20X8 and 20X7, which statements reflect total assets and revenues constituting 7% and 4% in 20X8 and 6% and 3% in 20X7, respectively, of the related consolidated totals. These statements were examined by other independent accountants whose reports thereon have been furnished to us and our opinion expressed herein, insofar as it relates to the amounts included for such subsidiaries, is based solely upon the reports of the other independent accountants.
As explained in Note A (9), the Corporation’s health spa subsidiaries have changed their method of recording revenues from the recognition of revenue at the time of sale to the recognition of revenue over the membership term and have applied this change retroactively in their financial statements. The other independent accountants’ reports, referred to previously, stated, “Accounting Principles Board (APB) Opinion Number 20, ‘Accounting Changes,’ provides that such a change be made by including, as an element of net earnings during the year of change, the cumulative effect of the change on prior years. Had APB Opinion Number 20 been followed literally, the cumulative effect of the accounting change would have been included as a charge in the 20X8 statement of operations. Because of the magnitude and pervasiveness of this change, we believe a literal application of APB Opinion Number 20 would result in a misleading presentation, and that this change should therefore be made on a retroactive basis.” Accordingly, the accompanying consolidated financial statements for 20X7 have been restated.
In our opinion, based upon our examination and the aforementioned reports of the other independent accountants, the financial statements referred to above present fairly the consolidated financial position of ABC Company and consolidated subsidiaries at December 31, 20X8 and 20X7, and the consolidated results of their operations and changes in financial position for the years then ended, in conformity with generally accepted accounting principles applied on a consistent basis, after restatement for the change, with which the other independent accountants and we concur, in the method of revenue recognition by the health spa subsidiaries referred to in the preceding paragraph.
Ernst & Young
New York, NY
February 27, 20X9
(March 6, 20X9, as to the reports of other independent accountants)
(9) Change in Accounting for Membership Revenues
The corporation has two subsidiaries, one of which is 80% owned, which operate health spas. These companies sell health club memberships that have specific terms, which presently range up to thirty months. In prior years, revenue from sale of memberships, less a deferred portion, was taken into income at time of sale. The deferred portion was taken into revenue on a straight-line basis over the membership terms and was equivalent to the estimated future costs of providing facilities and services. These costs consisted of a pro rata share of estimated future operating expenses. In December 20X7, Deloitte & Touche, independent accountants for the Corporation’s health spa subsidiaries, informed the Corporation that they had taken a position as a firm that, they suggested, should be effective for fiscal years ended after December 31, 20X7, to recognize membership fee revenue and associated costs over the period of membership.
The subsidiaries have concluded that, even though the change has not been required by an authoritative accounting body, there is sufficient authoritative support within similar industries and they have accepted the change suggested by their independent accountants.
Accounting Principles Board (APB) Opinion Number 20, Accounting Changes” provides that such a change be made by including, as an element of net earnings during the year of change, the cumulative effect of the change on prior years. Had APB Opinion Number 20 been followed literally, the cumulative effect of the accounting change would have been included as a charge, net of tax benefits, in the 20X8 consolidated statement of income and would have resulted in reporting a consolidated net loss of $3,398,000 ($.24 per common share) in 20X8 and a consolidated net income of $18,171,000 ($.44 per common share) in 20X7. Because of the magnitude and pervasiveness of this change, the Corporation believes a literal application of APB Opinion Number 20 would result in a misleading presentation, and that this change should, therefore, be made on a retroactive basis. The Corporation’s and the subsidiaries’ independent accountants concur in this treatment.
As a result of retroactive treatment of the change in the method of accounting for membership revenues, the consolidated financial statements for prior years have been restated. The effect of the change was to reduce consolidated net income for 20X8 by $90,000 and to increase consolidated net income previously reported for 20X7 by $5,160,000 ($.16 per share). The increase in deferred revenue at January 1, 20X7, net of related tax benefits, resulted in an adjustment to opening retained earnings of $19,037,000.

1 This report example does not reflect the new report form required by SAS 58 (see Section 508). The authors are not aware of any Rule 203 exception reports that have been issued under the SAS 58 report format.

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