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The Price Waterhouse audit report opinion of U.S. Steel in 1903 was on of the first financial statements accompanied by an independent auditor's report in the United States of America. Since then, the independent auditor's report has gone through numerous changes to reflect the responsibilities of auditors and management. Numerous lawsuits were caused by auditor's negligence, a lack of independence, and a failure to detect frauds and material misstatements. Auditors were issuing opinions that did no truly reflect the financial position of companies. Because it would be very hard for an auditing firm to completely verify everything in a company financial statements, changes were made to protect auditors from liabilities and to reiterate their responsibilities. The type of work to be performed, the number of paragraphs and the length of the opinion paragraph, the language used in the report were some of the changes that the independent audit report has gone through. The purpose of this paper is to provide a timeline and a review of the changes to the independent auditor's report over the years as users needs and wants were changing. The Federal Reserve Bulletin Pronouncements of 1917 and 1929, the revisions of 1934, 1939, 1948, 1977, and 1988 of the independent auditor's report will be discussed. The paper will also discuss the responsibilities of the auditor and some effects of the accounting scandals of early 2000 on the auditing profession.
BACKGROUND ON AUDITING
At the origin, auditing was primarily a tool to maintain and insure government accountancy and record keeping was its main purpose. The first record keeping began around 4000 B.C, with the oldest commercial documents being traced to around 3500 B.C (Brown, 1905). It is clear that record keeping and accountancy has always been important for human beings. In its early age, the audit function was already a tool to maintain proper recording of various transactions and emphasized financial accountancy. However, auditing gained its momentum in the 1750 to 1850 during the Industrial revolution where jobs and companies' revenues were increasing considerably. Businesses were expanding and the need for people to manage them arisen. Business owners found an increasing need to control financial activities for the accuracy of records and for frauds fighting. Entrepreneurs began to heavily rely on auditors' to protect their interest from none intentional errors, omissions, and frauds. The audit function began to develop into a field of fraud detection, financial accountability and would engage a review of most of the transactions recorded. With the increase in size and revenues of companies, the pressure from stockholders and other concerned parties, the pressure from distant investors not familiar with the firm an independent opinion of accounting records and reports started to weight in the balance in the United States. A review of the financial statements from an outsider point of view was then required from businesses on top of the presentation of their financial statements. The independent auditors' opinion became a requirement for firms with the Price Waterhouse being one of the first accounting firms to produce an independent auditor's opinion to accompany on a business financial statement.
EVOLUTION OF THE STANDARD AUDIT REPORT
1917 - Uniform accounting
Prior to the development of the first standard audit opinion in the United States, auditors had the discretion over the structure and the wording of their audit opinions. Audit reports were long in an attempt to provide a clear and precise description of the work that the auditor had performed. Some other auditors used a short form similar to the British audit opinions prior to the standardization of the audit report in 1917 by the U.S Federal Reserve. The Federal Reserve Bulletin of April 1917 titled "Uniform Accounting" suggested the following language for the first standard audit report opinion:
"I have audited the accounts of â€¦.. for the period from â€¦ to â€¦ and I certify that the above balance sheet and statement of profit and loss have been made in accordance with the plan suggested and advised by the Federal Reserve Board and in my opinion set forth the financial condition of the firm â€¦and the results of its operations for the period."
The Federal Reserve also specifies audit procedures that should be completed and the language that should be used in the audit report. The Federal Reserve was concerned about a uniform system of accounting at this time of increasing business operations. Investors, bankers, and users of audit reports were requiring more assurance as to the integrity of balance sheets numbers. The audit report opinion was developed in order to eliminate uncertainty and increase uniformity. The statement emphasized that auditors do not verify all transactions in a company's books but rather focused on the balance sheet figures and the statement of profit and loss.
1929 - Verification of financial statements
The next noticeable update to the auditor's opinion was introduced in the Federal Reserve Bulletin of 1929. "Verification of financial statements" was the name of the 1929 Bulletin. The update or change was the result of growing critics against the April 1917 publication of the Federal Reserve. Critics argued that the procedures in the preceding publication by the Federal Reserve failed to provide the desired information. The 1917 report was mainly about the balance sheet and the statement of profit and loss. The title of the 1929 Federal Reserve Bulletin emphasized the verification of financial statements and not just the balance sheets and statement of profit and loss. Language similar to the ones in the 1917 audit report opinion such as the word "certify" could be found in the 1929 revision. 1929 also introduced the word examine to replace "verify" which was very popular in prior years auditor report opinions. Audit sampling was introduced with the 1929 changes to the opinion. An examination of accounts implies a review of selected accounts or transactions which is in line with sampling techniques. The new terminology represented a shift from the verification or reviewing of all of the transactions of the business being audited.
I have examined the accounts of â€¦. company for the period from â€¦. to â€¦. I certify that the accompanying balance sheet and statement of profit and loss, in my opinion, set forth the financial condition of the company at â€¦. and the results of operations for the period.
1934 - Audits of Corporate Accounts
With the "Audits of Corporate Accounts", the word "certify" is removed by the word "examination" which is more in line with the work auditors were performing. The American Institute of Accountant felt that the previous term was misleading because it was expressing more than the auditors opinion about the statements. For the first time, the term "fairly present" was used in the auditor report. This represented a move from the idea that the statements being audited were completely correct. This new wording better communicated the responsibilities of the auditors in the process of auditing financial statements. With stockholders wanting more information about what was done in the audit process, a second paragraph was for the first time added to the opinion. The new paragraph added a scope to the opinion segment.
We have made an examination of the balance sheet of the XYZ Company as of December 31, 1933, and of the statement of income and surplus for the year 1933. In connection therewith, we examined or tested accounting records accounting records of the company and other supporting evidence and obtained information and explanations from officers and employees of the company; we also made a general review of the accounting methods and of the operating and income accounts for the year, but we did not make a detailed audit of the transactions.
In our opinion, based upon such examination, the accompanying balance sheet and related statements of income and surplus fairly present, in accordance with accepted principles of accounting consistently maintained by the company during the year under review, its position at December 31, 1933, and the results of its operations for the year.
1939 & 1948 - Statement on Auditing Procedure No. 1 & 24
The Statement on auditing procedure (SAP) No. 1 titled "Extension of Auditing Procedure" will bring significant changes in 1939. The changes to the auditor report opinion in 1939 were significant because many of the changes still on today's report. Changes that were introduced in 1939 resulted from the removal and the introduction of new words and terms. The most noticeable change was in the opinion paragraph which now included the term "in conformity with generally accepted accounting principles". Another significant addition in 1939 was the introduction of the word "consistency" in the opinion paragraph. With SAP No. 1, the scope paragraph states that the "auditors have reviewed the system of internal control" and the scope paragraph no longer mentioned "obtaining information from officers and employees".
We have examined the balance sheet of the ABC Company as of December 31, 1939, and the statements of income and surplus for the fiscal year then ended; have reviewed the system of internal control and the accounting procedures of the company, and, without making a detailed audit of the transactions, have examined or tested accounting records of the company and other supporting evidence by methods and to the extent we deemed appropriate. Â
In our opinion, the accompanying balance sheet and related statements of income and surplus present fairly the position of the ABC Company at December 31, 1939, and the results of its operations for the fiscal year, in conformity with generally accepted accounting principles applied on a basis consistent with that of the preceding year.
In 1948, SAP No. 24 titled Revision in Short-Form Accountant's Report or Certificate also introduced new words and while some terms were being removed. "Generally accepted auditing standards" and test of the accounting records and such as other auditing procedures" were used for the first time. These changes were in line with the creation of GAAS (Generally Accepted Auditing Standards) which provided an outline that each audit should follow. The removal of the "system of internal control" and "without making a detailed audit of the transactions" was they important modification to the scope paragraph in 1948. New auditing standards and the size of and level of businesses activities were the reason of the elimination of these words.
We have examined the balance sheet of ABC Company as of December 31, 1949, and the related statements of income and surplus for the year then ended. Our examination was 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.Â
In our opinion, the accompanying balance sheet and statements of income and surplus present fairly the financial position of ABC Company at December 31, 1949, and the results of operations for the year then ended, in conformity with generally accepted accounting principles applied on a basis consistent with that of the preceding year.
1976 & 1988 - Statement on Auditing Standards No. 15 & 58
From 1948 to 1976, the accounting profession went through numerous changes. The American Institute for Accountants for example changed its name to the American Institute of Certified Accountants. These events that occurred during the period 1948 to 1976 caused the 1976 changes to the standard audit report. Shareholders, as businesses continued to change requested more and more from auditors. The changes in 1976 emphasized a comparative evaluation with two balance sheets date presented. Prior year auditor reports referred to a single fiscal year end. The comparative evaluation was useful for investors who often compared years of operations to determine trends and make financial decisions. Rather than listing specifics reports, the 1976 change refers to the statements being audited as "financial statements". The Balance sheet, the income statement, the retained earnings statement, and the statement of changes in financial position were now considered in the audit process.
We have examined the balance sheets of ABC Company as of December 31, 19X2 and 19X1, and the related statements of income, retained earnings, and changes in financial position for the years then ended. Our examinations were made in accordance with generally accepted auditing standards and, accordingly, include such tests of the accounting records and such other auditing procedures as we considered necessary in the circumstances.Â
In our opinion, the financial statements referred to above present fairly the financial position of the ABC Company as of December 31, 19X2 and 19X1, and the results of its operations and the changes in its financial position for the years then ended, in conformity with generally accepted accounting principles applied on a consistent basis (AICPA, 1976).
The changes that occurred in 1988 with the statement on auditing standards No. 58 were the last one. They were the last changes because the independent auditor report opinion of 1988 is still the one being used by auditors today. Major changes to the report happened in 1988. The standard report moved from a two paragraphs to a three paragraphs audit report. The new paragraph being added laid the responsibility of the parties involved in the audit process (i.e. auditors and management). The new report stressed that the financial statements were the responsibility and product of the organization management and not the auditors. Precise information pertaining to the audit firm responsibility and the limitations of the audit function were now included in the scope paragraph. The new report of 1988 is definitely more detailed in an effort to reduce the "expectation gap" by clearly defining what is involved in the audit process and explaining the difference between management and auditors responsibility. The expectation gap in accounting is the gap between an auditor actual standard of performance and the more rigorous public expectation of what an auditors performance should be (Ventureline, 2010).The purpose of the changes of 1988 was to aid the public to better understand the audit process and the responsibilities of the parties involved.
We have audited the accompanying balance sheets of X Company as of December 31, 19X2 and 19X1, 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. Our responsibility is to express and opinion on these financial statements based on our audits.Â
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. 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 audits provide a reasonable basis for our opinion.Â
In our opinion, the financial statements referred to above present fairly, in all material aspects, the financial position of X Company as of [at] December 31, 19X2 and 19X1, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles
UNDERSTANDING THE AUDITOR'S REPORT
Responsibilities of the Independent Auditor
There will always be a need of an independent auditor because not all facts concerning financials are properly and accurately presented by businesses. To better understand the auditor's report, one must know or have a good knowledge of the role, responsibilities, and functions of the independent auditor. As discussed in AU Section 110, the auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud (AICPA.ORG, 2010). Financial statements are always the responsibility of management. It is the auditor responsibility to express an opinion on the statements and that the statements have been prepared in conformity with GAAP. Anything regarding internal control, records, authorization, process, policies is the responsibility of management. The independent auditor must have professional qualifications and an adequate education to conduct an audit. The independent auditor must also comply with the professional standards set for the Accounting profession. The American Institute of Certified Public Accountants (AICPA) sets standards and regulations for Certified Public Accountants providing professional services. The mission of the U.S. Securities and Exchange Commission (SEC) is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation (www.sec.gov, 2010). The SEC protects investors and the public by promoting transparency in financial statements. Another body of the Accounting profession is the Financial Accounting Standards Board (FASB) which mission is to establish and improve standards of financial accounting and reporting that foster financial reporting by nongovernmental entities that provides decision-useful information to investors and other users of financial reports. That mission is accomplished through a comprehensive and independent process that encourages broad participation, objectively considers all stakeholder views, and is subject to oversight by the Financial Accounting Foundation's Board of Trustees (www.fasb.org). It is the independent auditor responsibility to comply with the rulings set forth by the public accounting profession bodies.
The Auditor report
The audit report is the product of an examination of a firm accounting records by a certified auditor. It is a test of business financial statements for compliance with Generally Accepted Accounting Principles (GAAP). The current audit report has three paragraphs. An introductory paragraph which clearly states that the auditor is producing a report on the financial statement and not the accounting records, a scope paragraph which describes the audit, conformity with generally accepted auditing standards (GAAS), and provide assurance that the financial statements are free of material misstatement. The last paragraph is the opinion paragraph where the auditor expresses an opinion without guarantying or certifying that the financial statements are correct. There are a few audit reports that can be issued on a company financial statement by auditors. An unqualified report, an explanatory language added to the unqualified report, a qualified report, and adverse opinion, or a disclaimer of opinion can be issued. The report that every businesses would want is the unqualified report. Au unqualified report means that the statements are not misleading and that they were produce in conformity with GAAP. An explanatory language is often added to the unqualified opinion if there is need to emphasize a matter or there is inconsistency in applying the accounting principles for example. An example of an explanatory language that could be added to the unqualified auditor report is the following:
The accompanying financial statements have been prepared assuming that ABC Company will continue as a going concern. As discussed in Note 1 to the financial statements, ABC Company has suffered recurring losses from operations and has a net capital deficiency that raises substantial doubt about the entity's ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty (www.crfonline.org, 2010).
A qualified opinion is an audit report where the auditors do not agree with the fair presentation of the financial statements in accordance with GAAP. It decreases the auditors' exposure for fair presentation in areas of the statements. A separate paragraph usually discloses the reason of the qualification. An adverse opinion states that the financial statements are not presented fairly and do not represent the position of the company in accordance with GAAP. A disclosure paragraph explaining the reason of the adverse opinion should be included. A disclaimer of opinion is issued when auditors do not express an opinion. A disclaimer of opinion is issued when significant conditions prevent compliance with the generally accepted accounting principles.
The auditing profession and the financial statements frauds of early 2000
The issue of independence of auditors and the ability to effectively discover financial statement frauds has been raised with the accounting scandals of the past years. The failure big corporations such as of Enron, Adelphia Communications, and the Arthur Andersen audit firm in the early 2000 have triggered a lot of changes in the Auditing profession. The Sarbanes-Oxley Act of 2002, the SAS 99, the emphasis on ethics and professional skepticism are few of the changes that followed the failure of these giant corporations. Arthur Andersen, a major auditing firm in the early 2000 was convicted of obstruction of justice by shredding documents related to the audit of Enron (www.forbes.com, 2002). The failure of Enron was one of the biggest corporate scandals in the history of the United States. It was a negative period for the auditing profession. Investors and the public have lost trust in auditing firms and their ability to effectively uncover frauds related to financial statements was constantly raised. The statement on auditing standards 99 was issued and took effect on December 15, 2002 discussing the consideration of fraud in a financial statement audit (www.aicpa.org,). The statement on auditing standard 99 stressed the importance for auditors to exercise professional skepticism when considering the existence of material misstatement due to fraud. SAS 99 provided new guidance for the overall audit process. The accounting scandals have stressed the importance of teaching and training accountants on ethics and the exercise of professional skepticism. The Sarbanes-Oxley Act, with Senator Paul Sarbanes and Representative Michael Oxley as the masterminds (www.soxlaw.com, 2010) was the major change that affected the auditing profession following the many accounting scandals in the beginning of the current decade.
The Sarbanes-Oxley Act of 2002
In the wake of many corporate financial statements scandals, the Sarbanes-Oxley Act (SOX) was passed to protect the interest of investors by ensuring that corporate disclosures are accurate and conform to securities laws. The Sarbanes-Oxley Act introduced new standards for corporate governance as well as penalties for not doing the proper thing. New internal controls and measures to validate financials records were included in the Act. SOX requires the existence of adequate controls to guarantee the legitimacy of financial records. The Sarbanes-Oxley act applies to all public companies within the United States as well as to international companies that have securities registered with the SEC. It also affects the auditing firms that provide services to these companies. As a result of the Sarbanes-Oxley Act, the Public Company Accounting Oversight Board became responsible of the rules and standards to be used in performing and reporting on audits. Adherence to the rules and standards of the PCAOB became a requirement for all public accounting firms. Non compliance to the Sarbanes-Oxley Act by public companies and auditing firms can result in enormous fines, imprisonment, loss of exchanges listing, and potential loss of the directors and officers insurance. The Sarbanes-Oxley Act has many sections. Some sections are more significant to compliance than others. The key sections of the Sarbanes-Oxley Act are Section 302, 404, 409, 802, 804, and 806 (www.sox-online.com, 2010). The United Sates Congress thinks that the Act effectively addresses and resolves the issue of corporate frauds by enhancing corporate governance and strengthening accountability. The act enhances corporate governance and accountability by formalizing and strengthening internal checks and balances within corporations, instituting various new levels of control and sign-off designed to ensure that financial reporting exercises full disclosure, and that corporate governance is transacted with full transparency (www.sox-online.com, 2010).
The first standardized opinion was introduced with the Federal Reserve Bulletin of 1917. Since then, the opinion has been changed numerous times. Some of the changes were significant than others. The format of the opinion as well as the language of the opinion has changed over the years. The standard auditor opinion has gone from a one paragraph to a two paragraph, and finally to a three paragraph opinion. The complexity and increasing size of corporation operations, the needs, and the wants of investors and shareholders caused the auditor opinion growth in size. There was the need for more disclosure and a clear description of the auditor work and responsibility as more people were relying on the auditor opinion. The auditor report has remained unchanged since its last modification in 1988. The frauds discovered in recent years and the issue of independence of auditors has caused the United States Congress to create body and enact acts to regulate the audit profession. The Sarbanes-Oxley Act, the diverse statements on auditing standards issued by the AICPA, the control of the rules and standards setting by the PCAOB have helped in fighting corporate financial statements fraud. However, I believe the bulk of the work has to be done by the profession itself. There will always be the need of the independent auditor as an outside to give credibility to businesses financial statements. However, there is a necessity for the profession to take conscience and make every effort to do the right thing to regain the public and confidence in auditors.