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Guides, Handbooks and Manuals Accountants (AICPA) Historical Collection

1956

40 questions and answers about audit reports

American Institute of Certified Public Accountants (AICPA)

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Part of the Accounting Commons, and the Taxation Commons

40 Questions
and Answers
about
AUDIT REPORTS

answers to questions
bankers are likely to ask
about CPA audits and audit programs

AMERICAN INSTITUTE OF ACCOUNTANTS

270 Madison Avenue New York 16
 INDEPENDENCE
Excerpts from Rules of Professional Conduct,
American Institute of Accountants
5. In expressing an opinion on representations in financial state­
ments which he has examined, a member may be held guilty of an
act discreditable to the profession if
(a) he fails to disclose a material fact known to him which is not
disclosed in the financial statements but disclosure of which is neces­
sary to make the financial statements not misleading; or
(b) he fails to report any material misstatement known to him to
appear in the financial statement; or
(c) he is materially negligent in the conduct of his examination
or in making his report thereon; or
(d) he fails to acquire sufficient information to warrant expres­
sion of an opinion, or his exceptions are sufficiently material to nega­
tive the expression of an opinion; or
(e) he fails to direct attention to any material departure from
generally accepted accounting principles or to disclose any material
omission of generally accepted auditing procedure applicable in the
circumstances.

13. A member shall not express his opinion on financial statements

of any enterprise financed in whole or in part by public distribution of
securities, if he owns or is committed to acquire a financial interest in
the enterprise which is substantial either in relation to its capital or to
his own personal fortune, or if a member of his immediate family owns
or is committed to acquire a substantial interest in the enterprise. A
member shall not express his opinion on financial statements which are
used as a basis of credit if he owns or is committed to acquire a finan­
cial interest in the enterprise which is substantial either in relation to
its capital or to his own personal fortune or if a member of his immedi­
ate family owns or is committed to acquire a substantial interest in the
enterprise, unless in his report he discloses such interest.
 A Brief Note to Bankers

This publication has been prepared by this committee of

the American Institute of Accountants with the assistance of
the Robert Morris Associates and the American Bankers
Association. It is presented in question and answer form for
ready reference and has the following objectives:
1. To help explain the auditing standards observed, and
some of the auditing procedures that may be employed
by certified public accountants in forming an opinion
on the presentation of financial position and results of
operations in a company’s financial statements.
2. To emphasize the responsibilities assumed by the
members of the accounting profession when they ex­
press an independent opinion on financial statements.
If these two objectives are achieved by the publication of
this booklet, it will promote better understanding and better
and stronger ties between the public accounting profession
and those responsible for granting credit.

The CPA’s Function

In reaching a decision whether to extend credit, a banker
considers many factors. Among the most important of these
are the financial position of the borrower and the results of
its operations as shown by its financial statements. Bankers
rely upon the independent CPA for an opinion as to whether
the financial statements present fairly this information.
The banker desires the unqualified opinion of a CPA, ex­
pressed in language similar to that contained in the standard
short form of report developed by the American Institute of
Accountants and reprinted on page 17 of this booklet. The
language of the standard short form of report has been de­
veloped to express precisely and concisely the CPA’s repre­
sentations as to the examination performed and his conclu­
sions as to the financial statements. While these representa­
tions could be stated at greater length, added verbiage
would not alter the essential character of what is stated.
Perhaps one point should be stressed above all others. The
CPA’s opinion, whether unqualified or qualified, is not
formed merely by checking figures in the books or other rec­
ords. Many questions arise during an examination that re­
quire the exercise of mature, experienced judgment. Obvi­
ously, the value of a CPA’s opinion rests on the quality of his
judgment and his independence. In expressing an opinion,
the CPA assumes a heavy responsibility for the professional
competence of his work.
The answers given in this booklet cover most of the ques­
tions that may reasonably be expected to arise in the use of
audit reports issued by certified public accountants.

Committee on Cooperation with

Bankers and Other Credit Grantors
American Institute of Accountants (1955-1956)

R. Bauhof, Chairman Paul Katzen

P. J. Adam R. G. Rankin
James E. Burgess Joseph J. Seaman
Frank S. Calkins Lawrence J. Seidman
Carroll F. Davis Robert Zech
Boone Goode
Ralph V. Hunt Carman G. Blough
William P. Hutchison Director of Research

September, 1956
Contents
Page
The CPA’s Report
Opinions
1. Kinds of opinions ......................................................... 5
2. Unqualified opinion ..................................................... 5
3. Qualified opinion ......................................................... 6
4. Disclaimer of opinion ................................................. 7
5. No statement as to opinion ......................................... 8
6. CPA’s name on financialstatements or report cover 9

Auditing Standards
7. As referred to in audit reports ..................................... 9
8. Independence................................................................. 10

Accounting Principles
9. “Present fairly” ............................................................... 11
10. “Generally accepted accounting principles” .............. 11
11. Consistent application of accounting principles......... 12

Content of Report
12. General purpose report ................................................. 12
13. Auditing standards same for short-form and long-form
reports ........................................................................ 13
14. Details of scope of examination ................................. 14

The CPA’s Examination

Scope of Examination
15. Determination of scope of examination ..................... 15
16. Not a complete verification ......................................... 15
17. “Tests” ........................................................................... 16

Internal Control
18. Meaning of term ......................................................... 16
19. Effect on scope of examination ................................. 21
 Page

Receivables
20. Procedures to substantiate receivables ..................... 22
21. Confirmation of receivables........................................... 23

Inventories
22. CPA’s responsibility for correctness .............................. 23
23. “Observation” of inventories ...................................... 24
24. Stated value of inventories .......................................... 24
25. Obsolescence ................................................................... 25
26. Purchase commitments ...................................................... 25
27. Client’s representation letter ...................................... 25

Fixed Assets
28. Procedures to substantiate fixed assets ..................... 26
29. Commitments for acquisition or construction............. 27
30. Stated at cost ................................................................. 27

Other Items
31. Accounts payable ......................................................... 27
32. Accruals for expenses ................................................... 28
33. Loan agreements ........................................................... 28
34. Contingent liabilities ................................................... 29
35. Sales ............................................................................... 29
36. Operating accounts ....................................................... 30
37. Income taxes ................................................................. 30

Miscellaneous
38. Events between date of financial statements and date
of CPA’s report ........................................................ 32
39. Prepaid expenses and cash surrender value of life
insurance .................................................................... 32
40. CPA’s confidential relationship with client.................. 33

Explanation of Certain Terms.................................... 34

 The CPA’s Report
Opinions
1) What kinds of opinions do CPAs express regarding
financial statements?

Depending upon his findings, the CPA may express:

a) an unqualified opinion as to the over-all fairness of
the presentation of the financial data in conformity
with generally accepted accounting principles con­
sistently applied; or
b) an opinion qualified as to certain items on the
financial statements or as to the consistent applica­
tion of accounting principles.
However, he expresses only one kind of opinion on any par­
ticular set of financial statements. In some cases he may feel
that he cannot give an opinion under the circumstances, in
which case he should disclaim an opinion.

2) When does a CPA express an unqualified opinion?

If he is satisfied that the financial statements present

fairly the financial position and results of operations in con­
formity with generally accepted accounting principles con­
sistently applied, the CPA usually expresses an unqualified
opinion to that effect.
He should not express an unqualified opinion unless
he is satisfied in all material respects and has adequate
grounds for his opinion. Bankers can help to assure un­
qualified opinions on the basis of adequate examinations by
stressing to customers the necessity of receiving audit reports

[5]
on which they can rely. The standard short-form report, re­
printed on page 17 of this booklet, is an example of an un­
qualified opinion. Any deviation from the standard form
should be read very carefully.
On occasion the section of the CPA’s report dealing with
the scope of his examination states that he has not, for ex­
ample, confirmed accounts receivable, or has not observed
the taking of inventories. If the receivables or inventories are
material, he should disclaim an opinion except in rare cir­
cumstances where he may have been able to satisfy himself
as to the items by other procedures, in which case he should
say so and express an unqualified opinion. In other words, a
qualification as to the scope of the examination does not
always mean that the opinion is qualified.
An example of qualified scope of examination language is
shown on page 18.

3) When does a CPA express a qualified opinion?

When a CPA believes the statements are a generally

fair presentation, but he has not been completely satisfied on
some point, or he feels that some part of the financial posi­
tion or results of operations is not fairly presented, he may
express a qualified opinion and indicate the nature of the
reservation or exception. In general, the necessity for ex­
pressing a qualified opinion occurs when the CPA has not
been permitted or was otherwise unable to make an exami­
nation sufficiently complete to warrant the expression of an
unqualified opinion, or when he has found departures from
accepted accounting principles which the company is un­
willing to correct. Where a significant change has been made
in the application of accounting principles the CPA quali­
fies his opinion as to the consistent application of generally
accepted accounting principles. If he approves the change,

[6]
he usually so states. Where possible, the CPA indicates the
materiality of certain types of qualifications.
An example of qualified opinion language is shown on
page 19.
When the CPA’s exceptions as to accounting practices
followed by the client are of such significance that he has
reached a definite conclusion that the financial statements
do not present fairly the financial position and results of
operations, his report should clearly indicate his disagree­
ment with the statements presented and give his reasons.
The CPA should not express an over-all opinion on the
financial statements when, because of limitations on the
scope of his examination or departures in the statements
from generally accepted accounting principles, his excep­
tions or reservations would be such as to destroy the useful­
ness of an opinion on the statements taken as a whole. In
such cases, he is not in a position to have formed an opinion
as to whether statements make a fair presentation. (See
question 4.)

4) When does a CPA disclaim an opinion?

The CPA should not express an opinion that financial

statements present fairly financial position and results of
operations in conformity with generally accepted accounting
principles, when his exceptions are such as to negative the
opinion, or when the examination has been less in scope
than he considers necessary to express an opinion on the
statements taken as a whole. In such circumstances, when­
ever the CPA permits his name to be associated with finan­
cial statements, he should state that he is not in a position to
express an opinion on the statements taken as a whole and
should indicate clearly his reasons therefor.
His disclaimer of opinion should be stated in writing

[7]
either in a letter of transmittal bound with the financial
statements or in the more conventional short-form or long-
form report. However, when financial statements prepared
without audit are presented in a CPA’s report cover or on
his stationery without comment by the CPA, a warning,
such as Prepared from the Books Without Audit, appearing
prominently on each page of the financial statements is con­
sidered sufficient.
It is not contemplated that the disclaimer of opinion
should assume a standardized form. Any expression which
clearly states that an opinion has been withheld and gives
the reasons why is suitable for this purpose. However, it is
not considered sufficient to state merely that certain audit­
ing procedures were omitted, or that certain departures
from generally accepted accounting principles were noted,
without explaining their effect upon the CPA’s opinion re­
garding the statements taken as a whole. It is incumbent
upon the CPA, not upon the reader of his report, to evalu­
ate these matters as they affect the significance of his exami­
nation and the fairness of the financial statements.
An example of a disclaimer of opinion is reprinted on page
20 of this booklet.
When the CPA has had to disclaim an opinion on the
financial statements, his report is of dubious value to the
banker.

5) Is it an approved practice to recite in audit reports

the procedures followed without stating clearly wheth­
er or not an opinion is expressed?

No. The membership of the American Institute of

Accountants in 1949 approved a statement (incorporated in
the summary of generally accepted auditing standards as
the fourth standard of reporting and often referred to as

[8]
Statement No. 23) which calls upon the accountant either
to express an over-all opinion regarding the statements taken
as a whole, or to assert that such an opinion cannot be ex­
pressed whenever financial statements appear on his sta­
tionery or in his report. If no opinion is given, he should
state why. (See question 4.)

6) Does a CPA’s name on financial statements, or on the

report cover, mean that he approves them?

No. CPAs often perform services for clients that re­

quire little or no audit work. Accordingly, he may not have
a basis for approving the financial statements, depending
upon the services he has been engaged to perform in the par­
ticular engagement. The CPA is obliged to disclose in his
report the responsibility he assumes for the fairness of finan­
cial statements. The banker has an obligation to read the
CPA’s report carefully to be sure that the information de­
veloped by the engagement is suited to credit purposes.

Auditing Standards
7) What are the “auditing standards” referred to in
audit reports?

Auditing standards are the underlying principles of

auditing which control the nature and extent of evidence to
be obtained by means of auditing procedures. They are
broad in scope, and concern both the CPA’s personal quali­
fications, and the quality of his work. Whereas auditing
procedures must be varied to meet the requirements of the
particular engagement, standards to be observed in selecting
and applying the procedures are the same in all examina­

[9]
tions. (A summary of generally accepted auditing standards
adopted by the membership of the American Institute of
Accountants is presented inside the back cover of this
booklet.)
The circumstances that exist in each audit engagement
require differences to a greater or lesser degree in the audit­
ing procedures that should be employed, the manner in
which they should be used, and the extent to which they
should be applied. These differences make it impossible to
lay down a uniform program of procedures which would be
generally satisfactory. The program of procedures for any
particular engagement is developed through the exercise of
the, experienced judgment of the CPA. This philosophy is
summed up in the standard audit report in the words: “Our
examination . . . included such tests of the accounting rec­
ords and such other auditing procedures as we considered
necessary in the circumstances.”

8) What is the significance of “independence” in relation

to audit work?

The term “independent accountant” means what the

words imply. Independence is the keystone of the accounting
profession. It is one of the CPA’s most important attributes.
If a CPA abides by the Rules of Professional Conduct of the
American Institute of Accountants, and similar rules adopt­
ed by numerous state societies of certified public accountants,
he obviously must be independent in his relationship to
clients.
While none of the Rules of Professional Conduct of the
American Institute of Accountants deal solely with indepen­
dence, those which should be of particular interest to bankers
in this respect are reprinted inside the front cover of this
booklet.
[10]
 Accounting Principles
9) What is the significance of the expression “present
fairly" in the CPA's report?

The values of many items in financial statements can­

not be measured exactly. The items which, in part at least,
are subject to approximation are among the most important
in the financial statements, such as inventories and provisions
for current costs expected to be paid in the future.
Because of this, no one can be in a position to state that a
company’s financial statements “exactly present” financial
position or results of operations. Accordingly, the CPA usu­
ally states that the financial statements “present fairly” in
the sense that he believes they are substantially correct. For
the same reason, his findings are expressed in the form of an
opinion. However, it should be borne in mind that the judg­
ment involved is an informed one, and is guided by generally
accepted accounting principles.

10) What are “generally accepted accounting principles33?

They are a body of conventions for dealing with ac­
counting problems. They have been developed over the years
as a result of study and experience in presenting useful finan­
cial information, and have come to be widely recognized as
sound guides in making accounting decisions. When financial
statements have been prepared in conformity with generally
accepted accounting principles, they should reflect financial
facts fairly, even though approximations and estimates have
been necessary. The series of Accounting Research Bulletins
issued by the committee on accounting procedure of the
American Institute of Accountants are expressions of gener­
ally accepted accounting principles with respect to the
matters covered by the bulletins.

[11]
 11) What does the CPA do to determine consistency in
the application of accounting principles?

The audit work for the period under examination pro­

vides the basis for his opinion as to that period. If an ex­
amination was made in the prior period that, of course, also
provides the basis for the CPA’s opinion as to the prior
period. If no examination was made in the prior period, the
CPA makes whatever review of prior periods he feels is
necessary to satisfy himself as to the consistency of applica­
tion of accounting principles.

Content of Report

12) Are CPA audit reports prepared specifically for credit

purposes?

No. Most audit reports are prepared for “general”

purposes; that is, they are intended to be useful to manage­
ment, and stockholders and others, as well as to creditors.
However, if it is known that the report will be used for
credit purposes, and if the credit grantor makes known to his
customer the information he wants, the customer can usually
arrange to have the CPA present the desired information.
(A booklet prepared by the Robert Morris Associates, the
national association of bank loan officers and credit men,
entitled Financial Statements for Bank Credit Purposes, de­
scribes financial information generally required by bankers.
Copies may be obtained from Robert Morris Associates,
Philadelphia National Bank Building, Broad and Chestnut
Streets, Philadelphia, Pennsylvania, at 10 cents each.)
Some matters observed during the course of the examina­
tion are considered to be important primarily for internal
consideration and are generally excluded from reports pre­

[ 12]
pared for general purposes. For example, CPAs often pre­
pare separate memoranda for management which contain
suggestions for improving internal control, accounting pro­
cedures, method of operations, etc.

13) Are the auditing standards for a short-form report

any different than those for a long-form report?

No. The auditing standards to be observed by a CPA,

and the examination, are the same regardless of whether he
prepares a short-form or a long-form report. The only im­
portant difference between the two kinds of reports is that
the long-form report includes more details and comments
regarding the financial position and results of operations.
Language similar to that used in the standard short-form
report (reprinted on page 17 of this booklet) should be in­
corporated in the long-form report.
Frequently, the client does not need a report presenting
details and comments regarding financial position and re­
sults of operations, and is unwilling to pay the cost involved
in preparing one for his own purposes. However, bankers
find information as to such details useful. If they consider it
important to have it included in the report, they should
take the initiative by requesting the customer to authorize
the CPA to prepare it. They should recognize, however, that
there are data regarding which the CPA is willing to supply
the best information available but as to which it is not prac­
ticable or reasonable for him to express an opinion. Exam­
ples are unit sales, production figures, or monthly balances
of payables (which the ordinary audit would not cover in
sufficient detail to support a regular type of opinion), and
budget forecasts and adequacy of insurance coverage (which
by their nature are not susceptible to audit check).
The CPA’s opinion runs generally to the basic financial

[ 13]
statements, with a lesser degree of responsibility being as­
sumed with respect to the other financial data included in
the long-form report. Information included in the CPA’s
comments and financial data other than the basic financial
statements in the long-form report should not be construed
as being necessary to the fair presentation and understand­
ing of the basic financial statements in the report.

14) Why don't more reports present details as to the scope

of the examination?

Although some long-form reports comment in consid­

erable detail on auditing procedures employed, most CPA’s
believe that such comments are of no real use to bankers, and
therefore omit them. One reason for this is that it is not prac­
ticable to describe fully in a report the program followed
and the considerations involved. However, of even greater
importance is the fact that no one can judge solely from a
description of audit procedures whether an examination
was adequate in the circumstances unless he is familiar with
all of the facts in the particular case and with developments
during the examination as it progressed. Conclusions as to
the adequacy of an examination are not likely to be well
founded if based merely on the information that could be
presented in a report.
When a CPA states that his examination was made in
accordance with generally accepted auditing standards, he
takes responsibility for having made an adequate examina­
tion. Accordingly, bankers are justified in placing the same
reliance upon a short-form report which contains that state­
ment as they do upon a long-form report.

[14]
 The CPA’s Examination
Scope of Examination
15) Does the CPA have a free hand in deciding upon the
scope of his examination?
The CPA determines the scope of the examination
necessary to express an unqualified opinion. The client, how­
ever, determines whether an examination of such a scope
will be permitted. It is the CPA’s opinion that must be ex­
pressed. He assumes the responsibility and he must be per­
mitted to perform all of the procedures he considers neces­
sary if the objective is an unqualified opinion.
There may be reasons why a client decides not to permit
an unrestricted examination. While the CPA abides by his
client’s decision, he patterns his report accordingly. The
significance of this to bankers is that they should read the
report to be sure that the opinion expressed is adequate for
their purposes. To be sure that an acceptable opinion is ob­
tained, they should, before the work is begun, see that the
CPA is authorized by his client to perform an examination
of sufficient scope to provide a suitable opinion.

16) Is an examination an exact arid complete verification

of the figures on the statements?
No. In most examinations, investigation of every trans­
action would not only be excessively costly—it is also un­
necessary. The CPA bases his examination upon tests of the
records, and upon investigation of selected transactions. He
makes an examination which in his opinion is sufficient to
satisfy him that the financial information is fairly presented
in all material respects.

[ 15]
 17) What does the CPA mean by “tests”?

“Sampling” may also be descriptive of the word “tests”

frequently used by CPAs. When the CPA states that his ex­
amination has “included such tests of the accounting rec­
ords” as he considered necessary in the circumstances, he
means that he has examined a portion of the transactions
and records to the extent he believes necessary for the ex­
pression of an opinion in a particular situation.
The extent of testing in any examination is decided by
the CPA on the basis of his best judgment as to the amount
required to constitute a fair sampling of the record being
tested in the particular case. In deciding upon the character
of the tests to be made, and the extent to which they should
be applied, one of the most important factors taken into con­
sideration is the effectiveness of the company’s system of
internal control. Other factors which enter into the decision
include the materiality of the item to be tested, and the
relative risk of the existence of irregularities.
A statement, fact, or item is material, if in the surround­
ing circumstances as they exist at the time, it is of such a
nature that its disclosure or the method of treating it would
be likely to influence or to “make a difference” in the judg­
ment and conduct of a reasonable person. In applying his
auditing procedures, the CPA focuses principal attention
upon items which are, or may be, material.

Internal Control
18) What does the term “internal control” mean?

Internal control comprises the plan of organization

and all of the coordinate methods and measures adopted
within a business to safeguard its assets, check the accuracy

[16]
 Unqualified Opinion
(Standard Short-Form of Accountant's Report)

We have examined the balance sheet of X Company as of

December 31,195x and the related statements of income and
retained earnings for the year then ended. Our examination
was made in accordance with generally accepted auditing
standards, and accordingly included such tests of the ac­
counting records and such other auditing procedures as we
considered necessary in the circumstances.
In our opinion, the accompanying balance sheet and
statements of income and retained earnings present fairly the
financial position of X Company at December 31, 195x, and
the results of its operations for the year then ended, in con­
formity with generally accepted accounting principles ap­
plied on a basis consistent with that of the preceding year.

[17]
 Qualification as to Scope-Unqualified Opinion

... Our examination was made in accordance with gener­

ally accepted auditing standards, and accordingly included
such tests of the accounting records and such other auditing
procedures as we considered necessary in the circumstances;
however, it was not practicable to confirm accounts receiv­
able from government agencies, as to which we have satisfied
ourselves by other auditing procedures.
In our opinion, the accompanying balance sheet and state­
ments of income and retained earnings present fairly . . .

[18]
 Qualified Opinion

... Our examination was made in accordance with gener­

ally accepted auditing standards, and accordingly included
such tests of the accounting records and such other auditing
procedures as we considered necessary in the circumstances.
In our opinion, except as to such adjustments as may re­
sult from final determination of litigation as explained in
Note 1, the accompanying balance sheet and statements of
income and retained earnings present fairly . . .

[19]
 Disclaimer of Opinion

In accordance with the terms of our engagement, we did

not follow the generally accepted auditing procedures of
communicating with debtors to confirm accounts receivable
balances and of observing the methods used by your em­
ployees in determining inventory quantities. Because of these
limitations, the scope of our examination was not sufficient
to permit us to express an opinion on the accompanying
financial statements taken as a whole.

[20]
and reliability of its accounting data, promote operational
efficiency, and encourage adherence to prescribed mana­
gerial policies. From the viewpoint of the CPA’s examina­
tion, it means primarily the measures adopted by the busi­
ness to check the reliability and accuracy of its accounting
data.
The degree of internal control varies greatly among com­
panies. For example, most large companies have well devel­
oped and effective systems of internal control and internal
auditing procedures; while many small companies, because
of few employees or failure to recognize the value of internal
control, have less effective systems.
The primary responsibility for the establishment and en­
forcement of internal control rests with the company. The
ordinary examination incident to the issuance of an opinion
respecting financial statements is not designed and cannot be
relied upon to disclose defalcations and similar irregulari­
ties, although their discovery frequently results. If a CPA
were to attempt to discover defalcations and similar irregu­
larities, he would have to extend his work to a point where
its cost would be prohibitive. It is generally recognized that
good internal control and surety bonds provide effective
measures of protection.

19) To what extent does the scope of an examination

depend upon the effectiveness of the system of internal
control?

While the primary responsibility for adequate internal

control rests with the client, its effectiveness is of vital im­
portance in the selection and application of appropriate
audit procedures. When evidence exists that the system is
effective, the CPA properly concludes that the accounting
records and supporting data have a higher degree of de­

[21 ]
pendability than would otherwise be the case, and limits his
testing accordingly. However, when his investigation shows
that the system has points of weakness, he extends the scope
of his testing. If the internal control is considered grossly
ineffective, the CPA is compelled to extend his procedures
considerably before expressing an informed opinion on the
financial statements.

Receivables
20) What does the CPA do to substantiate the amounts
of accounts and notes receivable reported?

The principal purposes of the CPA’s examination of

receivables are to establish their genuineness, the proper re­
cording of receipts and the correctness of the balances, and
to test the internal control. In addition, the CPA takes steps,
such as analyzing the accounts according to age, to satisfy
himself that reasonable allowances have been made for
probable losses on doubtful accounts.
Accepted practice requires the CPA to seek confirmation
of a representative portion of the balances of receivables
wherever practicable and reasonable, and where the aggre­
gate amount of the receivables represents a significant por­
tion of the current assets or the total assets of the company.
The method, the extent, and the time of confirming receiv­
ables in each engagement, and whether all receivables, or a
part of them, should be confirmed, are determined by the
CPA in the light of the particular circumstances.
Although experience has demonstrated that confirmation
is generally the most important procedure in substantiating
receivables, it does not provide conclusive evidence. The
CPA employs numerous additional procedures to satisfy
himself as to the receivables, such as the inspection of subse­

[22]
quent collections, and making sure that the details on the
trial balances are in agreement with the balances in the in­
dividual accounts, and that the totals are in agreement with
the general ledger. The accounts may, at the same time, be
scrutinized for unusually large items or for items which for
other reasons appear to require special investigation.
The CPA also looks for the pledge, assignment or other
hypothecation of receivables and customarily inspects the
instruments in support of notes receivable.

21) What is meant by “confirmation of receivables”?

Confirmation consists of direct communication with

the debtor to determine whether or not the balance shown
on the company’s books is in agreement with the debtor’s
records. Confirmation of the receivables is frequently per­
formed on a test basis. If receivables have not been con­
firmed, and they are material, the CPA should state that
fact in his report and indicate whether or not he has satisfied
himself by other auditing procedures.

Inventories
22) What responsibility does the CPA assume for the
correctness of inventories?

The CPA’s procedures are designed to satisfy him that

the amounts set forth by the company as inventories repre­
sent actual inventories either on or off the client’s premises,
that they are presented with reasonable accuracy and in
accordance with generally accepted accounting principles
consistently applied, and that the bases of stating the inven­
tories as well as any pledge or assignment of inventories, are
properly disclosed. These objectives require the CPA to in­

[23]
vestigate the care and accuracy with which the company has
taken the inventories, the methods and bases adopted by the
company in pricing them, and the substantial correctness of
the company’s mathematical computations. The CPA does
not hold himself out as an appraiser, valuer, or expert in
materials. He does not “take,” “determine,” or “supervise”
the inventory.

23) What is “observation of inventories”?

To satisfy himself that the taking of the inventories

was done carefully and accurately, and also to gain general
familiarity with them, the CPA is required by generally ac­
cepted auditing practice to be present at the inventory tak­
ing to observe the effectiveness of the procedures when it is
practicable and reasonable to do so and the amount of the
inventories is significant. Although the CPA may review
and approve the instructions for taking the inventories and
may test some items, it is the company’s responsibility to take
the inventory satisfactorily. The CPA’s purpose in observing
the inventory taking is to satisfy himself that the company is
discharging its responsibility.

24) What does the CPA do to satisfy himself as to the

fairness of the value at which inventories are stated?

It is the CPA’s duty to make sufficient tests to satisfy

himself that the method, or combination of methods, used to
determine “cost” and “market” is being applied properly
and consistently. To do this, it is generally necessary to make
rather extensive tests of the inventory records. These tests
may include comparisons of items as shown by the inventory
taking with quantities shown on the records, inspection of

[24]
purchase invoices, investigation of current market quota­
tions, and verification of footings and extensions. They may
also involve a general examination of the company’s cost
system, including a review of the allocation of overhead, as
a check upon the pricing or valuing of inventories of work
in process and finished goods.

25) What does the CPA do about determining the extent

of obsolescence of inventories?
Throughout the inventory examination the CPA is on
the alert to detect obsolete and slow-moving stock and to
ascertain that adequate provision has been made to cover
any probable substantial losses thereon.

26) What does the CPA do as to inventory purchase

commitments?
The CPA’s primary objective with respect to purchase
commitments is to satisfy himself that adequate provision
has been made for indicated probable losses. Evidence of
such commitments may be disclosed during almost any
phase of the examination, and the CPA investigates any leads
obtained. He also makes general inquiry among those who
would be in a position to have knowledge of such commit­
ments, and often obtains a letter of representation from the
management to the effect that adequate provision has been
made for all expected losses.

27) Why are officers of the client asked to sign representa­

tion letters regarding inventories and other matters?
This is a customary procedure based on management’s
primary accountability for the company’s financial state­

[25]
ments. These certificates merely supplement the CPA’s work
on the examination but do not relieve him from responsi­
bility for his opinion with respect to the financial statements.

Fixed Assets
28) What does the CPA do to substantiate the amount
reported for property, plant and equipment?

In examining these accounts the CPA’s work consists

largely of a review of the accounting principles applied by
the company, analysis of the property accounts, and tests of
the suporting data.
His review of the accounting principles applied is direct­
ed to the company’s accounting practices with respect to
depreciation, betterments, additions, retirements, repairs
and replacements, to determine that these practices are in
accordance with generally accepted accounting principles
and have been consistently applied.
In his analysis of the accounts, the CPA customarily pays
particular attention to the changes during the period under
review, relying to a large extent upon inspection of support­
ing documents, such as authorization by the board of direc­
tors, work orders, invoices, and journal entries, in assuring
himself that these changes had been properly recorded.
If the company leases its premises, the CPA generally ex­
amines the leases, noting their terms, and reviews the com­
pany’s records to satisfy himself that any leasehold improve­
ments are being properly written off, and that significant
information regarding any long-term lease arrangements is
adequately disclosed.
The CPA’s review of the company’s depreciation policies
is generally made in conjunction with his examination of
the property accounts. It is the CPA’s responsibility to satisfy

[26]
himself that the method adopted by the company is an
accepted method and that it has been properly applied.
This conforms to the general concept that the financial
statements are statements of the client, and that the CPA’s
function is to examine the statements.

29) What is the CPA’s responsibility with respect to com­

mitments for the acquisition or construction of major
capital additions?
The CPA has the responsibility to make inquiry as to
the existence of significant commitments for the acquisition
or construction of major capital items. These should be ap­
propriately reflected by footnote to the financial statements.
The CPA should ascertain that such disclosures are in ac­
cordance with the agreements and other evidences of the
contemplated transactions.

30) Why are fixed assets stated at cost?

The primary reason for using cost is that financial
statements are usually prepared on the basis of reporting
on stewardship; i.e., the concept that the management is re­
porting on how it has utilized the resources made available
to it. The net amount at which fixed assets are shown on a
financial statement does not necessarily have any direct
relationship to their market value or their replacement cost.

Other Items
31) What does the CPA do to determine that accounts
payable are properly reported?

The examination of accounts payable is designed to

establish, so far as possible, that all are included in the
[27]
financial statements. In addition to checking open items in
the accounting records, CPAs during the course of their
examination customarily inspect vouchers and payments en­
tered in the records subsequent to the balance-sheet date,
unpaid invoices not yet entered, and regular monthly state­
ments from creditors.
Large accounts which do not represent recent items and
accounts which have been active during the period but show
no balance at the date of the examination, are generally
investigated. Confirmation of such accounts is occasionally
requested from the creditors by correspondence, especially
when the internal control is weak.

32) What does the CPA do to determine the adequacy of

accruals for expenses?

The CPA examines evidence supporting accruals for

such liabilities as interest, taxes, salaries and wages, commis­
sions, legal expenses and damages, obtaining confirmation
where appropriate, and makes whatever computations are
necessary to be satisfied that proper accruals of the liabil­
ities for these items at the end of the period have been made.

33) What does the CPA do to ascertain that the provisions

of loan agreements have been carried out?

The CPA should review loan and similar agreements

to satisfy himself that the financial requirements of the
agreements, such as working capital, surplus, and dividend
restrictions, are being observed. The significant terms of
the agreements, together with any defaults in the principal,
interest, or sinking fund provisions, or other financial re­
quirements, should be disclosed and the amounts involved
stated.

[28]
 34) What does a CPA do to determine the amount and
nature of contingent liabilities, if any?

To satisfy himself that all significant contingent liabil­

ities have been given appropriate recognition in the financial
statements, the CPA customarily investigates or inquires
of the most authoritative sources available for such informa­
tion—including revenue agents’ reports, the company’s legal
counsel, the banks with which the company does business,
and minutes of the meetings of directors and stockholders.
He usually obtains from the management of the company
a representation letter enumerating all significant items of
this nature, and stating that adequate provision has been
made in the statements or the pertinent information dis­
closed.
Although the dollar amount of litigation is often disclosed
in footnotes to the financial statements, there frequently is
no way of estimating, even within reasonable limits, the
amount at which pending litigation will eventually be
settled. Accordingly, it may not be possible to assign a
reasonable dollar amount to the litigation in the accounts,
although the existence of any significant litigation should al­
ways be disclosed. The CPA usually relies upon the opinion
of the company’s legal counsel in deciding what recognition,
if any, should be given to pending litigation in the financial
statements.

35) What does the CPA do to determine material omission

or inflation of sales?

Since sales are so closely related to other items in

the accounts, particularly inventories, accounts receivable
and cash, he relies very largely on his examination of these
accounts in satisfying himself as to reliability of the sales

[29]
figures. Procedures directed specifically to satisfying himself
that material amounts of sales have not been omitted, or
that they have not been inflated, include checks on the
cut-off procedures as to purchases and sales at the end of
the accounting period and gross profits tests. The latter in­
dicates whether or not gross profits for the period compare
with experience in prior periods; the reasons for any material
variations should be determined.

36) Does the CPA review the operating accounts of a

business?

Yes, if he is to express an opinion on the financial state­

ments. Much of his review of the operating accounts is per­
formed in connection with his work on related assets and
liabilities in the balance sheet. As to the operating accounts
as such, the CPA depends primarily upon the results of care­
ful review, tests, and analyses of the accounts with respect
to items recorded during the period and upon comparison
with previous periods. He usually tests the more material
or extraordinary items by reference to such supporting evi­
dence as payrolls, vouchers, journal entries, statistical data
prepared by the company, copies of various kinds of agree­
ments, budgets, and provisions of corporate minutes.

37) What responsibility does the CPA assume with regard

to the income tax provision?

So far as the financial statements are concerned, the

CPA’s principal function with respect to income taxes is to
satisfy himself that the provision is reasonable. Often, he
assists in preparing the tax return and this provides an excel­
lent basis for his decision. If he does not prepare the return
himself, he usually reviews it. He also ascertains the last date
[30]
to which the tax returns have been examined by government
representatives and determines whether or not there are any
items in dispute the tax effects of which should be reflected
in the financial statements.

[31 ]
 Miscellaneous
38) What is the CPA's responsibility as to events occurring
between the date of the financial statements and the
date of his report?

Events or transactions sometimes occur subsequent to

the balance-sheet date and before the date of the CPA’s
report, which may be either extraordinary in character or
of unusual importance. They may, therefore, have a material
effect on the financial statements or be important in consid­
ering the statements.
The CPA has no duty to extend his audit procedures to
events or transactions of a subsequent period as such. How­
ever, it is well recognized that an effective audit program
relating to the period under examination should include
certain procedures which are designed to acquaint the
CPA with those post-balance-sheet events or transactions as
to which he can be chargeable with a duty to have knowl­
edge. If any such matters come to his attention, the CPA
may request adjustment or annotation of the statements, or
make disclosure in his report.

39) Why are prepaid expenses included in current assets

and cash surrender value of life insurance policies
excluded?

For accounting purposes the term current assets is used

to designate cash and other assets or resources which are
reasonably expected to be realized in cash, or sold or con­
sumed during the normal operating cycle of the business.
Prepaid expenses such as insurance, interest, rents, taxes,
unused royalties, and current paid advertising service not
yet received, are considered current assets under this defini­

[32]
tion. They are not current in the sense that they will be
converted into cash, but in the sense that, if not paid in
advance, they would require the use of current assets during
the operating cycle.
The accounting concept of the nature of current assets
excludes cash surrender value of life insurance policies from
the current classification because, as a practical matter, life
insurance policies are more in the nature of long-term in­
vestments which in the ordinary course of business do not
provide working funds.

40) Is the CPA free to discuss his client’s affairs with

bankers?

The CPA’s relationship with his client is a confiden­

tial one similar to that which a banker has with his customer.
However, the CPA will be glad to discuss his client’s affairs
with bankers if authorized to do so by the client. It is often
desirable for the client, the banker, and the CPA to meet
together.

[33]
 Explanation of Certain Terms
There are a number of terms used in this booklet which
deserve special mention, either because they have technical
meanings that differ somewhat from their meanings in every­
day usage or because the concept they express requires a
more complete explanation than seems appropriate in a
series of brief questions and answers. The more important
of these are explained here.
Analysis and Review: The principal means by which the
CPA carries out his audit procedures is through careful
analysis and critical review of the data presented, with a
view to appraising whether they appear to be reasonable
and reliable, rather than through a detailed checking of
transactions.
Auditing Standards: The underlying principles of auditing
which govern the nature and extent of the evidence to be
obtained by means of auditing procedures, and which relate
to the CPA’s personal qualifications and the quality of his
work, are referred to as generally accepted auditing stand­
ards. A summary of these standards appears inside the back
cover of this booklet.
Confirmation: In numerous phases of the examination, the
CPA seeks information as to items shown on the records
by direct communication with the individual or company in
a position to verify such items. This is commonly referred
to as “confirmation,” and is particularly valuable because
the CPA communicates directly with persons or organiza­
tions that are independent of the company under examina­
tion.
Disclaimer of Opinion: A statement to the effect that the
CPA is not in a position to express an opinion on the fair­
ness of the financial presentation.

[34]
Examination (Audit): The process through which the CPA
reaches an opinion as to the fairness of financial statements,
including:
a) A review and evaluation of the existing internal con­
trol ;
b) A general review of the accounts and records, and
comparison of the figures shown on the statements with
the sources from which they were drawn;
c) A study of the accounting procedures regularly fol­
lowed by the company, and consideration of any de­
partures from these practices;
d) Independent sampling tests (through inspection, cor­
respondence, or other means) of the existence of assets;
e) Tests to determine so far as reasonably possible, that
all liabilities are reflected in the balance sheet;
f) Analyses, tests, and over-all review of the income and
expense accounts;
g) Test procedures designed to determine the credibility
and general correctness of the accounts on which the
statements are based; and
h) Inquiries of officers, employees and others to supple­
ment the information otherwised developed by the
examination.
Inspection: The CPA’s work involves the inspection of some
physical assets, and of documents and other evidence sup­
porting the figures in the accounting records. This process
includes such procedures as counting cash on hand and
securities, examining notes, leases, etc., testing the inventory
taking, and visiting plants to gain general familiarity with
the company’s facilities and operations. It also includes such
steps as examining invoices, checks, and other documents
supporting entries in the books, and reading the minutes
of stockholders’ and directors’ meetings for information on
actions authorized by those groups.
[35]
Internal Control, System of: Internal control is a big subject
about which it is difficult to generalize. However, a satis­
factory system of internal control would certainly include:
a) Appropriate segregation of functional responsibilities;
b) Adequate authorizing and recording procedures to
provide reasonable accounting control of assets, lia­
bilities, revenues and expenses;
c) Sound practices in the performance of duties and
functions of each of the organizational departments;
and
d) A degree of quality of personnel commensurate with
responsibilities.
Observation: The term “observation,” as used in examina­
tions, refers to the practice of being present to observe the
manner in which various procedures of the company are
being performed by its employees. In particular, it is used
in reference to the CPA’s attendance at the taking of the
inventory. In the course of his examination, the CPA should
also observe the company’s procedures in the handling of
cash, and in the operation of other phases of its system of
internal control.
Opinion: The CPA’s statement as to his conclusions regard­
ing the fairness of the financial presentation.

[36]
 SUMMARY OF
GENERALLY ACCEPTED AUDITING STANDARDS
General Standards
1. The examination is to be performed by a person or persons hav­
ing adequate technical training and proficiency as an auditor.
2. In all matters relating to the assignment an independence in
mental attitude is to be maintained by the auditor or auditors.
3. Due professional care is to be exercised in the performance of the
examination and the preparation of the report.

Standards of Field Work

1. The work is to be adequately planned and assistants, if any, are
to be properly supervised.
2. There is to be a proper study and evaluation of the existing inter­
nal control as a basis for reliance thereon and for the determination of
the resultant extent of the tests to which auditing procedures are to be
restricted.
3. Sufficient competent evidential matter is to be obtained through
inspection, observation, inquiries and confirmations to afford a reason­
able basis for an opinion regarding the financial statements under ex­
amination.

Standards of Reporting
1. The report shall state whether the financial statements are pre­
sented in accordance with generally accepted principles of accounting.
2. The report shall state whether such principles have been consis­
tently observed in the current period in relation to the preceding period.
3. Informative disclosures in the financial statements are to be re­
garded as reasonably adequate unless otherwise stated in the report.
4. The report shall either contain an expression of opinion regard­
ing the financial statements, taken as a whole, or an assertion to the
effect that an opinion cannot be expressed. When an over-all opinion
cannot be expressed, the reasons therefor should be stated. In all cases
where an auditor’s name is associated with financial statements the re­
port should contain a clear-cut indication of the character of the audi­
tor’s examination, if any, and the degree of responsibility he is taking.