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    Modified Audit Report: Level of Materiality and Alternatives

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    The following independent situations, assume that you are the audit partner on the engagement:
    1. In the last 3 months of the current year, Oil Refining Company decided to change direction and go significantly into the oil drilling business. Management recognizes that this business is exceptionally risky and could jeopardize the success of its existing refining business, but there are significant potential rewards. During the short period of operation in drilling, the company has had three dry wells and no successes. The facts are adequately disclosed in footnotes.
    2. Your client, Harrison Automotive, has changed from straight-line to sum-of-the years' digits depreciation. The effect on this year's income is immaterial, but the effect in future years is likely to be material. The facts are adequately disclosed in footnotes.
    3. Toronto Technology Corporation has prepared financial statements but has decided to exclude the statement of cash flows. Management explains to you that the users of their financial statements find this statement confusing and prefer not to have it included.
    4. Marseilles Fragrance, Inc. is based in New York but has operations throughout Europe. Because users of the audited financial statement are international, your audit firm was engaged to conduct the audit in accordance with U.S. auditing standards and International Standards on Auditing (ISAs).
    5. The controller of Brentwood Industries, Inc. will not allow you to confirm the receivable balance from two of its major customers. The amounts of the receivables are material in relation to Brentwood Industries' financial statements. You are unable to satisfy yourself as to the receivable balances by alternative procedures.
    6. Approximately 20% of the audit of Lumberton Farms, Inc. was performed by a different CPA firm, selected by you. You have reviewed their audit files and believe they did an excellent job on their portion of the audit. Nevertheless, you are unwilling to take complete responsibility for their work.

    For each situation:
    a. Identify which of the conditions requiring a modification of or a deviation from an unqualified standard report is applicable.
    b. State the level of materiality as immaterial, material, or highly material. If you cannot decide the level of materiality, state the additional information needed to make a decision.
    c. Given your answers in parts( a) and (b), state the appropriate audit report from the following alternatives (if you have not decided on one level of materiality in part b, state the appropriate report for each alternative materiality level):
    1. Unqualified - standard wording 5. Qualified scope and opinion
    2. Unqualified - explanatory paragraph 6. Disclaimer
    3. Unqualified - modified wording 7. Adverse
    4. Qualified opinion only

    d. Based on your answer to part c, indicate which paragraphs, if any, should be modified in the standard audit report. Also indicate whether an additional paragraph is necessary and its location in the report.

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    Solution Preview

    1. (a) footnote is enough, no modification; (b) materiality not a issue;( c) 1; (d) no modification.

    2. (a) footnote is enough, no modification; (b) immaterial; (c) 1; no modification

    3. (a) This is a material departure from gap and has a pervasive impact on the financial complexion (impacts many areas); (b) highly material; (c) 7; (d) the opinion paragraph would be modified and the basis for adverse opinion paragraph would be added for example:

    Basis for Adverse Opinion:

    Management has not included a cash flow statement for the year presented. Accounting principles generally accepted in the United States ...

    Solution Summary

    Your discussion is 374 words and a reference. The type of report and sample language for modifying the report are given for those situations where it is needed.