Under 4220 there may be instances when the staff will not object to an audit report on the financial statements that contains a qualification.  However, before filing the outside auditor must request a waiver from the Division of Corporation Finance and the Office of Chief Accountant.  Topic 4, subsections 4220.1 through 4220.4 also set forth examples of audit reports on the financial statements that represent a substantial deficiency in the filing.

The auditor must express a clear opinion.  Anything disclaiming an opinion on the financial statements for any reason or qualification of the scope of the audit does not satisfy the requirements of Regulation S-X, 4220.1 and 4220.3a.  An audit report that states that the financial statements taken as a whole are not presented fairly in conformity with GAAP does not satisfy Regulation S-X, Article 2. 4420.2.  Similarly, an audit report that expresses a qualified or "except for" opinion due to a departure from GAAP does not meet the requirements of Regulation S-X.  If the financial statements do not conform with GAAP, they are presumed to be inaccurate or misleading irrespective of any explanatory disclosures in the footnotes or in the report.  4220.4. 

If the auditor is unable to be present to observe the taking of the company's inventory, the auditor must be satisfied through alternative procedures.  If the alternative procedures are acceptable, the report should not contain any language that implies a qualification based on not being able to be present to observe the company's inventory.  4220.3b. 

If an auditor issues an adverse opinion on the company's internal controls over financial reporting, the auditor must first determine the affect such an opinion has on its opinion on the financial statements.  The auditor should then disclose whether an adverse opinion on internal controls affected its opinion on the financial statements.  4220.5

A going concern modification must include appropriate and prominent disclosure about the financial difficulties that gave rise to the uncertainty.  The discussion must include any viable plans that have the capability of removing the threat to the continuation of the business.  Under certain circumstances a viable plan may include a best efforts offering of securities, as long as the minimum proceeds needed to remove the threat is disclosed and the plan indicates that the company will remain viable for the next twelve months.  If the management has no viable plan, the staff has indicated that the use of going concern financial statements may be inappropriate.  If that is the case, the auditor must use an alternative liquidation-basis for presenting the financial statements, or adjust the classification and amounts of assets and liabilities.  AU341 does not apply to financial statements based on a liquidation assumption.

Subsection 4230.2 covers the following topics relating to changes in accounting principles in the auditor's report: (i) when to include; (ii) correction of material misstatements; and (iii) preferability letters.  Subsection 4230.3 covers clarification(s) regarding no audit of internal control over financial reporting. 

This is only a summary of the items discussed in Topic 4.  A complete copy of the recently revised Topic 4 to the Division of Corporation Finance's Financial Reporting Manual can be obtained at no cost from our office.

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CHARLES HECHT has been a principal of his own law firm specializing in securities law since 1971. He was previously on the staff of the Division of Corporate Finance of the Securities and Exchange Commission at its headquarters in Washington, DC. Contact him at 212.490.3232 or visit www.securitiescounselors.com