STAFF QUESTIONS AND ANSWERS

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Washington, DC 20006

Telephone: (202) 207-9100

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STAFF QUESTIONS AND ANSWERS

ADJUSTMENTS TO PRIOR-PERIOD FINANCIAL STATEMENTS AUDITED BY A

PREDECESSOR AUDITOR

June 9, 2006

Summary: Staff questions and answers set forth the staff's opinions on issues related

to the implementation of the standards of the Public Company Accounting

Oversight Board ("PCAOB" or "Board"). The staff publishes questions and

answers to help auditors implement, and the Board's staff administer, the

Board's standards. The statements contained in the staff questions and

answers are not rules of the Board, nor have they been approved by the

Board.

The following staff questions and answers related to adjustments to prior-period

financial statements audited by a predecessor auditor were prepared by the Office of

the Chief Auditor. Additional questions should be directed to Greg Scates, Associate

Chief Auditor (202/207-9114; [email protected]rg) or Sam Guzman, Assistant Chief

Auditor (202/207-9117; [email protected]).

General

Q1. Circumstances arise that require a company to make adjustments to prior-period

financial statements. Such circumstances include, for example, the reporting of

discontinued operations, and the retrospective application of a change in accounting

principle or the correction of an error in prior-period financial statements pursuant to

Financial Accounting Standards Board Statement of Financial Accounting Standards

No. 154, Accounting Changes and Error Corrections ("FASB Statement 154").

Pursuant to Financial Accounting Standards Board Statement of Financial

Accounting Standards No. 154, Accounting Changes and Error Corrections ("FASB

Statement 154"), the retrospective application of a change in accounting principle also is

STAFF QUESTIONS & ANSWERS

Adjustments to Prior-Period Financial

Statements Audited by a Predecessor Auditor

June 9, 2006

Page 2 of 12

If the prior-period financial statements that require adjustments were audited by a

predecessor auditor, which auditor, the predecessor or the successor, may audit the

adjustments to prior-period financial statements?

A1. Either the successor auditor or the predecessor auditor may audit the

adjustments made to prior-period financial statements so long as the auditor is

independent and registered with the PCAOB. Issuers sometimes select the

predecessor auditor to audit the adjustments because that auditor has performed

the audit of the prior-period financial statements and has knowledge of the

transactions that occurred during that period. In addition, the use of the

predecessor auditor sometimes can be more cost-effective for performing this

work. However, the successor auditor also may audit the adjustments.

Predecessor Auditor Audits the Adjustments to Prior-Period Financial Statements

Q2. If the predecessor auditor audits the adjustments to the prior-period financial

statements, how should the predecessor auditor date his or her report on the reissued

financial statements?

A2. The predecessor auditor should dual-date his or her reissued report in

connection with the audit of the adjustments made to the prior-period financial

statements. Paragraph .73 of AU section ("sec.") 508, Reports on Audited

Financial Statements, states that, "A predecessor auditor's knowledge of the

current affairs of his or her former client is obviously limited in the absence of a

continuing relationship. Consequently, when reissuing the report on prior-period

appropriate when there are no transition requirements specific to a particular accounting

pronouncement.

The term "adjustments to prior-period financial statements" should be

understood for purposes of this set of questions and answers to include, among other

things, the reporting of discontinued operations, as well as, restatements to correct

errors and retrospective applications of changes in accounting principles, as described

in FASB Statement 154.

STAFF QUESTIONS & ANSWERS

Adjustments to Prior-Period Financial

Statements Audited by a Predecessor Auditor

June 9, 2006

Page 3 of 12

financial statements, a predecessor auditor should use the date of his or her

previous report to avoid any implication that he or she has examined any

records, transactions, or events after that date. If the predecessor auditor revises

the report or if the financial statements are restated, he or she should dual-date

the report."

Q3. If the predecessor auditor audits the adjustments made to the prior-period

financial statements, what is the successor auditor's responsibility with regard to those

adjustments?

A3. If the predecessor auditor audits the adjustments made to the prior-period

financial statements, he or she is responsible for the audit conclusions reached

with respect to those adjustments. However, because corrections of errors and

the retrospective application of a change in accounting often have the effect of

changing the periods in which transactions and events are recognized in the

financial statements, the successor auditor should obtain an understanding of the

adjustments made to the prior-period financial statements and their effects, if

any, on the current-period financial statements.

In addition, the successor auditor should evaluate the consistency of the

application of accounting principles from period to period. Paragraph .24 of AU

sec. 420, Consistency of Application of Generally Accepted Accounting

Principles, states:

When the independent auditor has not audited the financial

statements of a company for the preceding year, he should adopt

procedures that are practicable and reasonable in the

circumstances to assure himself that the accounting principles

employed are consistent between the current and the preceding

year.

See the requirement for the auditor to plan and perform his or her work

with due professional care in paragraph .02 of AU section ("AU sec.") 230, Due

Professional Care in the Performance of Work.

STAFF QUESTIONS & ANSWERS

Adjustments to Prior-Period Financial

Statements Audited by a Predecessor Auditor

June 9, 2006

Page 4 of 12

Successor Auditor Audits the Adjustments to Prior-Period Financial Statements

Q4. What factors are relevant to a successor auditor's determination as to whether he

or she is able to audit only the adjustments to prior-period financial statements or

whether a reaudit of those financial statements is necessary?

A4. To audit only the adjustments to prior-period financial statements that

were audited by a predecessor auditor,

a successor auditor must be able to

form an opinion that the adjustments are appropriate and have been properly

applied.

In determining whether he or she is able to form such an opinion

without performing a reaudit of the prior-period financial statements, the

successor auditor should consider:

• The extent of the adjustments. The less extensive and pervasive

the adjustments to prior-period financial statements are, the more

likely it is that a successor auditor can form an opinion that the

adjustments are appropriate and have been properly applied

without performing a reaudit of those financial statements. More

extensive and pervasive adjustments make it more likely that a

reaudit is necessary.

This staff question and answer assumes that the predecessor auditor

reissues his or her report on the prior-period financial statements before the effects of

the adjustments.

This series of staff questions and answers assumes that the predecessor

auditor has not ceased operations as the term "ceased operations" has been defined in

footnote 2 of AU sec. 9508, Reports on Audited Financial Statements: Auditing

Interpretations of Section 508. In cases in which the predecessor auditor has ceased

operations, the successor auditor should refer to AU sec. 9508.60-.75.

See paragraph .74 of AU sec. 508, Reports on Audited Financial

Statements.

STAFF QUESTIONS & ANSWERS

Adjustments to Prior-Period Financial

Statements Audited by a Predecessor Auditor

June 9, 2006

Page 5 of 12

• The reason for the adjustments. A successor auditor is ordinarily

more likely to be able to form an opinion that adjustments to prior-

period financial statements are appropriate and have been properly

applied when those adjustments are due to the retrospective

application of an accounting principle rather than when the

adjustments are necessary to correct an error.

In the latter

situation, the auditor should consider the risk that there may be

other undetected misstatements in the prior-period financial

statements. In particular, if the adjustments correct an intentional

misstatement,

it is more likely that a reaudit is necessary.

• Cooperation of predecessor auditor. A successor auditor is more

likely to be able to form an opinion that adjustments to prior-period

financial statements are appropriate and have been properly

applied if he or she has the cooperation of the predecessor auditor.

For example, a successor auditor may determine that he or she is

able to audit adjustments to prior-period financial statements if he

or she has access to the audit documentation relating to the prior

periods and if the predecessor auditor is responsive to questions

relating to those periods.

After a successor auditor has determined that he or she is likely to be able to

form an opinion that adjustments to prior-period financial statements are

FASB Statement 154 defines an error in previously issued financial

statements as an error in recognition, measurement, presentation, or disclosure in

financial statements resulting from mathematical mistakes, mistakes in the application

of GAAP, or oversight or misuse of facts that existed at the time the financial statements

were prepared. Errors, also referred to as misstatements, include those that are

intentional or unintentional.

See paragraph .05 of AU sec. 316, Consideration of Fraud in a Financial

Statement Audit.

STAFF QUESTIONS & ANSWERS

Adjustments to Prior-Period Financial

Statements Audited by a Predecessor Auditor

June 9, 2006

Page 6 of 12

appropriate and have been properly applied, the auditor might obtain evidence

indicating, or otherwise might determine, that the prior-period financial

statements are materially misstated in other respects. In this circumstance, the

successor auditor should reevaluate whether auditing only the adjustments is

appropriate or whether a reaudit of the prior-period financial statements is

necessary.

Q5. If the successor auditor audits adjustments to the prior-period financial

statements audited by a predecessor auditor, how should the successor auditor report

on the results of the audit of those adjustments?

A5. AU sec. 508.74 describes how a successor auditor should report when he

or she audits adjustments and the predecessor auditor's report is not presented.

The successor auditor may use a similar form of reporting if he or she has

audited the adjustments made to prior-period financial statements in connection

with his or her audit of a subsequent period and if the predecessor auditor also

reissues his or her report on the prior-period financial statements. It also is

appropriate for the successor auditor to emphasize in the report that he or she

was not engaged to audit, review, or apply any procedures to the prior-period

financial statements other than with respect to the adjustments.

The following are examples of a paragraph the successor auditor may include in

his or her report on the audit of the financial statements of a subsequent period:

Example for retrospective application of a change in

accounting

We also have audited the adjustments to the 20X4 financial

statements to retrospectively apply the change in accounting

In addition, the successor auditor has responsibilities under paragraphs

.21-.22 of AU sec. 315, Communications Between Predecessor and Successor

Auditors, when the successor auditor becomes aware of information that leads him or

her to believe that the prior-period financial statements reported on by the predecessor

auditor may require revision.

STAFF QUESTIONS & ANSWERS

Adjustments to Prior-Period Financial

Statements Audited by a Predecessor Auditor

June 9, 2006

Page 7 of 12

[describe accounting change], as described in Note X. In our

opinion, such adjustments are appropriate and have been properly

applied. We were not engaged to audit, review, or apply any

procedures to the 20X4 financial statements of the Company other

than with respect to the adjustments and, accordingly, we do not

express an opinion or any other form of assurance on the 20X4

financial statements taken as a whole.

Example for correction of an error

We also have audited the adjustments described in Note X that

were applied to restate the 20X4 financial statements to correct an

error. In our opinion, such adjustments are appropriate and have

been properly applied. We were not engaged to audit, review, or

apply any procedures to the 20X4 financial statements of the

Company other than with respect to the adjustments and,

accordingly, we do not express an opinion or any other form of

assurance on the 20X4 financial statements taken as a whole.

Q6. When a successor auditor audits and reports on adjustments made to prior-

period financial statements due to the correction of an error, may the predecessor

auditor reissue his or her report on the prior-period financial statements?

A6. Yes. A predecessor auditor may reissue his or her report on prior-period

financial statements when a successor auditor has been engaged to audit and

report on adjustments made to those prior-period financial statements, provided

that the predecessor auditor has determined that the report on those financial

statements is still appropriate, other than with respect to the error correction.

10/

When determining whether the report is still appropriate, the predecessor auditor

may consider factors such as:

See AU sec. 508.71. The predecessor auditor also may decide to

withdraw his or her report on those financial statements. See

AU sec. 561, Subsequent

Discovery of Facts Existing at the Date of the Auditor's Report.

STAFF QUESTIONS & ANSWERS

Adjustments to Prior-Period Financial

Statements Audited by a Predecessor Auditor

June 9, 2006

Page 8 of 12

• The nature and extent of the adjustments pertaining to the error

correction,

• Whether management has withdrawn the prior-period financial

statements, and

• Whether the errors were intentional.

Q7. If the predecessor auditor does not reissue his or her report on the prior-period

financial statements, may the successor auditor reaudit and report on those financial

statements as adjusted?

A7. Yes. A successor auditor or another independent auditor may reaudit and

report on prior-period financial statements as adjusted.

Q8. In circumstances in which a successor auditor audits and reports on adjustments

made to prior-period financial statements audited by a predecessor auditor, what

procedures should the predecessor auditor perform prior to reissuing his or her report

on those financial statements prior to adjustment?

A8. AU sec. 508.71 states that, "a predecessor auditor should (a) read the

financial statements of the current period, (b) compare the prior-period financial

statements that he or she reported on with the financial statements to be

presented for comparative purposes, and (c) obtain representation letters from

management of the former client and from the successor auditor. The

representation letter from management of the former client should state (a)

whether any information has come to management's attention that would cause

them to believe that any of the previous representations should be modified, and

(b) whether any events have occurred subsequent to the balance-sheet date of

the latest prior-period financial statements reported on by the predecessor

auditor that would require adjustment to or disclosure in those financial

statements [except for the adjustments]. The representation letter from the

successor auditor should state whether the successor's audit revealed any

matters that, in the successor's opinion, might have a material effect on, or

STAFF QUESTIONS & ANSWERS

Adjustments to Prior-Period Financial

Statements Audited by a Predecessor Auditor

June 9, 2006

Page 9 of 12

require disclosure in, the financial statements reported on by the predecessor

auditor [other than the adjustments disclosed to the predecessor auditor]."

Q9. In circumstances in which a successor auditor audits and reports on adjustments

made to prior-period financial statements audited by a predecessor auditor, are there

any modifications the predecessor auditor should make to his or her reissued report on

the prior-period financial statements?

A9. Yes. If the predecessor auditor was not engaged to audit the adjustments

to the prior-period financial statements, the predecessor auditor should modify

his or her reissued report to indicate that (a) the reissued opinion relates to the

prior-period financial statements before the effects of the adjustments, and (b) he

or she was not engaged to audit, review, or apply any procedures to the

adjustments.

The following are examples of how the predecessor auditor may modify his or

her report:

11/

Example for retrospective application of a change in

accounting

Report of Independent Registered Public Accounting Firm

We have audited, before the effects of the adjustments to

retrospectively apply the change in accounting described in Note X,

the balance sheet of ABC Company as of December 31, 20X4, and

the related statements of income, changes in shareholders' equity,

and cash flows for the year then ended (the 20X4 financial

statements before the effects of the adjustments discussed in Note

X are not presented herein). The 20X4 financial statements are the

responsibility of the company's management. Our responsibility is

to express an opinion on these financial statements based on our

audit.

11/

See PCAOB staff question no. 6.

STAFF QUESTIONS & ANSWERS

Adjustments to Prior-Period Financial

Statements Audited by a Predecessor Auditor

June 9, 2006

Page 10 of 12

[Same second paragraph as the standard report]

In our opinion, the 20X4 financial statements, before the effects of

the adjustments to retrospectively apply the change in accounting

described in Note X, present fairly, in all material respects, the

financial position of ABC Company as of December 31, 20X4, and

the results of its operations and its cash flows for the year then

ended in conformity with U.S. generally accepted accounting

principles.

We were not engaged to audit, review, or apply any procedures to

the adjustments to retrospectively apply the change in accounting

described in Note X and, accordingly, we do not express an opinion

or any other form of assurance about whether such adjustments

are appropriate and have been properly applied. Those

adjustments were audited by [name of successor auditor].

[Signature]

[City and State or Country]

[Original Date]

Example for correction of an error

Report of Independent Registered Public Accounting Firm

We have audited, before the effects of the adjustments for the

correction of the error described in Note X, the balance sheet of

ABC Company as of December 31, 20X4, and the related

statements of income, changes in shareholders' equity, and cash

flows for the year then ended (the 20X4 financial statements before

the effects of the adjustments discussed in Note X [have been

withdrawn and] are not presented herein). The 20X4 financial

statements are the responsibility of the company's management.

STAFF QUESTIONS & ANSWERS

Adjustments to Prior-Period Financial

Statements Audited by a Predecessor Auditor

June 9, 2006

Page 11 of 12

Our responsibility is to express an opinion on these financial

statements based on our audit.

[Same second paragraph as the standard report]

In our opinion, except for the error described in Note X, the 20X4

financial statements present fairly, in all material respects, the

financial position of ABC Company as of December 31, 20X4, and

the results of its operations and its cash flows for the year then

ended in conformity with U.S. generally accepted accounting

principles.

We were not engaged to audit, review, or apply any procedures to

the adjustments for the correction of the error described in Note X

and, accordingly, we do not express an opinion or any other form of

assurance about whether such adjustments are appropriate and

have been properly applied. Those adjustments were audited by

[name of successor auditor].

[Signature]

[City and State or Country]

[Original Date]

Q10. When a successor auditor audits and reports on adjustments made to prior-

period financial statements audited by a predecessor auditor, how should the

predecessor auditor date his or her report on the reissued financial statements?

A10. When the successor auditor has audited and reported on the adjustments

made to the prior-period financial statements and the predecessor auditor is

reissuing the report on the prior-period financial statements, the predecessor

STAFF QUESTIONS & ANSWERS

Adjustments to Prior-Period Financial

Statements Audited by a Predecessor Auditor

June 9, 2006

Page 12 of 12

auditor should use the date of the previous report to avoid any implication that he

or she has examined any records, transactions, or events after that date.

12/

Successor Auditor Has Not Completed an Audit

Q11. Can a successor auditor audit and report on the adjustments made to the prior-

period financial statements if he or she has not yet completed an audit of the current-

period financial statements?

A11. No. If the prior-period financial statements have been adjusted, the

successor auditor may audit and report on the adjustments made to the prior-

period financial statements in connection with the successor auditor's audit of the

financial statements of the company for a subsequent period.

13/

Unless the

successor auditor has completed an audit of the financial statements of the

company, he or she will not have sufficient knowledge of the company and its

financial reporting to adequately plan and perform an audit of the adjustments to

conclude on whether they are appropriate and have been properly applied. If the

successor auditor has not completed an audit of a subsequent period, the

successor auditor, or another independent auditor, may be engaged to reaudit

the prior-period financial statements and audit the adjustments to those financial

statements.

12/

See AU sec. 508.73.

13/

See AU sec. 508.74.