* unqualified opinion, assuming beginning inventory is immaterial;

* unqualified opinion based on alternative procedures;

* unqualified opinion on the balance sheet only;

* unqualified opinion on the balance sheet and a qualified or disclaimer of opinion on other statements; or

* unqualified opinion on the balance sheet with a review report on other statements.

Unqualified Opinion Based on Materiality

If the beginning inventory is immaterial to the income statement, the issuance of an unqualified opinion on the basic financial statements taken as a whole is appropriate. Of course, under GAAS, if the inventory is material, an unqualified opinion is appropriate only when warranted by alternative procedures that would provide sufficient, competent evidential matter.

Unqualified Opinion Based on Alternative Procedures

If the beginning inventory is material, the first option is eliminated. In this case, the beginning inventory number must be supported. Since it is physically impossible to observe the beginning inventory, the auditor must conduct alternative procedures to support beginning inventory in place of the observation of physical inventory. According to SAS No. 1 (AU 331.13), an independent auditor may "be able to become satisfied as to such prior inventories through appropriate procedures ... provided that he or she has been able to become satisfied as to the current inventory." Appropriate procedures include, but are not limited to, tests of prior transactions, review of prior inventory counts and inventory instructions, performance of gross profit tests, and client inquiries. Additional matters to consider are familiarity with the client, length of association, and prior years' inventory balances. If sufficient evidence is obtained regarding the beginning inventory, the auditor may appropriately issue an unqualified opinion on all the financial statements.

Unqualified Opinion on Balance Sheet Only

Another alternative some CPAs have considered in such situations is to perform an audit of the balance sheet while treating other statements as accompanying information. However, according to SAS No. 1 (AU 504.01), the fourth standard of reporting requires the report of the auditor to "contain an expression of opinion regarding the financial statements, taken as a whole." The wording "taken as a whole" indicates the opinion expressed by the auditor encompasses all financial statements.

Supporting this interpretation of taken as a whole, SAS No. 29 (AU 551) addresses information accompanying the basic financial statements. The statement defines the basic financial statements to include the balance sheet, income statement, statement of retained earnings or changes in stockholders' equity, and statement of cash flows. Accompanying information is information not required to conform with GAAP that is presented in addition to the basic financial statements. SAS No. 29 states that a "report should state that the accompanying information is presented for purposes of additional analysis and is not a required part of the basic Financial statements." Therefore, information concerning operations and cash flows should be presented in basic financial statement format, not as accompanying information. It would be possible to express an unqualified opinion if just the balance sheet is presented.

Unqualified Opinion on the Balance Sheet and a Qualified or Disclaimer of Opinion on Other Statements

If an auditor cannot be satisfied with beginning inventory by means of alternative procedures, according to SAS No. 58 (AU 508.42), the auditor "should decide whether he has examined sufficient, competent evidential matter to permit him to express an unqualified or qualified opinion, or whether he should disclaim an opinion." In such a qualification, the auditor's report should contain a paragraph preceding the opinion paragraph that describes the reasons for the qualification, and the scope and opinion paragraph should be appropriately modified. In the final paragraph, the auditor should then issue an unqualified opinion on the balance sheet and a qualified or disclaimer of opinion on the other statements. The exhibit illustrates one such report. However, the client may lind this option undesirable. To minimize this conflict between the CPA and the client, the auditor may consider one other option before issuing a qualified opinion or disclaimer of opinion on the other statements.

Audit of the Balance Sheet and Review of Other Statements

A final option for nonpublic companies involves auditing and expressing an opinion on the balance sheet while issuing a review report on the other statements. Although this type of split level of service is uncommon, it is not prohibited by any authoritative literature. Instead of a qualified opinion or disclaimer of opinion necessitated by a possible misstatement of operations and cash flows due to the beginning inventory, an auditor could express an unqualified opinion on the balance sheet alone. The accountant would review the other statements and include such review in a separate report. For both reports, the auditor should follow the guidelines set forth in authoritative professional standards.

RELATED ARTICLE: EXHIBIT

INDEPENDENT AUDITOR'S REPORT

To The Board of Directors:

We were engaged to audit the accompanying balance sheet of X Company as of December 31, 1994, and the related statements of income, retained earnings, and cash flows for the year then ended. These 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.

Except as explained in the following paragraph, we conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform our audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. 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 audit provides a reasonable basis for our opinion.

We did not observe the taking of the physical inventory as of December 31, 1993, since that date was prior to our appointment as auditors for the Company, and we were unable to satisfy ourselves regarding inventory quantities by means of other auditing procedures. The inventory amount as of December 31, 1993, entered into the determination of operations and cash flows for the year ended December 31, 1994.

Because of the matter discussed in the preceding paragraph, the scope of our work was not sufficient to enable us to express, and we do not express, an opinion on the results of operations and cash flows for the year ended December 31, 1994.

In our opinion, the balance sheet of ABC Company as of December 31, 1994, presents fairly, in all material respects, the financial position of ABC Company as of December 31, 1994, in conformity with generally accepted accounting principles.

February 1, 1995

Your Independent Auditor

C. Wayne Alderman, PhD, CPA, is Dean of the College of Business at Auburn University. Norman H. Godwin, CPA, is a doctoral candidate at Michigan State University.